Gold Price -- $650 Oz.

The price of gold has broken down from the powerful
uptrend line underway since mid-2005 on my tattered
semi log chart. This is not necessarily a bearish
development, but it is a "heads up". Sometimes a break
like this is just a fluke in an ongoing trend. Sometimes
such a break is fatal, and, sometimes it is a warning of
a break to come. So, you have to pay attention.

Gold is at short term support at $650 oz and the bugs may
move to bounce it up next week. Even so, a reliable trend
support has been violated and the game may be changing
as a result. Weekly $GOLD chart.

The Long Treasury ($TYX)

I still view the bond market as overvalued, so I do not
post much about it. However, the recent spike up in the
yield on the 30 yr Treas. is interesting. I like to
watch bond yields against their 40 wk. moving averages.
When yields stray 40 or more basis points from the
averages, it is worth noting, as a trade might be at
hand. The $TYX at 5.25% currently, is over 40 basis
points above its 40 wk. M/A. When you think of the bond
in terms of price, it is fair to say that it is becoming
oversold. As you will see on the $TYX chart linked to
below, the 10 week RSI suggests it is oversold, and
interestingly, the yield has moved up to significant 12
month resistance. Worth keeping an eye on.

The Treasury has responded to the significant upticks in
the ISM Surveys of new orders for both manufacturing and
services for both April and May, continuing low unemployment
insurance claims and the steadfast climb of industrial
commodities. Bond players have grown concerned that a
possibly stonger US economy could scotch expectations for a
lower Fed Funds rate and also lead to further inflation.

However, by my approach, the technical signs now say I
should watch to see if there might be a mildly good trade on
the long side of the market. The $TYX chart.

Stock Market -- Technical

The broad market remains in an uptrend. Recent
momentum loss and today's sell-off have erased the
case for a short term overbought condition. However,
viewed in the intermediate term (3-6 months), the
market, although still in a clear uptrend, is both
extended and overbought, even when operating within
the confines of the strong upward trajectory underway
since mid-2006. The intermediate term work does not
presage an imminent correction as it stands, but it
does suggest a little caution is in order. I have
linked to the broad Value Line Arithmetic index ($VLE)
below.I like this one because it includes the top
mid and small caps along with the majors, but is not
capitalization weighted. The $VLE.

Gold Price -- $670 0z.

Gold remains in a long term bull market and the price
is holding the strong uptrend that started 07/05.
Gold has yet to recover the highs seen at the end of a
parabolic blow-off top which wound up during 05/06.
This is not a source of concern as long as the metal
holds the trend from 2005.

The macroeconomic indicators remain positive for gold.
The primary indicator is just a touch below an all time
peak, largely reflecting a continuing advance in the
broad industrial commodities component (oil included)
since year's end. Another measure -- the $ cost of
heavy industry production is at an all time high. My
global economic supply / demand pressure gauge is in
high ground, although below last summer's peak due to
a work-off of excess oil inventories. The micro model is
up sharply because mining companies are producing low
grade ore under the $650 + oz price umbrella.

The ratio of credit driven liquidity to monetary liquidity
is in a strong uptrend. This will not favor gold unless
the metal's fundamentals are positive as they are presently.
The tailwind from credit liquidity is likely adding about
$120 per oz to the gold price presently.

Gold price chart is included. It is recovering some with
chart support at $625 - 630 0z. Chart.

Stock Market -- Fundamentals

Well, the SP500, a laggard during this cyclical bull run,
closed at a record 1532 today. The Market Tracker has the
SP500 fairly valued at 1540 - 1550 through July. It appears
investors are still comfortable with a 17 p/e based on
rolling twelve month earnings and an inflation assumption
of roughly 3%. Measured yr/yr, the CPI has been running a
little below 3%, but the market has yet to show an appetite
to factor in a lower inflation rate.

SP500 consensus earnings are projected to rise 7.3% in 2007
and then crack the century mark in 2008, with a 12.6% rise
to nearly 106.00. Earnings acceleration is projected to
begin late in 2007 and carry over into next year, with
expectations for telecom and tech earnings leading the way.
Implicit here is a moderate acceleration of US economic
growth and decent global growth.

