Bond Market

1. The bond market remains in a cyclical bear phase.

2. Note, however, that the long Treasury is now significantly
oversold. The chart of the $USB shows o/s on RSI and the stochastic, but observe as well how far the price is below its 200 day m/a.

3. To view the long Treasury yield in longer term perspective, click here.
The bond yield is moving up to test long term downtrend lines. Over the
past two decades, the tests have provided excellent buying opportunities.

4. The market is approaching an important crossroads. If the current
cyclical bear phase in the yield remains intact, the downtrend lines
may well be violated and this would be a prima facie warning that the
long term bull market in bonds could be coming to an end.

5. Since the current economic expansion began, the bond market has been
sensitive to the trend of commodity industrial raw materials prices and
less so to the CPI and energy feedstock prices. Spot industrials
remain in an uptrend, but have moderated recently. Even so, the bond
market has been weakening, suggesting a broadening out of focus,
perhaps to include the oil price as well as ongoing moderate economic
expansion in the face of rising short rates.

6. One continuing concern I have regarding the bond market is the
possibility that once the Fed is done raising rates, the FFR%
could be kept at a plateau level, as the economy might well
continue to expand with growth of economic demand and supply rounding
into decent balance. I suspect that in such an environment, players
might opt to put some risk premium back into bond yields.

7. I have stayed away from the bond market for the past year, primarily
because I think it is overvalued, with too little premium in Treasury
yields to reflect interest rate risk, supply risk and future long
term inflation potential.

8. If the market does show signs of bouncing from the current oversold
condition, I might go long for a fast trade, but that would be it.

Inflation Picture

For me, the primary stimulants of inflation are commodities
prices and a range of key cyclical sector operating rates.
My inflation stimulus pressure gauge is essentially flat
for the past six months, suggesting little forward momentum
for inflation. As I have argued, the "core" inflation rate,
or inflation excluding volatile commodities such as energy
and foodstuffs, is overdue to show some acceleration following
the dramatic run-up in fuels prices in recent years. Nevertheless,
the inflation vanguard has slowed. Moreover, productive capacity
overall is beginning to grow a little faster.

The inflation pressure gauge remains on a high plateau, and
the recent positive bounce in oil and refined products is
putting a little stress on the financial markets. Iran, with
help from an equally belligerent Bush admin. is doing a swell
job of kiting the oil price and keeping traders in the game.
There is plenty of supply, but an abundance of fear as well,
and traders are thankful as it is keeping the oil price
up ahead of the forthcoming US hurricane season. After the
last two years, you can bet that weather.com will get a big
play as the air warms in July and August.

There is even a growing buzz on the web that the US is planning
to try and take out Iran's nuclear capacity. Understandable
given the Bush Doctrine of pre-emptive strikes when He spots
peril. And there's the low approval rating, too. Patriotism
as the last refuge of a scoundrel and all that.

Interesting stuff all, but at quite an advance to the economics
on the ground. There is a message here too for the Fed as well,
which is not to overreact to the powerful scarcity fear psychology
gripping the petrol sector.

The FOMC Decision on Short Rates

The first FOMC policy meeting under new chair Bernanke is
winding up over lunch, and their decision on rates etc. will
be announced in a couple of hours.

Most everyone out there is looking for business as usual --
a 25 basis point hike in the FFR%. Since the Fed also has a
God given right not to be psychoanalyzed, I would not presume
to say what the gang will come up with.

The customary cyclical fundamentals that are usually front
and center for the Fed are vibrant enough -- broad cyclical
expansion, rising operating rates and strong and rising
short term credit demand. there's enough rolling out there
to support a FFR% of 5.00 - 5.25% in my view, and we should
have been there already, save for Uncle Al's baby step policy
inclination.

The Fed has eased on the liquidity front since this past
autumn, but not enough to signal a policy change.

The one item in the usual mix that is of interest to me is
the mild acceleration underway in the growth of production
capacity. Over the past several months, yr/yr capacity
growth has moved up from a paltry 1.1% to near 2.0%.
The longer term trend seems to be turning up and this is
very important because, should it continue, production
supply / demand growth will come into much better balance,
and this will undercut inflation stimulus within the system.

I am hoping that Benny The Banker will step right up and
put his fingerprints all over the FOMC decision and
consequent statement rather than toodle along like a Greenspan
acolyte. We'll all see shortly.

Gold -- Not For A Cheapskate Like Me

Well, there it is, trading in a range of $550-560 oz.
Some of the pundits tell me $600 is the next stop on
a glorious upward ride. Wow, and here I am thinking
that I could eke out a decent case for gold at $450
oz. based on commercial demand / supply/ extraction
costs. I even thought it would sell off sharply over
the first four or five months of 2006. I know there
are concerns that oil supplies could be disrupted, but
when I look at that market, I can make out a good case
for oil at $40-50 bl., not $60+. No comfort there either.
looks like the same guys are in that market, too.

When I look at the gold charts, I see a sitting duck,
with intermediate term weekly MACD rolling over from very
high levels, yr/yr price momentum very high, Wilder
ADX closing in favor of internal supply. But, a
big drop has not come.

So, for now, I am consigning gold to the "out of my
league" category, to be dusted off periodically.

I do get a kick out of the gold bug websites. Not
even the more voracious Wall Street Bankers can touch
these guys for hucksterism.

A Little Trouble In Big China

China is averaging about 200 protests / riots a day.
This is not spontaneous. China's political left is
recovering after years of quiet.

Well paid workers in the eastern part of China are
leaving their country cousins in the dust. Plus,
the new running dogs of capitalism are turning the
country into an environmental cesspool and are
swiping turf the peasants once claimed.

Leader Hu has spoken of developing a "golden harmony"
that brings the 800 million Chinese who are not
sharing in China's economic development into the tent.
A very tall order.

As the NY Times reported today, the Chinese left is
starting to get its voice back, sounding strong
criticism of the country's growing imbalances in
the wake of its economic development.

Hu now has to straddle the fatcats and the peasants'
slow burn which is heating up steadily. This guy is
going to be tested right down to his new Ferragamo's.

Beijing hosts the 2008 summer Olympiad. This is planned
as Beijing's coming out party as a world capital. Losing
face in China is bad business, so 2008 should be a quiet year.
But the left will be pressuring hard for goodies through
2007.

The Chinese excel in traumatic political upheaval, and now
that the old commies are hooking up with the peasants, the
small trouble in China may well become very big trouble in the
years ahead if China fails to rapidly shift its focus from
the fatcats ball to the downtrodden.

Just one more thing that's going to heat up in the years ahead.

The US Trade Account

The LDCs and the weaker OPEC countries experienced economic
depression in the early 1980s as oil and other commodity
prices collapsed. It was a stock Kondratieff downwave that
was eclipsed from going fully global by timely major
central bank intervention, large US income tax cuts and a
relaxing of regulations regarding the writeoffs of non-
performing LDC/OPEC credits.

The US had been the lender of last resort. Now it had to
become the buyer of last resort to stave off spreading depression.
The original global rescue plan called for three locomotives to
pull the world back from the abyss: The US, Germany and Japan.
Between 1983-87, Germany and Japan welched on the deal, leaving
the US to carry the load. The strong US $ policy of 1980-85
did the trick, but the US began to run a deep trade deficit.
A weak US $ from 1985-95 reversed this situation, and by 1991-
92, the US was running a modest surplus on current account.

Powerful US economic fundamentals over 1995-2000 produced a
dramatic rally in the dollar which actually ran until 2002.
At first, both imports and US exports were strong, but export
growth faded and the trade gap again accelerated. Moreover,
it continued to grow rapidly even as the dollar tumbled from
2002-2005. The elixir to eliminate the current account deficit,
namely a weak US $, failed. Many exporters, China notably and
much of the rest of East Asia tied their currencies to the dollar,
while Europe and Canada gave up profit margin to maintain market
share.

Strong US interest in "free" trade has a long term objective.
We know as the massive baby boomer cohort passes into the
retirement years, US consumer purchasing power will moderate
very substantially. The hope is that exports will pick up
a fair portion of that slack and that countries like China
and India will eventually focus on growing their own
consumer economies.

All the countries who export to the US know that the consumer
will soon be past his prime, spending wise, and it is
Katy bar the door to sell as much into the US as they can
before demand slackens.

Only time will tell whether our policy aim will prove effective.
However, it seems to me that the next 5-7 years are going to be
difficult and risky on the trade front. Big US companies like
Dell and The Gap have large offshore production which they
distribute here. So the open market concept benefits many major
US companies. But smaller companies -- the backbone of US job
creation -- will be at increased risk as more niche markets
come under attack from abroad. On the flip side, the US is
exporting $ liquidity to the tune of nearly $800 billion a year.
Foreign currency reserves are ballooning, and the risk of
all manner of speculative excess abroad is rising rapidly.
Japan went bananas with this liquidity in its real estate and
stock markets in the 1980s and it has only been recently that
it has regained a comfortable degree of equilibrium.

When an exporter to the US locks its currency to the dollar,
it is engaging in a form of mercantilism. The US should
hammer China and the other bandits that are keeping
currencies artificially low. But it has chosen to let it all
happen so large US corporate and banking interests can prosper
abroad. This is a dumb policy that will hurt smaller
domestic interests as well as the overconfident foreign
treasurers who think they can manage mushrooming liquidity
with ease.

So we have to keep eyes on the trade sector, particularly
throughout developing Asia as the central banks out there
have yet to show their mettle.

The more one watches major US business interests, the more one
is reminded of Ike's admonition to watch that military / industrial
complex.