My inflation indicator has picked up some so far in 2007,
primarily because of a surge in US gasoline prices.
However, the indicator is still relatively quiet. Given
how commodities have driven inflation in this current
expansion, it is understandable that investors have a
conservative bent regarding inflation expectations.

The market's earnings / price yield has dropped to 5.9%.
The premium to the 91 day T-Bill is slightly over 100 basis
points, and the e/p yield premium to prime commercial
paper is a scant 65 basis points. The narrowing of these
spreads points to increasing market vulnerability to a
rise in short rates.

The SP500 price premium to the SP500 price level implied
by my monetary base model is rising significantly and
reveals growing market dependence on credit driven liquidity.
No problem so far, but risk from this measure is rising.
Keep in mind also that an acceleration of economic growth
coupled with even a mild pick up of inflation pressure can
rapidly use up the excess liquidity now being generated
through the credit window.

Stock Market -- Psychology & Technical

No momentum this week, so a day of profit taking was
in the offing. But there was also a frisson of concern
as well. What if the economy is close to re-accelerating
and perhaps doing so in a less than benign inflation
environment? That could freeze the Fed. Worse, the Fed
could tighten down the road...This little thought is
supported by data showing strength in orders and home
sales as well as a weakening bond market and a slight
tilt up in the dollar. Even the gold bugs are showing
hesitation. Well, it is worth keeping in the back of your
mind.

Most know the market got itself overbought and extended and
that a key indicator -- MACD -- has turned down. Watch the
market against the first two lines of trend defense -- the
10 and 25 day moving averages. Here is the SP500 chart.

If a correction is about to unfold, the 10 day M/A will turn
down, break below the 25 and lead both down behind the market.

Gasoline Price

The price of gasoline has been an important inflation
driver in the US this year. Ostensibly, supply has been
constrained by a series of spot refinery outages. The
futures contract price for gasoline is juicily volatile
and, interestingly, is looking overbought, with an MACD
near the top of the scale and with yr/yr price momentum
high but past a recent peak. Check $GASO.

Stock Market -- Longer Term Perspective

With 1995 as base year, the SP500 is tracking an 8.8% positive
trendline, right in line with earnings. Coupled with a 1.8%
yield, the implicit return is 10.6% per year. I have assumed a
3.0% inflation rate to compute the multiple. So, the market is doing
fine, based on trendline growth of 8.8% and a moderate inflation level.
Now, it is critical to notice that 8.8% growth is well above the very
long term norm of 6.0 - 6.5%. Over the past 10-15 years, ROE% has
risen strongly up to over 17%. The dividend payout rate on earnings
has dropped below 40%. With a high plowback of earnings, the SP500
has implied eanings growth potential in excess of 10%. Most companies
generate more cash than they can profitably re-invest, so they buy
back shares and generate acquisitions. Balance sheets are stronger
now but are still aggressively managed. Many companies could pay out
more in dividends without harming growth, but since senior management
bonuses are so often tied to maxxing out eps, they keep more cash.
Companies have also been skimping on capital expenditures, but there
is still excess capacity in the system.

US only earnings growth has decelerated with an economic slowdown, and
this has recently lead to greater interest in the big multinationals
which have large foreign bases of revenue and have been benefiting
from a moderately weaker US$ and faster offshore growth.

This longer term view of the market helps drive home the point of
the need to recognize how the market has been led by a historically
rapid rate of earnings growth backed by high growth corporate financial
internals. Fretting bears have consistently missed the importance of
a powerful earnings trend, and longer term bulls risk taking this
performance for granted.

When I look at companies, I am more interested in return on total
assets (ROA%) than ROE%, since companies can pump the latter through
borrowing and share reduction. In looking at ROA%, I am interested
not just in a company's ability to maintain profit margins but asset
turnover -- sales divided by assets. You would be surprised how many
companies can cover over declining asset turn with increased leverage.