Stock Market -- Fundamental

S&P 500: 1274

I use three different fundamentals - based models to track
the SP500. All imply that from an empirical perspective the
S&P is reasonably valued in the range of 1280 - 1300. I
do not put too much stock in the predictive value of any
of these approaches, but use them more as a diagnostic
reference. Even then, I would not make too much out of
divergences until they exceeded 6% or so. For me, the market
looks reasonable enough now.

To summarize the output of the models, the market's rally since
this past autumn reflects a continuation of above average
earnings growth and an expanding p/e ratio to reflect a moderation
of inflation pressure which in turn has been supported by a
moderate easing of liquidity policy by the Fed as well as
continued good growth of the SP500 dividend. The key changes in
the mix since last October or so have been a step up in the
growth of the monetary base and a reduction of inflation pressure
stemming from lower fuels prices.

The risk premium of the market (earnings/price yield - 91 day T-Bill
yield) is continuing to shrink from once very high levels. Thus,
risk continues to rise, and it will be interesting to see how
the market holds up if the Fed tacks on another 50 basis points
to the FFR% over the next few months. Could be a character builder
for investors.

Yield Curve Inversion

The yield curve inverts when short maturities sport yields
above those of longer dated maturities. We have seen yield
curve inversion in the US Treasury market on a day to day
basis since late in 2005.

Historically, an inverted yield curve has been a good
indicator of an impending sharp economic slowdown or
even recession. That's because yield curve inversion is
normally a symptom of either a liquidity squeeze or a
developing credit crunch wherein banks severely restrict
shorter term lending.

We have no squeeze or crunch now. Far from it. The
broad money aggregate M-3 is up 8.4% yr/yr, commercial
and industrial loans are up 15.5% yr/yr and trending higher,
and real estate loans continue to grow. In fact, the
financial sector is generating excess liquidity
now, or more liquidity than the economy actually needs.

Now, if the Fed Funds rate gets put up above 5.25% I'd wager
that banks will begin to take notice, and may well begin to start
to ration credit modestly. M-3 growth would slow because
funding requirements would slow, and the economy would
enter the very early stage of a liquidity squeeze. Bond
yields could even go lower in such an environment because
bond players would begin to anticipate eventual recession,
lower inflation and a flight to quality.

I'm strictly guessing the Fed may cut off the push on the
FFR at 5.0-5.25% in the months ahead, up from the current
4.5% posting. I doubt the Fed wants to become a centerpiece
political issue in a critical off-election year such as is
2006.

What might be of interest is how the bond market behaves
if the Fed goes to a FFR 5.0% and signals it may well
stay there for a while. That might send bond yields
sharply higher since some players would likely conclude
they may as well shorten maturities.

Note as well that following Uncle Al's silly roller coaster
ride with Fed credit post-Katrina, the FOMC is again adding
to holdongs, thereby signalling another bit of easing.

Inflation Situation

Advance inflation indicators have dropped off during
February, notwithstanding today's short squeeze on the
price of crude following reports of an aborted attack on
the Saudis' largest production facility. With crude
supplies on an upswing, pricing may ease further in the days
ahead. Crude producers and pit traders are doing their best
to try and kite the price, particularly Iran and the world's
newest tin horn dictator, Venezuela's Chavez.

The longer term advance inflation indicators remain in an
uptrend and this is a continued concern. I do not for one
minute buy into the differentiation between "headline"
inflation and the popular "core" rate. No one who shops
for all the goodies we need can help but notice that the
"core" rate is going up, too. But, you cannot ignore it
since the bond and currency traders are among the official
"core" rate "believers."

Stock Market And Monetary Liquidity

The stock market has been sensitive to changes in the
levels of Fed Credit and the Adjusted Monetary Base (AMB)
since mid-2003. This has been so because traders have
taken to monitoring The Federal Open Market Commitee's
doings carefully as the economy has expanded to glean
changes in monetary policy. The Fed has tightened up
gradually on liquidity since late 2003, and took a
tough line in 2005, until Katrina etc. forced it to
ease up some. The periodic increases to Fed Credit
via reserve injection have led stock and gold traders
particularly to celebrate. Each stock market rally
since Half 2 '04 has been triggered off by FOMC
Treasuries purchases which have quickly showed up in
the AMB.

It is too early to tell yet whether the Fed will extend
the moderate net easing of recent months, although
seasonal factors mitigate against it. Moreover, traders
should note that the stock market is about as extended
as it has been against the trend of the AMB since traders
jumped on the monitoring program after late 2003. Fed
Credit and the AMB do go out of favor as key variables
from time to time, but traders should keep them in mind
now, since the inclination to determine an interim top
in market short rates is running strong at present.

Well, with this piece, I am content to leave the monetary
data alone for a few weeks to look over some other stuff.

Monetary Policy Issues

The rapid drop in commodities price composites since
the end of 1/06 almost broke the longer term uptrend
in place. But, as this week wanders to a close, the
basic fuels group has been able to stabilize, thus
holding the positive edge for the broader composites.

Now since the acceleration of inflation in recent years
has been driven by commodities and oil and gas in
particular, new Fed chair Bernanke will be watching the
action here with special attention. For example, if
fuels remain stable, the threat of accelerating
inflation will begin to wither as there is still goodly
excess productive capacity in the entire US system.
Such a development would leave the Fed room to stop
raising short rates after another couple of boosts.

So it is heads up time for investors and traders, since
for example, the KR-CRB Commodities Index ($CRB) is
once again right down on trend support. Just keep in
mind what a devilish issue this is, since the CRB has
continually held and rebounded off trend support in
each of the past five years. So, a break and hold below
support would be a big deal for macro policy.

As all know, the US economy absorbed some heavy shocks
over the last four months of 2005, with real GDP dropping
to a puny 1.1% AR in the final quarter of the year. In
response Uncle Al had the FOMC spike the punch bowl with
a full quart of 100 proof rum late in the year. That
plus milder winter weather produced a strong January,
leading FOMC to quickly dilute the bowl by blowing out
about $20 billion in Treasuries from its portfolio.
On balance, the advance liquidity measures such as
Fed Credit and the Adjusted Monetary Base now have a
slightly positive bias, with the leader -- Fed Credit --
now stabilizing after a patented Greenspan roller
coaster ride. Bottom line, if the CRB et al take
a stable path, the Fed may slowly ladle more punch
into the bowl even as it raises short rates and talks
tough.

As discussed a week or two back, the cyclical case
for raising rates somewhat higher remains in place for
now. With Katrina relief and more defense spending
expected to produce a larger budget deficit this year,
It is doubtful the Fed will unrelievedly raise rates.
At some point, revenues would slow or crack, and then
there would be a fine mess. A politically astute Fed
chief would likely cut off pushing up rates well
enough ahead of this very important off-year election
to keep the Fed out of the headlines and the line of
fire. Again, a more gentle movement in commodities
prices would be a boon to Bernanke.

BB did field inquiries at the HH hearings about the
Fed's decision to stop reporting M-3 data. He
politely gave the lame excuse about bankers' complaints
regarding costs they must absorb to gather and submit
the data. By this subtrefuge, Bernanke buys time to
study over what should be done about Greenspan's
foolhardy decision to cede so much of Fed control over
reserves back in 1992 in exchange for having commercial
banks take on much of the burden of the splintered S&L
industry.

M-3 has been zipping along at a 10.8% AR over the past
six months. The liquidity cycle is credit driven and
not monetary driven. In fact, there has been enough
excess liquidity not only to fuel housing prices, but
fuels prices as well! (Glad you are gone Al.) The M-3
phenom keeps the economy and profits rolling, but it
has impaired the Fed's ability to slow inflation. This
issue can play hob with policy, and it will be a good
test of Bernanke's courage and ingenuity as well.

Stock Market -- Technical

S&P500: 1275

Well, the market has rallied a little off the 1260 level
of the recent post, as anticipated. As well, I have not
tried to play it, either.

When trading a bull market, I like to go long on deep
oversolds with a significant $ commitment. No such
event occured this time. In fact, when I look at the
broader market viewed weekly, to include small and mid
caps, I see a market that's still overbought when put on
an equal $ dollar weighted basis. The same holds true for the
cumulative NYSE A/D line. So, I am on the sideline for
now.

I keep a proprietary index of the cumulative NYSE A/D line
which I adjust econometrically for the daily TRIN. I feel
it gives me a good picture of internal supply and demand.
Like most of the indices, the proprietary one also features
an ascending triangle, with the base extending back to the
July, 2004 lows. Advancing this triangle gives me an apex
in April, 2006, which will automatically close this chapter
of the market's more recent history. I see that as an
important heads up for all as it may well be make or break time
for 2006.

Stock Market -- Brief Technical Note

S&P500:1260

The S&P caught bids today off a mild oversold and at short term support.
I have passed on it. Looking at the broad market, there are still
too many stocks that are extended on the upside. The S&P fell a
little short of my Jan. 2006 target of 1310, but the broader market was
lit up pretty well in the latter part of the past month, and the
consequent pullback leaves too many stocks still hanging high. So
as a guess and as a conservative gesture, I am not putting on any
long trades just yet.

Economic Indicators

Leading indicator sets are pointing to an acceleration of
economic growth a little down the road.

Dollar order rates have been bouyant in recent months, but
there is upward bias there reflecting sharp increases for
commercial aircraft.

Breadth of new orders for businesses remains in a downtrend,
but the readings are still nicely positive nonetheless.
Although housing has been the media headliner, manufacturing
and service sector order rates were tremendously strong in
late 2003 - early 2004. Understandably, these sectors have
lost zip, but continue to signal moderate growth ahead.

Sensitive materials prices are trending up and unemployment
insurance claims are low and trending down.

One worrisome element remains the real or inflation adjusted
wage. It is not growing. Business is pocketing the income
gains from productivity and not sharing with the labor force.
Continuation of this trend for an extended period will backfire,
leading to lower returns on capital.

Monetary Update

The Fed is widely expected to increase the FFR% tomorrow.
The cyclical fundamentals support an increase, with
the economy, capacity utilization, short term credit demand
and sensitive commodities prices all trending up. The Fed
remains about 75 basis points behind the curve suggested
by the underlying trend of the CPI (5.0% FFR implicit).

In the wake of the hurricanes and the resulting surge of
fuel prices, the Fed moved aggressively to liquify the system
through the holidays. Fed system credit surged by $43 bil.
or a sizable 5.4% over the final four months of '05 through
the new year.

As discussed in prior posts, such injections of liquidity can
be bullish for gold and bearish for the US dollar. Such was
the case this time as well. Note though, that the Fed has been
draining liquidity rapidly so far in 2006, already shrinking its
portfolio of Govs. and RPs by over $20 bil. This development
puts dollar fundamentals back on a firm positive footing and
leaves the gold bugs having to search around for another reason
to add to their piles.

All players will read the Fed's comments tomorrow with great interest.
Buttressed by knowledge of Fed liquidity injections, analysts and
pundits elected to put a very positive spin on the commentary
attending the 12/05 FFR% hike. With liquidity now being drained,
the appraisals of tomorrow's linguistic tealeaves may be more
sober.

Stock Market -- What Am I Smoking?

SP 500: 1267

Well, here I sit. Feeling like an old Wall Street tout.
The fundamental work I do implies 2006 will be an ok year
for the stock market, with the SP 500 closing out the
year around 1385 - 1405 for a gain in the range of 11 to
13%. I have also been fiddling around with business cycles
in terms of confidence, and this bit of experimental thinking
suggests 2006 will see the US at least with a sunnier
disposition.

The keys to what I suspect is an utterly mundane consensus
view are as follows: Moderate 7% topline sales growth, further
expansion of profit margins, increased share buybacks and an
inflation picture, which, while volatile, will wind up the year
at around 3.5% (CPI).

I am well aware of the of the four year cycle of important
bottoms in the market, and by my calculations -- based upon
SP 500 data going back through 1872 -- a typical or average
significant price low could come in the Jun / Jul interval
of this year. A number of well regarded chartists and
technicians are factoring in a substantial sell-off this
year with the Mar / Oct period common. May be, but my
reads of the fundamentals do not now support this view.

However, when I look at 2007, I see a rather negative picture
developing, with inflation pressure intensifying as the
economy closes in on effective capacity. In fact, I now
see 2007 as a down year for the market which could only be
rescued by a strong surge of capacity expansion to balance
off the growth of demand.

I also use a couple of models based on Federal Reserve Credit
and the Adjusted Monetary base. These models correctly forecast a
dull and minor advance in 2005, but have recently turned a little
rosier.

I use this little exercise as the basis for a game plan for the
year and then track the market and the key fundamentals against
it. I play close attention to the deviations in actual from
expected, because they are often the kernels of opportunity.

Katrina On The Installment Plan

Systems here have been down since the last post on Jan. 18. Following nearly 18
inches of rain in October in this area, we've had one 11" snow and several major rain storms, including a doozy this Wednesday with winds topping 70 mph. The 'net
cable connection went down with the power, McAfee slipped a disc and took out
operating system directives. So, we had to rebuild and reboot in the bargain.

This was the week I had expected the S&P500 to top out at 1310. It made 1296 just a short while back, but with Iran carefully kiting the oil price, the jitters set in.
That combined with tech earnings shortfalls certainly ended the March over 1300. The
more conservative guidance from the tech sector was also largely unanticipated.

It was a good run up from late October, with nice trades for all heads up players.
I plan to reconnoiter for a week or so since the short term play to the upside over
the last three months is certainly suspect as of today.

Stock Market -- Short Term Technical

SP 500: 1273

As discussed in a brief technical note on 12/12/05, I have been looking
for this market to pop further to the upside, with the SP 500 projected
to move up to 1310 by mid to latter January.

My view has been that the price momentum and breadth compression witnessed
from 6/05 through early October was rather unusual and that a breakout - be
it up or down - should be powerful and time compressed into a three month
frame. The market did break out of the tight period to the upside, with the
SP 500 moving quickly from 1178 0n 10/20 up to 1265 on 12/2. It then meandered
up to 1273 on 12/14, and then entered a well deserved back and fill period
until yesterday. In the two trading days of '06, we have seen a move from 1248
up to 1273.

For the coiled spring to pop fully, the SP 500, which has been bumping up
against well observed trend resistance in place since 3/04 on every technician's
chart, really needs to get a move on. Players seem to be involved in a game of
"Alphonse and Gaston" -- You go first; No, you go first, with many waiting
patiently for the other guys to run the market up decisively through resistance.

The clock is running on my gambit and if the market does not pop up strongly
over the next week or two, I will have to head back to the drawing board.

Santa Stopped For Oil Instead

The rally in oil off recent support just above $56 bl. to a tad over
$61 sets the stage for an important January for both the economy and
the markets. $61 bl. is no threat, but if this yearend upmove in oil
is the precursor to a strong seasonal rally, it will force some rethinking.
It has been my view for several months that the behavoir of fuels in
this first month of the new year will be important in casting Fed policy
and in setting confidence levels for a decent portion of 2006.

HAPPY NEW YEAR TO ALL.

Economy in 2006 -- Short Version

As we roll toward '06, the inflation indicator for the short term is signalling
a continuing though less dramatic moderation than the Oct./Nov. period. This is
critical because with wage growth now up to 3.0% yr/yr, the real wage can recover a little. This sets the direction for consumer spending. I also believe housing activity
was shocked by the turmoil of the hurricanes and the spikes in fuels cost. Much
higher heating bills need to be taken into account. Even so, housing should recover
but progress will be modest. There is clear evidence of lost business sales, production
and employment in the wake of the storms. The hits were smaller than I thought they would
be, but bounceback potential is there for early in the year and release of nearly $70
billion hurricane damage relief will be a plus too. Overall the safest bet is to look for growth to accelerate off a flattish final quarter of 2005 and move nicely ahead into mid-year. There may be a slow quarter then, but I look for the year to finish out very strongly
because companies are going to have to begin to add some bricks/mortar capacity by then.
I am more concerned about 2007. Demand is outstripping capacity growth in the US, and
unless capacity grows markedly, the economy will begin to overheat. Profit growth in '06 should stay near 10%, although oil industry profit contributions could slip some as the year rolls on.

My biggest concern is with the continuing profound inflation in fuels costs. We are in a
seasonally quiet period now. Nat. gas is nearly $5 per mcf off its post Katrina/Rita peak
and oil is down $10. to $60 per bl. These are disappointing declines and leave me concerned
as we move into heating season. There is a decent consensus oil will average $54-55 a bl
next year. Devoutly to be wished for at this point. One also has to carefully monitor basic
grain and food commodities. These remain depressed and appear woefully overdue for some
positive price action.

My short rate cyclical indicators point to continued firming by the Fed ahead. Certain key
ones, such as the ISM manufacturing diffusion index have been far too strong to prompt a
let up. Moreover, with 3.0% inflation readings at several points this year, the Fed has no
business keeping short rates so low if they wish to see people begin to rebuild liquid savings.

As I have discussed in several prior posts, banks have been switching to offering jumbo
no or low reserve deposits to counteract Fed pressure on regular reserves. M-3 growth
has accelerated substantially to over 8% yr/yr. Not only will M-3 fund economic expansion,
it is well more than the real economy needs and will flow either into price or asset inflation. Uncle Al has the bubble machine on again, the old fool.

I plan to talk about the stock market in the next post or two. Many market prognosticators, mindful of the four year cycle low (year two of the presidential cycle) are jumping through hoops to find a basis for a hefty sell-off in 2006. As of now, I do not see it, but I have reserved one for 2007.

In all, if commodities do not run roughshod to the upside, it could be a decent year for
the economy/

Interest Rate Scorecard

The comparisons discussed below are based on super long term rgression
models built around the 12 mo. moving average of the CPI.

With a CPI of 3.3%, the Fed Funds rate should be between 5.0 - 5.25%. The
Fed is bringing the FFR%, now at 4.25%, steadily higher, but it still
remains well short of where it should be. That short rates have been too
low for some time is well attested by a continued zero savings rate for
the consumer sector and the increased use of real estate based leveraging
techniques by same. To preserve domestic purchasing power, dollars saved
need to earn returns which greatly offset inflation and the income tax bite.
Homeowners have come to regard unrealized appreciation in home value as a
prime source of savings. This has been nice to have, but it is an unwise
practice since the great Baby Boomer housing boom is winding up to a close
now, and appreciation in home prices above the inflation rate will be ending.

By my models, the 30 yr Treasury should be trading around 6.375%. The market
is currently at 4.65%. The model value is a little high since Fed tightening
should lead toward a flattening of the yield curve, but, that said, The Bond
is still to dear in my view. There is insufficient premium for key long
term risk factors such as market volatility and a prospective rising supply
of new issues. I love trading the bond market but I have stayed away since
March, 2005 because I would prefer to trade bond volatility around fair value.

Bond Market

10 yr Treas: 4.46%
30 yr Treas: 4.66%

As we near 2006, cyclical conditions for the bond market are
both negative and volatile. In addition there remains a good sized
coterie of bond players trying to handicap an economic slowdown
and presumed deceleration of inflation pressure. I conclude the
market is in a mild cyclical upturn in yields which may also feature
more occasional spikes both up and down in yield levels.

That conclusion above was brief enough, but one could easily write
on and on about the many "ifs" and nuances and shadings that could
be added to fully flesh out an intriguing picture. I will content
myself with just a few brief remarks.