Liquidity Check

The Fed reversed the big infusion of two weeks ago, so the
growth of monetary liquidity remains modest. The temporary
liquidity injection may have added modestly to the basic
money supply, which needed a transfusion.

The broader, credit driven liquidity measure I utilize did
accelerate markedly in April as banks returned to the
real estate market and C&I loans moved up. Yr/yr, my M-3 proxy
is now up 10.2%, high, but in line with the growth of short term
credit demand. Seasonally, we are moving in to a stronger period
for home sales, but I was still a little surprised by the
size of the move up in the real estate book.

The financial system is generating more liquidity than is required
for current dollar economic output, leaving excess liquidity in the
system to fuel financial and commodities markets in favor. since
the volume and diversity of derivatives also continues to grow there
is rich leverage behind the markets. On top of this, the US trade
deficit widened in March, sending more $ abroad. To this hefty brew
we can add the new rule change in China which allows its commercial
banks to diversify IM accounts away from Chinese securities (It will
be interesting to see whether the "big" money in China starts to
exit Shanghai and Shenzen to leave the smaller retail accounts holding
the bag.)

There is a small but growing chorus of markets observers who are
starting to warn of the risks of markets inflated by credit driven
liquidity. I have mentioned a number of times that markets powered
by credit driven liquidity are riskier than when markets are supported
by monetary liquidity growth. In the latter case, you have central
banks on your side.

One economic possibility that all need to watch concerns the US. If the
domestic economy re-accelerates and there is a little bounce in inflation
pressure as well, the excess liquidity will fizzle quickly, gobbled up
by the real economy. I have been cautious on stocks this year because I
am interested in seeing how well the balance of economic supply and
demand may shape up once the economy shakes off its torpor. So far, that
concern has proven premature given a sluggish environment. Perhaps worse
for me, I may well wait until autumn to see whether the cautious approach
pans out or not.

Shanghai Express -- #2

There is a link to the Shanghai Stock Composite at the end of
the post. As all but the dead know, this market has been in a
very sharp parabolic upmove since early 2006, as China's retail
investors rediscovered their market following a long drought.
There is a mania underway. To qualify as a bubble under my
tough parameters, the SSEC, now just over 4000, will need to top
6700 by late 2008. That is a tall order after the run-up so far,
but a true bubble is far more spectacular than most realize.

There is long term trend resistance by some measures in a range
of 4000 - 4200. A tightly drawn parabolic curve had the market
topping out at prior trend resistance of 3350 in March, but
the market has taken that all out in a nearly vertical assent.
There is a broader, looser parabolic loop that has a top up
around 4500. Suffice it to say, this is a doozy of a mania.
Moreover, despite mentions of mania and bubble in the Chinese press,
the folks are still flocking in to open accounts and buy.

It is worth watching, not only because it is exciting, but because
the Chinese authorities could, at some point, try to stop it. And
this could involve policies that might reverberate in other markets.

I warned several times over the years that when mercantilism turns
greedy as it has in China, temendous mania activity and eventual
financial and economic dislocation can occur. And here we have a
case where rampant real estate speculation has shifted to the
local equities market.

Keep a weather eye on this baby. The SSEC

FOMC & Monetary Policy

Most observers expect the FOMC to leave the Fed Funds rate
(FFR) unchanged at 5.25% at tomorrow's regular meeting. The
key data I track for monetary policy trended down over the
second half of 2006, but have stabilized recently, particularly
capacity utilization and manufacturing activity. It should be
said that the Bernanke Fed may have diverged from the Greenspan
Fed in electing to hold the FFR% at 5.25% despite evidence of
a weakening economy over Half 2 '06. I guess the Fed can coast
on this data for a while if it wants to.

The leading economic indicator sets I follow show a sharp firming
up for the month of April. As Aristotle liked to say -- one swallow
does not a summer make -- so the upturn needs to be carefully noted
but not raptured over. If the Fed does elect to mention that the
economy could be regaining strength in the FOMC meeting statement,
it could give the markets a shiver, since some players would
immediately conclude prospects for an eventual FFR% cut are out
while potential for a FFR% increase later in the year is in. So,
the FOMC wordsmithing tomorrow might be of special interest.