The markets are neither overbought nor oversold.

Bullish sentiment, as measured by Market Vane, is still positive
at around 60%, but is hardly excessive. the best buying opportunities
come along when this gauge is down around 30%.

There is much speculation that the yield curve could invert. An inversion
would carry substantial forecasting weight if it reflected tightening
credit conditions. But credit conditions are still easy -- there is no
liquidity squeeze.

There is also intense speculation about when the Fed will end its firming
up of the FFR%. If that happens to be, say 4.75%, it could well turn out
that the Fed may maintain that rate for quite some time, in which case
players will gradually realize they may as well shorten maturities.

Looking longer term, the great bull market in bonds is technically still
intact as yield remains in a downtrend. There is an extensive base building
under the downtrend which could be signaling that the bull is coming to
and end, but it is still too early to conclude same. For example, the
case for an end to the bull would be more compelling if the long Treasury
yield takes out 5.00% and then 5.25% this year. We've a ways to go before
we come to those bridges.

Monetary Policy

FF Rate: 4.25%

Cyclical factors that normally govern Federal Reserve policy actions
remain in firm uptrends and it is not difficult to posit another 25
basis point add on to the FF rate at the close of 01/06.

At this point, key factors such as manufacturing order rates and breadth
of same, factory operating rates and the balance between the supply of
loanable funds and short term loan demand all look positive going into
'06, but the momentum of these indicators may well slacken enough next
year to allow the Fed to call a temporary halt to pushing up the FF
rate after it reaches 4.75% or so. At this point, I do not see production
and loan demand growth as strong enough to warrant the Fed to move from
a newly minted "neutral" position to a squeeze.

The action of commodities prices in the seasonally strong winter months
will continue to rank high on the Fed's watchlist. The momentum of the
CRB commodities index has waned in recent months, but not by nearly enough
to give the Fed any comfort. Oil and natural gas prices in particular
remain sticky, and industrial commodities composites are moving higher
as well. The action in the trading pits over the next six weeks could
establish the FOMC meeting for late Jan. next year as pivotal.

I have been very confident about monetary policy and right on in my
thinking concerning same for nearly two years now. But, looking forward,
I find myself much more tentative and less assured about my projections
for rates and basic liquidity.

Stock Market -- Technical

S&P 500: 1260

I am impressed enough with the upwave in the market since October
to look for it to move higher, with the S&P 500 now expected to
rise to the 1310 area at some point well into January.

The move in the S&P from 1248 to 1268 over the week of 11/18 - 11/25
was a pleasant surprise but the sideways to down action since then
was not a surprise, as the market had become short term overbought as
indicated in the last technical comment on 11/19.

The impulse up during October and November was clearly strong enough
to warrant an extended consolidation, which could easily last another
week or two before we begin to run out of time in looking for a resumption
of the rally. I am also uncomfortable with the high degree of bullish
sentiment I see in the popular gauges such as Marketvane and Consensus,
so a brief continuation of the sideways/down bias might be in order
to reduce the head on this glass of beer.

If I have a more substantive bother, it would be in the intermarket
area where the charts for oil and the bond yield are no longer
so hospitable to stocks as during most of November. The tenacity of
oil around $60 has been a surprise as this is a seasonally weak period
for oil.

I plan to discuss the stock market more fully as we get a little bit
closer to 2006.

Gold Bugs Frothing At The Mouth

Boy, higher inflation this year and then Uncle Al says the Fed will
no longer publish M-3 after 3/26/06! Sacre Bleu! The Gold bugs see
a plot hatched to hide the inflationary ways of the central bank!
Get the women and children off the streets! Buy gold in a hurry they
declaim.

The best time to buy gold is late in the first quarter or in the second
quarter of the year when commercial demand is in a lull. Commercial demand
gets rolling later in the year to provide the metal for holiday gifts
in the West, and the wedding seasons in South Asia (India, Thailand etc.).
Gold can spike up late in the year on last minute commercial needs and
speculation of a sharp seasonal move up in the commodities markets.

I put Gold's commercial value at $440 per oz. under normal commercial
supply/demand conditions. At $493 an oz. now, it is well over what I would
want to pay for it as an inflation hedge speculation. Maybe I'll wait until
spring of 2006 and hope to pick up some below $450.

Stock Market -- Technical

The "Day of Atonement" rally half-facetiously anticipated in the
10/12 technical note came to pass right on time, putting an
exquisite but understandable squeeze on the bears just after the
market seemed to have broken down clearly. The Street simply
spent part of September accumulating stock to distribute it out
on the turn.

The market is clearly overbought short term and is slightly above
the top of the lengthy compression range in effect since June.
However, it did bounce convincingly up from long term support
(70 week M/A) and my internal supply/demand indicator shows an
overbought but sturdy advance.

The longer term price momentum indicators remain very anemic and
directionless and raise the question of whether the advance is but
a seasonal one that could meander into early January following a
correction at some point in the next week or two.

Key intermarket factors have been positive for stocks, notably a
rally in Treasuries and a weaker oil price. Reversals in these
sectors would probably undercut the enthusiasm for stocks.

For me, stronger readings on long term price momentum measures
are needed to warrant more than light exposure.

Stock Market -- More On The Profile

S&P 500: 1233

I wanted to discuss further some of the risk factors in the
stock market environment.

Liquidity leading indictors such as Federal Reserve Credit and
the adjusted monetary base (St. Louis Fed) remain very anemic in
growth. Not surprisingly, real money growth -- M-1 and M-2 -- are
now down yr/yr on a % basis. Normally this is threatening to
prospects for continued economic expansion. However, as often
previously discussed, banks have switched funding to low and no
reserve deposits not counted in to M's 1 and 2. Even so, the
expansion is less well anchored because with no customary growing
base of liquidity, the economy is running on a mix of incomes and
increasing leverage only.

I also look at the earnings / price yield on the S&P 500 compared to
the "risk free rate" -- the 3 mo. T-Bill. The S&P e/p yield is 6.0%
based on 12 mo. earnings while the Bill is near 4%. This indicates
a still rather moderate risk level, but the gap has been closing as
the Fed raises short rates.

Important as well is inflation risk. The market has lost most of
its positive momentum over the past eighteen months because of a
sharp acceleration of inflation, which in turn, has reduced the
p/e multiple or earnings capitalization rate. In short, investors
have been raising the ROI% hurdle rate. Now the CPI yr/yr % change
may ease a bit for a couple of months, but the inflation rate trend
is still up.

To date, the gathering of incremental risk has acted only as a drag
on the market's progress and not as a negative trigger. But you have
to keep track.

Fed To Stop Publishing M-3 Money Aggregate

Or, Uncle Al's Revenge....

Readers of this blog know that way back in 1992, Uncle Al
and the gang eliminated or greatly reduced reserve requirements
on a variety of large and jumbo time deposits ostensibly to
provide extra liquidity as the commercial banks stepped in
to the mortgage market in place of the S&Ls which had failed
or were being merged out. This was a legitimate response by
the Fed at the time.

As the economic expansion progressed and the Fed started to
raise rates, the banks quickly learned to reduce the cost of
funding by switching to the reserve-exempt deposits to fund
lending operations. By 1995, the Fed should have reversed
course and re-imposed the reserve requirements on the big
deposits. It did not and the banks used this loophole for
years to feed the economic and stock market booms. The banks
also began to use the RP market more aggressively to fund
FX traders, hedge fund managers and the mutual fund industry.
They also started using RPs to fund lending out of the pot,
a cheaper way to raise money than Fed Funds where other banks
will charge 20% or more in a tight Funds market.

Rather than re-claim the control that is rightly theirs, Uncle
Al has decided to stop reporting the data and to leave analysts
to scramble to find appropriate proxies.

There will be a vigorous and vocal protest from a number of
economists. The Fed might spin an explanation, but many will
be unhappy and only time will tell whether the Fed will relent.

There are proxies that can be used in place of M-3, although
I will dearly miss the Repo data (now a $550 billion item).

Uncle Al has whipped a digit on his detractors in his final hours.

M-3 is slated to dropped starting 3/23/06.

Stock Market Profile

S&P 500: 1220

I continue to employ a "pocket change only" exposure to
the US stock market. We are well past the low risk / high
return phase of this still extant cyclical bull market.

Risk to the market continues to rise, but in fairness to the
bullish, the risk is coming up from extremely low levels seen
in Q4 2002. Moreover, confidence in the economy remains fairly
high as well. But it is not the type of "easy money" period I
favor.

My S&P 500 market tracker stands at 1150. It declined sharply
with the surge of the CPI in September to 4.7% yr/yr. I have
given some thought to smoothing out this unexpectedly large
lurch in the CPI to give the market a somewhat higher multiple,
but decided not to so as to avoid fiddling each month with
the inflation input. I doubt we will see yr/yr inflation stay
at this high level for too long, so the value of the market
may be understated at 1150 or 15.3x current operating earnings.

My earnings model has been holding up well, but there has been
some internal slippage, as the continuation of reasonable top
line or sales growth is increasingly more dependent on pricing
rather than volume growth. Cost inputs remain under control
reflecting good productivity growth and mild wage/benefit
pressures. So, many companies should still be experiencing
profit margin expansion.

To qualify as a "normal" cyclical bull market, the S&P would have
to reach 1360 by year's end or early Jan. 2006. Statistically, that
is a tall order at this point. The earnings underneath the market
have held up very well, but the market p/e ratio has been clipped
by the acceleration of inflation starting in mid-2004.

I have not given up on this market yet. With the overall operating
rate for the economy below 80%, we are far below effective capacity
and not in imminent danger of over heating. Secondly, the progress
of the market relative to a broad liquidity measure such as M-3
has not been so strong to date as to leave one concerned.

So, there is plenty of upside, but to realize it, the surge in
commodities inflation which has been driving inflation higher needs
to at least level off so that the Fed does not have to put the
economic expansion at ever greater risk to choke inflation pressures.
For now, the drivers in the commodity sector are fuels -- oil and
natural gas. We are in a seasonally weak period for fuels right now,
so a better test of the power of fuels pricing trends likely awaits
the closing days of 2005 and early next year.

I have been looking for weakness in oil and gas prices, but the
declines to date off the Katrina induced highs have fallen short
of expectation. Recovery of US production has been slow, and OPEC's
solemn promise to boost its output appears to have been a bluff.

I am guessing now that late January, 2006 will be a critical time for
the market and for the Fed as that will be an important window to
measure continuing inflation pressure, economic progress without some
of the recent distortions, and the arrival of new Chair Bernanke.

More on the stock market in upcoming days.

Commodities Inflation

As discussed in prior posts, I have pointed out that the
current surge in commodities price aggregates, although
not so broadly based, has been the most powerful we have
witnessed in over thirty years.

The historical record shows that grand commodities inflations
begin in sudden and dramatic fashion, almost "out of the blue"
as it were. They tend to follow upon long periods of price
stability and, on occasion, deflation.Thus, prior to a
sudden breakout of upward price pressure, there is usually a
long interval of underinvestment in the capacity to supply
the market which results in a jump in pricing when demand
does finally accelerate.

Grand commodities inflations can last for periods of up to
15 - 20 years. Commodities composites at wholesale can
easily triple and quadruple over such periods. Interestingly,
oil per barrel is now trading about six time above its 1999
low. In short, these are very powerful events, and when one
is underway, it will in a cumulative fashion have a pronounced
effect on the general price level, as measured say by the CPI.

I bring this up for a couple of reasons. first, the power of
the recent run in the CRB and wholesale commodities composites,
following a long dormant period, strongly suggests to me that
another grand bout of commodities inflation is underway.
Secondly, although run-ups in commodities prices can be
squelched for a while by rising interest rates and a tightening
of liquidity, the upward pressure on prices tends to resume
in a strong fashion when the rate / liquidity pressures are
relaxed. This occurs because of the long lead time necessary
to bring large incremental capacity on stream (Developing
small increments to capacity generally proves uneconomic.)

Thus, for the third time in the past one hundred years, we
may well have another major upleg of inflation to contend
with. I lay this out as a prima facie case, but one which
I think has some merit.

I did play the big 1968 - 1983 commodities cycle. I bought
some gold but enjoyed excellent fortune in the grain markets,
which as irony would have it, have yet to participate in this
round.

Surprisingly, it is possible to make good money in stocks and
even a little money in bonds during commodities booms. But
to be successful, you have to re - equilibrate risk and return
assumptions and not use the more favorable profile that likely
obtained during the lengthy preceding period of commodity
price stability.

Monetary Policy Update

We have now baby stepped up to a FF rate of 4.0%. Fed/FOMC
liqudity measures -- Fed Credit and the adjusted monetary base
remain constrained, although the money base did pop up for a
week or two past Katrina.

M-3 growth has accelerated sharply this year as bankers switch
funding from regular reserve deposits to the larger no or low
reserve deposits. The banks have the window open to lend and
loan growth continues brisk. Ironically, the system liquidity
embodied in M-3 has no doubt helped the energy pit traders and
hedgies keep rolling.

Uncle Al continues to push up rates gently, hoping to coax a break
in the energy driven commodities market. Tricky business. Just so
you know, recent experience (1995-2000) shows that the CRB commodities
index did not buckle until after market short rates exceeded 5.0%.

The Bernanke Appointment

As was widely expected, GWB selected Ben Bernanke to replace
Uncle Al come the end of 1/06. This was a wise choice. The
Bernanke facial countenance reminds me of a rotogravure of a
nineteenth century British scientist, someone like the great
empiricist John Stuart Mill. Unlike Greenspan, who, when all is
said and done, was a laissez-faire theorist on the economy
and the markets, Bernanke is much more sharply focused on
the-matter-fact and how economic developments cumulate to
produce the future path of an economy. In contrast to Uncle
Al, he is at once more of a pragmatist and far more plain
spoken as well.

His primary interest from a policy point of view is to have the
Federal Reserve provide a monetary environment of stability and
to avoid policies which are so one sided as to increase economic
volatility and produce economic trends which may be extreme.
His concern is that once extremes are met within the economy,
reactive processes may be needed which in turn will produce
their own excesses and deficiencies, thus taking positive,
directional initiative away from the Fed. Thus, he is at once
an anti-Greenspan and an anti-Volcker who sees the past twenty
five years of policy as having been needlessly tumultuous and
risky.

He has also expressed a strong interest in inflation targeting,
suggesting a longer term low inflation rate consistent with
assuring a stable, growing economic environment. This will not
be an easy sell at the Fed, since many on staff will be tempted
to say that they have been endeavoring to do that. Bernanke
wishes to de-mystify this process and to foster much clearer
communication with all constituencies. However, what most
interests me about the concept is that it may well free up the Fed
to use its tools -- rate setting, liquidity provisioning and
reserve regulation -- in more flexible and pragmatic ways.

Bernanke's practical and empirical approach is very congenial to
me and I am happy to give him the benefit of the doubt.

Inflation For Idiots

In its 9/05 CPI report, the Bureau of Labor Statistics again
but still belatedly acknowledged the growing impact of rising
fuel costs on inflation. The whopping 1.2% increase in the
monthly CPI puts the yr/yr rate of inflation at 4.7%. Note
though, that the BLS is still fibbing about the "core" rate of
inflation which it posted as 2.0% yr/yr. ("Core" inflation
excludes the volatile foods and fuels components of the CPI).
Apparently, no one at BLS ever goes shopping, because if they
did, they would know prices are popping up like dandelions in
springtime.

The statistical scam here, I think, is to more fully load the
fuels prices into the CPI first, which they are doing, and then
to start loading the effects of the several year fuels price surge
into the core, with the hope that the worst of the price surge
in the food and fuels component is now behind us. Then, as the
"core" inflation rate rises, the Street can say, "look the
leading edge of inflation is simmering down."

Now, don't get all indignant, Presidents have been cooking the
economic statistics for years now. Johnson and Nixon were
heavy handed chefs. Clinton was by far the most earnest and
attentive fibber, and George W. is just in-your-face cynical.
Fed chairmen from Arthur Burns to Greenspan have been their
willing accomplices.

Some of the idiots out there are going to try to keep the old
scam going. Here's Morgan Stanley chief economist Steve Roach:
"Energy is being driven by a unique set of forces -- supply and
demand -- that are not bearing down on other goods and services."
Guess Steve does not go shopping either.

So, where does all of this leave us? Well, based on 4.7% inflation,
Fed Funds should be at 6.5%. Long Treasuries should be at 7.5%
and the p/e ratio for the S&P 500 should be 15.3X with an index
value of 1146. Interest rates are so low relative to these indicated
levels because rates are being priced off the low "core" rate readings.
Depositors are being ripped off and bondholders are surrendering
wealth after taxes on the income streams are figured in.

I am expecting fuels prices to ease because those markets should be
coming into better balance. I also expect the "core" inflation rate
to go up. For example, US produced auto prices have returned up to
ordinary retail from the employee discount levels. Moreover, the
BLS will have to start showing the effects of higher fuel costs
on all items or the fib will grow too large to correct without major
dislocation.

My best guess now is the CPI, measured yr/yr, will slowly drop back
into a range of 3-4%. From my perspective, that implies that interest
rates remain too low and that the current market p/e of 15.9x estimated
12 mo. operating earns. through 9/30/05 is reasonable.

Realistically, given the hanky panky with the inflation rate,
each player has to decide for himself or herself what a reasonable
inflation estimate is and factor that into his/her return
expectations for the capital markets.

Stock Market -- Technical

S&P 500: 1177

My primary technical indicator gave me a sell signal on 8/16 with
the S&P 500 above 1230. I paid it no mind because I could see the
market in a compression zone. I got a short term buy signal on
9/6 with the "500" at about 1215 and ignored it as well for the
same reason. I then got another sell signal on 10/4 at 1214 on
the index. This one is more worth notice, because it heralded
a break down from the compression zone and raised the question
of whether a more substantial decline might lie ahead,
with the prospect of the "500" falling to about 1075.

For fundamental reasons I have been playing only with pocket
change since March, 2005, so I am not at risk on the long
side. Moreover, we have moved into respectable oversold
territory, so I am not contemplating a short position.

I have not yet given up on the idea we remain in a cyclical
bull market, which makes me doubly loathe to short this baby.
So, I am going to see how resolution of the oversold
develops before taking action, although my sense is the
time to trade has drawn nigh. Frankly, I also remember my
days on Wall St. where we had a amusing rule: Sell on Rosh
Hashanhah (10/4 this year) and buy on Yom Kippur (tomorrow
10/13). It's a fun contrarian rule if you know the holidays
and not a bad one at that. So, I'll wait to see what the
next few days bring.

US Economy

Since this spring I have been pointing out that the
Federal Reserve was engaged in a classic form of
Greenspan fine-tuning, to wit, gently but persistently
raising interest rates and curbing basic monetary liquidity
with an eye to slowing down the economy enough to produce
a flattening of or deceleration of inflation pressure.
The Fed also desires to raise short rates enough to restore
a better balance between savings on the one hand, and
consumption/investment on the other.

A slowing of economic growth was a "gimme" since it had
already began decelerating even before the Fed first swung
in to action in mid-2004.

The Fed, as discussed in past months, has not had any real
luck with the rest of its plan. Inflation pressure has
accelerated and broadened, and there has not been enough
of an incentive created to get folks to boost savings.

When I extend present trends on the relevant economic
charts, I see we are headed for trouble by the end of the
second quarter, 2006. By then the US would be at effective
capacity, inflation pressures would have intensified
further, and short rates would have reached levels high
enough to curb credit demand and produce an economic
retrenchment. This scenario would be entirely
consistent with development of cyclical bear markets in
both stocks and bonds prior to yearend, 2005.

And, as we have seen in recent weeks, investors are
already beginning to shade the market multiple and to
push up yields.

I have also argued that the Fed should be moving in
50 basis point increments with Fed Funds, but that appears
to be neither here nor there as things now stand.

I am standing back from the bearish scenario because I
suspect fuel prices have risen to levels sufficient to
induce rising conservation and a rethinking of household
and business budgets. My best guess is that should
such eventuate, fuel prices would roll over and come
down substantially from present levels. This adjustment
would temporarily pressure economic momentum but might
allow the US to escape far more serious trouble next
year. I also need to direct attention once more to the
continuing very low growth of productive capacity, which
in turn puts more of the weight on demand suppression,
if the US is to escape a nasty time.

Short term, I am going to be focusing on commodities
prices, the leading inflation precursor, and on personal
consumption factors, for these are the two spots where
it can best be determined if the softer landing can be
achieved. At this stage, a pick up in the growth of
productive capacity can only be devoutly wished for.

Stock Market -- Technical

Well, my momentum and internal market supply / demand
measures continue to show a pattern of compression which
could extend up to another 2-3 weeks. I have avoided
trading since early August, since the extended compression
period has left me bereft of a sense of direction.

My guess is that to have a positive breakout from this
compression interval, we may need to see a rotational
change in leadership to groups that might benefit from
a weakening of oil and gas prices. The prevalent
psychology in the market is that the fuels sector has
advanced enough to damage profit margins for a broadening
array of companies, enough so that improving margins
for fuels producers will be more than offset by reduced
profitability for net fuels consumers. Players have also
been shading the market multiple to reflect expected
higher inflation readings near term. Thus a rekindling
of positive momentum of oil and gas prices and the
energy stock complex could produce a fuels led rally
that might not lead far at all, whereas as a rally
led by beneficiaries of lower fuels prices could be
explosive.

But first, let's get through the compression period.

Oil Rolling Over

I have made some terrific calls over the years, but making
calls in markets is not my strong suit. So any call I make
requires a disclaimer as to veracity.

That said, oil looks like it's put in a top up at $70 and
change per barrel. There's support at $60 and again in the
mid-50s, but I think it will drop to $45-50 per barrel before
year's end.

Globally, conservation efforts should be taking hold. Household
budgets will also be trimmed some as well. OPEC may well push up
production in the weeks ahead. The US will gradually add back 1
million bd. It is not hard to see surplus at the wellhead move
up to 3 million bd. for a while before the end of this year.
That should be enough to assuage the shortage mentality that has
gripped a market yet to experience any shortages.

To me, natural gas over $10 per mcf is also hyper-extended, and it
would not surprise me to see gas down under $10 before long either.

Rita Readies To Go To Work

In the end, trading is about booking profits. You do not
have to be first on the right side of the market and there
is no sin to leaving a little money on the table.

Rita is going to hit land full force about 24 hours from now.
It will be a major event and forecasters say that with the
jet stream way north, the storm will linger and not dissipate
as quickly as did Katrina.

Next week will be soon enough for me to look at opportunities.
I am particularly interested in seeing what the total bill
might be for reconstruction / redevelopment in the wake of
both storms and how economic policy will respond.

Two Tough Broads

First, Katrina rolled in and did phenomenal damage
in Miss. and Louisiana. Now Rita is humming through the
Gulf, building strength as it is nurtured by the warm waters.
It reached Cat. 4 quickly and could easily attain Cat.5.
The tightening of the storm's bands and rapid build up in
wind speed now suggest a smaller but more concentrated and
powerful storm than Katrina.

If it makes landfall in Texas as a Cat. 4 or 5, it will
do tremendous economic damage, particularly in coastal
and nearby residential areas. It is too early yet to tell
whether the storm will pass close enough to the Houston
Channel to damage up to 1 million bd. of potentially
exposed oil refining capacity. The storm needs to make
a Northward turn first before specific target areas
can be singled out.

If the storm stays strong and slams coastal Texas, the
resultant damage, coupled with the destruction wrought by
Katrina, could well throw economic policy into a cocked
hat, as legislators and the Fed struggle to come to grips
with a suitable reconstruction plan.

Rita, unlike Katrina, has the President's attention and
you can bet that Rita's damagees would have considerable
clout with GWB.

Traders are looking for an opening to grab a rally
along the lines of "sell the rumor (Rita's spectre), and
buy the fact (Rita's arrival)". Not my cup of tea unless
Rita somehow weakens and or misses the US.

I plan to see just what this broad winds up doing before
I take a serious look.

Fuels Conservation

Over the last several weeks, I have been thinking about
easy ways to conserve on fuel use without making any
substantial $ investment. And, as I thought about it,
I realized there were indeed a number of ways to cut down
on both gasoline and heating expenditure without greatly
crimping lifestyle. I have been doing so with the car
as have the wife and kids with theirs.

I bring it up because I suspect that many in the US, Canada
and Europe are thinking similarly. What is interesting,
I believe, is that fuels demand may still be quite a bit more
elastic than many of the fuel demand models and projections
I see. I do not think it is that difficult to knock 2% off
my demand or that of most others. Globally, that would restore
about 1.6 mil. bls a day to supply, a sizable increment.

I suspect it may be worthwhile to begin to incorporate
allowances for conservation into one's thinking about oil
and gas, because I doubt the price channels for both that
have been in place for the past year or two reflect it.

Post Bush Speech Impressions

People are reviewing how they can cut their fuel bills and whether
to trim or defer spending on the most discretionary items. So, maybe
oil/gas demand growth will decelerate for a while in the US at least.
Ditto for Europe.

The massive mid-Gulf redevelopment program will favor heavy industry,
construction, technology and industrial and commercial services.

Rotation should be pro-cyclical in the stock market.

As orders flow in to production sites, operating rates should rise,
and inflation pressures will broaden.

The bond market viewed rising oil and gas prices as a tax on consumption,
not an inflationary development. It will be vulnerable to rising operating
rates and higher sensitive materials prices.

Gold is a mug's game. It was safe enough to buy it in recent years
when it was selling below its commercial value, but it has just
moved above that level and the gold bugs and hucksters will be
coming out of the woodwork to tout it.

The economy is slowing now, but looks to pick up speed in 2006
as the big project down south unfolds. I do not know what the Fed
will do Sep. 20, but if the redevelopment program is as large as it
now looks to be, short rates could eventually go quite a bit higher.

There should be no dollar dumping from abroad, not when the US is
working out of an emergency situation. US retaliation would be swift.

You know George, he is going to try and borrow all he needs to
run the war, redevelopment and other programs that may be on
his short list. That could be a negative for the bond market.

The mis-handling of the rescue efforts in the Gulf in the
early going gutted Bush's presidency. If this inept man drops the
ball on the redevelopment program, his Party could be badly mauled
in 2006.

Stock Market -- Technical

S&P 500: 1234

The rally underway since the end of 4/05 has served to extend
the second leg of the cyclical bull market.

There are cycle factors which suggest the broad market should be
in a topping mode over the course of most of this month. Curiously
enough, most of the short and intermediate term indicators I follow
suggest the market turned up around the beginning of the month.
However, what is most striking to me is the substantial compression
in the proprietary momentum and internal demand / supply indicators
I follow. I have never been able to figure a sound method to tell
how extended compression periods will be resolved (topping out vs.
consolidation). It is clear there has been an ongoing battle between
the bears and the bulls since early July, 2005. My charts suggest
this battle could go on for up to four to six weeks before it is
resolved. When extended compression periods are resolved, the move
in the market, be it up or down, is usually sure and powerful.

I am a discretionary trader and a trend follower, but I have hesitated
to go long so far this month because of the compression I see in
the market. So, I may just wait until that issue is resolved before
deciding what to do.

Stock Market -- P/E ratio Recovers

The sharp spike in the price of crude led the stock
market to shade the multiple in anticipation of higher
inflation readings for August and perhaps September.
The fast erosion in the price of crude since Katrina
struck and oil market fears were finally realized has
produced a sharp relief rally which restores the p/e ratio
back up close to 17x, and leaves the market content with
a 3.0% inflation expectation. Currently the market reflects
a consensus that the worst in oil's steep price rise has
ended and that Katrina will not produce long
lasting economic damage. Note again though how sensitive
the market continues to be to the price of crude.

Curiously enough, the stock market remains the most
reasonbly priced sector of the capital market.

Monetary Liquidity Indicators

Uncle Al talked tough the other week out at Jackson Hole, WY.
But, in vintage style, the Fed has removed its foot from the
brake. It has been buying bonds for its own portfolio, and its
version of the monetary base has started to grow. I think this
development commenced to meet seasonal "add" needs to cover
back to school shopping and then the holiday season down the
road. It remains to be seen whether post-Katrina economic
developments will promote further easing. Note that the Fed,
by jiggling reserves day-to-day, can push short rates higher
even as it adds liquidity to the system.

I bring this up not only because it is worth watching to help
glean the intent of monetary policy, but also because the large
primary dealers, who are also big players in the currency,
commodity, and stock markets, use their knowledge of changes
by the FOMC to trade. These advance notice liquidity indicators
are FALLIBLE markets guides, but players need to pay attention.

When the Fed is adding to its portfolio, it tends to benefit
stocks and gold, and to hurt the dollar. This easing can
also lift the commodities markets and bond prices, but given
the peculiarities of this cycle, the bond market might grow
uncertain since the bulls have been counting on tight money.

The Fed can run this type of easing for a few months without
compromising its longer term intent, which based on the longer run
growth trends of Fed Bank Credit and it monetary base, continue
to support a restrictive policy approach.

Short Term Interest Rate Fundamentals

Based on economic data available through today, 9/01, the
cyclical case for boosting the FFR% at the 9/20 FOMC meeting
remains in place. Moreover, with inflation at 3.1% and
accelerating, an FFR of 3.5% as a short rate anchor is a
savings dis-incentive, which continues to weaken the
internal or domestic purchasing power of the dollar.

Now, as indicated yesterday by Phila. Fed Gov. Santomero,
the Fed will have to take in a thorough briefing of the
likely economic effects of Katrina's punch to the system
in deciding whether to move ahead with another rate increase.

A key factor in deliberations should be the rapid rise in
fuel costs relative to consumer disposable income. The fuel
bill is rising rapidly from a very low base and is hardly
high relative to DPI historically. Even so, the momentum of
change, being very rapid, could disrupt household budgets
in the months ahead. Secondly, the Fed will have to gauge
direct output and income losses from Katrina since these
losses will be consequential, at least for the short term.

I have never found it helpful to probe the collective
psyche of FOMC prior to a meeting. So, I am just guessing
they will go ahead with a FFR% boost if there is no
major red flag in the data available to them on 9/20.

"Down On The Levee..."

As pundits and analysts were engaged in trying to figure on
the direction of crude and natural gas prices yesterday, Katrina
swirled past New Orleans. The backwash from the storm deluged
Lake Pontchartrain with rain. Waters rose overnight, several
levees were breached, and now the City has been inundated
with a toxic swill replete with petrochem, sewage and tumblin'
gators and water moccasins. Since The Big Easy is set in a bowl
below sea level, 80% of it is now under water with no natural
run-off. Although it may be true that the flashy Red Rhino
Dance Club near Bourbon St. may have survived, the City has
effectively been destroyed.

Katrina, for her part, is cruising north toward eventual
extinction in Quebec, but not before damaging the economies
of several other states. All told, probably upwards of 15%
of the US economy will have been damaged, with said damage
ranging from total devastation to the loss of power for a few
hours.

Them's that know me have seen an icy cool money manager
deal with tough issues over the years. I am no alarmist, but
it appears to me we have a national emergency on our hands.
President Bush will be in CA today to give a speech or two.
This curiously defective man is handling this blow to the US
with his customary nonchalance. Why he is not down south
where he is needed escapes my understanding. At the least,
they could have swept Cheney from his iron lung and deposited
him there.

Folks are only beginning to get an inkling of damage done and
the fully national effort that will be required to restore the
central Gulf and areas north. The effective loss of New Orleans,
a wonderful and unique American City is a national calamity, and
the sight of our President whistlestopping up in CA is a national
embarassment.

Katrina Damage To Be Widespread

Markets focus has been on the damage the storm may have done
to the LA petrol/gas complex. However, this storm could easily
wreak havoc in up to seven or eight states before it settles
down and begins to dissipate. Flooding, structural damage and
power outages will do severe damage to small and local businesses
from the tip of LA right up the midsection of the country through
TN. Homelessness will surge temporarily and job and business
losses and downtime could last many weeks. The breadth of the
storm and rainfall amounts are alarming. The losses sustained
here will have quite an impact on the economy.

Greenspan's Valedictory Part 1 -- Inside Scoop

Fed Chairman Alan Greenspan is winding up his tenure at the
Fed. He is using the Fed conference at Jackson Hole, WY to
discuss the history of the Fed, his tenure, and unresolved
issues that will carry forward. It will provoke quite a bit
of discussion among the pundits and will have the hard dollar
analysts in a tizzy of sardonic snickering.

Folks will work hard to unlock its many meanings and their
implications for policy, the economy and the capital markets.
As a semi retired senior investment executive with 40 years
of experience with the Fed, mostly at arm's length distance,
but occasionally up front and personal, I can tell you
clearly the meaning of what he said today in Part 1 of his
valedictory.

The speech was quintessential Fedspeak, but it can be
quickly boiled down to: "Whatever bad may happen to the
economy and or the markets after I leave ain't my fault."
There you have it, plain and unvarnished. Thanks Al.

Bond Market Profile

The long term bull market in bonds remains in place.

The most recent downtrend in yields, which began around
mid-2004, also remains in place, although the market is
overbought for the very short run.

At 4.40%, the long Treasury is discounting a return of
inflation to 1.5-2.0%. Moreover, there has been some
slight shrinkage in the longer term volatility premium
as well.

With the CPI now at 3.1% yr/yr, the market is running
entirely on forecast and expectation. Viewed historically,
this is very unusual behavoir for this market.

The forecast/expectation is that the combination of rising
short rates and fuel prices coupled with a tightening of
basic monetary liqidity will be sufficient to produce
enough economic slack to return inflation to 1.5-2.0%.

The market is likely also forecasting that oil and gas prices
will ultimately retreat markedly from levels seen as well
above reasonable. This seems a fair assumption since
continued significant strength in fuels will eventually
infect popular "core" inflation readings as producers and
service providers move to raise prices as they can to
protect operating margins.

Market players are also clearly chasing yield. Even though
the expectation is of a slow economy ahead, Medium grade
corporate credits have also rallied from the 7.0% level
seen in Q2 '04 to 6.45% recently. So, there has been but
a minor widening of spreads between Treasuries and lesser
quality investment grade corporates.

Advisory sentiment as measured by Market Vane is too bullish
but not at the extreme levels seen in the past quarter,
when the measure registered 77% bulls.

This is all heady stuff, particularly the willingness of
bond players to forecast the future with such confidence.

The market leaves me edgy. I am not used to seeing the bond
market look so far out in time with such confidence, and as
discussed in the prior post, it appears to me that the Fed
does not have as full control of the situation as the market
may think.

Business Expansion -- New Wrinkle

Historically, business expansions have been fueled by three
factors: monetary liquidity, internal cash flows and credit.
The key driver has been monetary liquidity. Expand it and the
economy follows suit. Contract it and a recession will
eventually occur.

Economic expansion over 1995-2000 was different. The basic
money supply M-1 was flat over this period, yet the economy
flourished, funded by cash flow and short term credit. Note
though that it took only a mild liquidity squeeze in 2000
to tip it over.

I bring this up because M-1 is not growing fast enough to
sustain economic expansion. This means that business must
rely on cash flow and credit to keep it going, as must the
consumer.

In my view, it is riskier when an economic expansion is
reliant on cash flow and borrowing alone. It does not
have the sure footedness it has when money is flowing
in and through the system adequately. My problem is that
I cannot quantify it. I can only say the resiliency of
the expansion is now being undermined to some degree.

How did this new wrinkle come about? It results from
the Fed's decision in 1992 to eliminate or minimize
reserve requirements on a host of large and "jumbo"
deposits to liquify a financial system stressed out by
the S&L and commercial real estate debacles. Regrettably,
I think, the Fed never re-imposed those requirements,
giving the banks a much freer hand to fund loan demand.

In giving talks to investment managers over 1995-2000,
I introduced these thoughts and issues. What I thought
was an interesting insight was met by shrugs. And it
paid not to worry for the longest time, right up to
the moment when the Fed tapped ever so lightly on the
brakes.

Now one piece of good news is that the adjusted monetary
base which leads the direction of M-1, has finally
started to creep up a little after a dead flat six
month period. We'll see.

Oil And Natural Gas -- Caution: Flammable

Sep. crude is printing $64.25 - 64.50 bl and gas is printing
over $9.00 mcf. On longer term charts these are spike breakouts
that signify an erosion of market discipline. There should be a
ton of overhead in each of these markets, and if demand can
continue to chew through it, the ball game will change to the
rankest of speculation and dramatically increased volatility.

From my perspective, we have moved beyond the pale of reason
and are watching these two markets move into fantasyland on a
speculative binge. As my Irish mom used to say, "The devil shall
take the hindmost."

Step Up To 50 BP Al.....

The Fed is widely expected to raise the Fed Funds Rate
by 25 BP to 3.5% today. I think it would be better if they
stepped up the FFR by 50 BP to 3.75% and then add another
50 BP at the September meeting to bring the FFR up to 4.25%.

I measure the domestic purchasing power of the dollar by
whether dollars left in money market and sweep accounts
provide a positive return after adjusting for inflation
and for taxes. In my view, monetary policy should only
act to depreciate the dollar internally when the economy
is in peril. The economy seems to be doing ok, and I see
no compelling reason to drag out the restoration of
internal dollar integrity. Presently, there is no
incentive for people to save, and this is a bad thing
to allow to drag on.

Brass Band Bear Parade Could Be Ahead

Well, it's that time again. After August comes September
and October, two of the diciest months of the year for
stocks. But wait, it gets worse, for next year is 2006
and time perhaps for the quadrennial low. As both the
big money and the smart money know, the market tends
to have a sell-off period every four years or so, and
2006 is it. I's well documented enough through time
that most market pros have respect for it.

As we move through the remainder of this year, do not
be surprised to see market punditry and forecasts start
to get tweaked to the downside. And, expect a number of
bears to proclaim that leg two of the long term bear
market is fast approaching. The spectre of 2006 will
change a fair bit of thinking across the grid.

The low volatility of this cyclical bull and the absence
of a good 10% correction so far does make one wonder. Still,
my strategy here is to stay with my disciplines and let others
do the tweaking.

In that regard, my advance monetary liquidity indicators
have started to perk up in recent weeks and the negative
divergence with the stock market has lessened. But it is
still early in the game to posit that the Fed
has made a directional change toward letting its foot
up on the liquidity brake especially since short rates
remain too low.

Tim Woods of Cyclesman hag good charts on the four year
cycle. Go to www.cyclesman.com/4-year_cycle.htm to see.

One Hand Takes; The Other Giveth In Abundance

For a little over a year, the Federal Reserve has been
"removing accomodation" by raising short term interest
rates and squeezing monetary liquidity. That would be
the Hand That Taketh.

But friendly bankers have swooped in on the scene. And
Giveth they have. Measured yr/yr, bank credit growth
has rapidly accelerated by 12% to nearly $5.2 trillion.
Loans to individuals -- mortgages, home equity and
personal have jumped 15% to $3.9 trillion. So not only
are folks not saving, they are happily leveraging up
to buy homes, cars and all of life's other necessities.
Sound money types and assorted other bears are seething
at what they see as wanton profligacy.

Now, after a couple of quarters of inventory rebalancing,
order rates for business have turned up, promising
higher production and more jobs. Earnings estimates will
inch up, and this has supported and extended the rally
in the market.

The Fed will likely press on with its accomodation removal
program and the banks will likely be glad handing both
consumers and business, at least for a while.

The issue here is that money left on deposit or in money
market accounts is still a loser.It depreciates in value
and in an expanding economy, it is going to be spent until
short term rates rise enough to protect its value and/or
economic developments occur which give consumers pause.

Inflation stimulus has originated with commodities in
this cycle, a typical development. And looked at seasonally,
the push to higher inflation is still in place, although
it has narrowed primarily to oil, gas and fuels. So, the
Fed has another reason to remain cautionary.

In the long run, the Fed will win out. That is why economic
and financial risks in the system are continuing to rise,
even if corporate earnings do better than many expected
in the short run.

The 0.0% Savings Rate

Consumer spending surged at a nearly 10% annual rate in
June reflecting strong auto price promotion and sales.
The savings rate fell to 0.0%. With money funds in the
2.8 -3.5% area, there is no incentive to save when the
real return on these funds is negative after adjusting
for taxes and inflation of 3.0%.

This is another reminder that short rates need to rise
significantly further to start to regain a better
balance between consumption and savings.

Earnings Trend Factors

I use a variety of economic data to try and track earnings
growth and momentum on a monthly basis. Some observations:

The recovery of SP 500 operating profits off the Q2 '01
recession low was very powerful, with quarterly earnings
basically doubling to $18. through Q1 '05.

Sales rose far more rapidly than costs, leading to sizable
improvement in profit margins. But other specific factors
were important, namely a weak dollar, large inventory profits
for basic industry and especially for oil and gas producers,
and the fact that many companies took huge writeoffs over
2001-02 that were not captured in operating earnings.

As is normal, earnings momentum is now decelerating after
such a remarkable bounce.

Business sales growth measured yr/yr peaked at nearly 10%
during Q2 '04 and has now slowed to the 6-7% area. This
still beats estimated cost growth of 5.5-6%, so gross margin
is still expanding, although far more modestly.

Currency translation gains are evaporating rapidly reflecting
a much stronger dollar, and basic industry inventory profits
have also levelled off. On the plus side, oil and gas
inventory profits are still surging.

Forecasters expect yr/yr earnings growth for the SP500 to
average roughly 10% each quarter through the end of 2006.
This is a reasonable projection provided sales can continue
to grow at 6-7% and margins can continue expanding via
further productivity gains.

What is troubling about the consensus expectation is that
it implies absolutely ingenious and faultless fine
tuning of the economy by the Fed. The continuous 10%
growth expectation is too high relative to the current
direction of monetary policy (now restrictive). I sure
do not know if the Fed can move through policy with such
perfection.

I guess I will be following my earnings indicators more
closely than I have recently, because the market seems to
me to be priced heavily on the assumption of strong earnings going forward.

Short Rates & Bank Liquidity

With the economy expanding and business short term loan
demand in a pronounced uptrend, The Fed still has
significant leeway to push rates higher without having
to drain the reserve base. A 4.00 - 4.25% FFR still looks
OK for year's end.

The banks remain in good shape as far as liquidity is
concerned. I define "liquidity at the margin" as the
ratio of C&I loans to US Gov't. securities holdings.
That ratio now stands at .85. This compares to a
reading of 1.48 at the last top in C&I demand in
March, 2001.

Yuan to Speculate?

Hu Jintao has authorized a baby step revaluation of the yuan, 2.1%.

Presumably, this will keep China under the radar when the US Treasury
again reviews currency management in Sept. '05. Hu is hard to take
seriously and Treas. boss Snow will look equally silly if the US
does not hammer China this autumn for damaging currency manipulation.

The dinky revaluation of the yuan sets promise of further dinky
ones to come. This will keep the speculative money flowing in and
will feather the nests of the Beijing power elite.

If this is the plan, US business and other foreign companies can
continue to invest in China with a wink from Snow.

Risk will rise even higher in China as more money flow will further
tax an already overburdened and corrupt financial system. Prospective
upward revaluations of other Asian currencies against the dollar
will up speculative flows to these spots as well, such as Malayasia.

Hu will be headed here some time over the next month or two. He
has earned the frostiest of greetings, but don't count on him
receiving such.

Stock Market Comments

Henry To of Marketthoughts was nice enough to invite me to be
a guest commentator. I chose the occasion to tie in recent
observations on the economy with the market outlook. Click below
fo more:

http://www.marketthoughts.com/

Stock Market -- Near Term

The rally in force since the spring tested important support last week and remains intact.
It continues impressive in breadth but not so in volume. Momentum in the popular major averages like the S&P 500 is subpar, mainly because there is continuing rotation into
mid and smaller cap. stocks. Fittingly, I do not have the large cap. indices as short term
overbought, but the broader NYSE Adv / Dec line is.

The S&P 500 is falling behind the course for a normal cyclical bull, partly reflecting monetary liquidity restraint but more so because of rotation toward smaller stocks.

My Basic Trend Index (NYSE A / D line adjusted by daily TRIN)remains in an uptrend and
is not yet overbought because TRIN readings have not been that low.

I have the S&P 500 as exactly fairly valued given the prevailing inflation and earnings levels.

The S&P 500 is trading at a modest 10% premium to my dividend discount model (Premiums or
discounts to the DDM of 25% or more require much greater due diligence).

My monetary liquidity trackers suggest the Fed is still tightening, which increases fundamental earnings risk in the market and keeps me with occasional, light exposure to
the long side.

Market risk is higher than that indicated by my work on monetary liquidity for two reasons:

> Oil and natural gas prices may be seasonally elevated, but the sharp long term uptrends
remain in force (inflation potential);

> Continuing rotation into higher p/e smaller caps puts many portfolios at greater risk if a correction ensues for valuation and market liquidity reasons.

I AM STILL HAVING TROUBLE WITH WINDOWS, SO POSTS WILL REMAIN EDITORIALLY PRIMITIVE FOR A
WHILE LONGER.

System Problem

Key blogger pages not accessible today. I'll try tomorrow.

Stock Market & Monetary Liquidity

Data for the Fed's own portfolio show a sharp rise in Treasury holdings, both via direct purchase and through the Repo window for the week ended July 6. It was a larger than normal holiday liquidity injection. The data was released late yesterday, and no doubt caught public notice. There are one or two other positive divergences in the liquidity data, but it does not yet add up to a more compelling case for stocks from my perspective. Even so, it all represents the first good news on the liquidity front in over six months.

The way I align the liquidity data, it does not add up to a case for a low risk / high return market. So for now, I continue to play nickel / dime on the long side with a very large reserve. I have done no shorting since 2002, and have not given it much thought this year.

I plan to do a more thorough analysis of the market over the weekend.

Monetary Policy -- Liquidity

According to the Fed, the Fed Funds rate is still at an accomodative level. Monetary liquidity trends paint a different picture. Liquidity has become increasingly restrictive. The economy has been growing faster than the broad money supply (yr/yr). Thus, the velocity of money is rising and, correspondingly, liquidity is shrinking, relatively speaking. As most know, short rates tend to rise with velocity. We do not have a full liquidity squeeze, because banks have their credit windows open. Monetary velocity is not rising fast enough yet to signal an economic downturn, but is consistent with development of a more pronounced slowdown. Timing is a tough issue, because the banks are friendly. Businesses are not stressed in meeting expanded working capital needs because cash flow is still on the rise and companies are tapping credit lines easily.

The Fed can let the economy coast this way for a while, but to avoid a serious crimping of growth or a downturn, It will have to begin providing fresh liquidity sooner or later. The Fed is interested in a long growth cycle because that assures a rising revenue take for the Gov. which must progress in reducing Its deficit. When the moment comes for the Fed to reverse course and ease up, follow through will have a substantial impact on the markets.

The liquidity deficit relative to the real economy began to show up over March / April, 2004. You will note that since then the stock and gold markets have made little headway, the 10 year Treas. has been rangebound, lower quality credit yields have moved up and even the US dollar, which been strong this year, is still a notch below levels of early spring, 2004. Only the Long Treasury has been able to hold a rally.

So long as the Fed allows liquidity to taper down, the capital and commodity markets are at elevated risk. Even the Treasury market is vulnerable, since players may turn bearish if they come to think that the process of slowing the economy to wring out unwanted inflation pressure may take longer than earlier anticipated.

The smart money knows that liquidity trend is every bit as important as the level and direction of the Fed Funds rate. In fact, the Fed may well signal an easing in policy first in the liquidity area, particularly if business credit demand begins to ease off. One place to watch is what the Fed is doing with its own portfolio (For this series, click here).

Finally, for an excellent e-chartroom briefing on the economy, click here.