I also note that FOMC added substantially to its portfolio last week
both via outright Treasuries purchases and RPs. It is not clear
why they did this, although cash in the system is very low, and they
have been stingy in recent weeks. The Fed Bank Credit portfolio will
be worth watching carefully over the next week or two as well.

SP 500 At Fair Value (1500+)

The SP 500 closed above 1500 today, so I have it as fairly valued,
having caught up with the higher price level dictated by lower
inflation and a still positive earnings progression.

To stay in a bull market in the US, here is what is needed:

1) The US economy must gradually resume growth of about 2.75%.
SP 500 profits need to resume yr/yr growth of at least 8-10% well
before the year is out. This implies moderate pricing power at
the top line coupled with 1.5% productivity growth and continued
moderate wage growth. Look for continued share buyback programs
as too many companies have implied internal growth rates that
cannot be satisfied by internal investment (Book ROE% is high and
earnings plowback is high, yet the global economic pie is not
growing fast enough to accomodate internal redeployment of all that
capital).

2) Inflation must stay contained at 3% or lower when viewed on an
intermediate term basis. US economic growth of 2.75% will put upward
pressure on domestic operating rates. Thus capital investment must
expand rapidly enough to keep operating rates rising only slightly.
Capacity growth has been too slow to date in this current economic
expansion.

3) Further increases in the Fed Funds rate -- now 5.25% -- would be
an unwelcome development as it would reduce the relative attractiveness
of SP 500 ROE% at market value.

3) There are obviously a host of exogenous factors that could make things
better or worse, but factors 1-3 are the time honored critical ones.

Economic Quickie

The Inst. For Supply Mgmt. report on manufacturing turned
up sharply in April, signaling faster growth in this sector.
Most interesting was the very large increase in the breadth
of companies experiencing higher new order flow. This ISM
report can be volatile, so the very positive turn in the data
could be a fluke. However, since I use the ISM new orders indices
as leading indicators, I'll take it as a heads up on a possible
turn in manufacturing. The jump in new order breadth for April
breaks a downtrend underway for some time.

The ISM site is worth a tour. www.ism.ws

Stock Market -- Technical

On the basis of trends, the market is obviously positive.
It is also short term overbought and extended. Moreover,
the longer term momentum work I do suggests an extended
market in the sense that investors and traders have been
unwilling to keep pushing shares up with the market at its
recent premium to the 40 week M/A during the upcycle underway since
late 2002. There have been periods in the past, especially
during the raucous 1990s, when no such discipline was observed
and the market went to very large premiums to the underlying
trend. But this cycle has shown far more constraint and
discipline.

It is also interesting to note that May is becoming an "iffy"
month seasonally. Longer term, May exhibits seasonal strength
that builds on April, but in recent years, May has triggered
some aggressive selling as some players like to exit the market
in the spring with an eye to re-entry in the autumn.

It has been my view that the market entered a topping process a
short while back. So far, that view has proved incorrect as the
market has pushed to new cyclical highs without breaking a sweat.
I have hesitated to make a 2007 forecast of the market based on
fundamentals, and perhaps I should have buttoned my lip on the
technicals as well. From my perspective, the suggestion will have
proven a big disappointment without a solid 5-6% sell-off in the
next couple of months.

Stock Market -- Fundamentals

In Monday's post, it was pointed out that the SP500 (1488)
was closing in on fair value of 1500. That works out to a
p/e of 17.0 x twelve months of operating earnings for the
index through 3/31/07. The big change in the environment
since mid-2006 was the sharp drop of the inflation rate.
Thus, from my perspective, the run-up in the market since
mid-2006 does not represent a blow-off but a move up to
reasonable levels based on an advancing economy and a return
to a more moderate inflation level. If you were to push the
envelope a little to incorporate a 2.5% inflation rate, you
could argue for 1550 on the SP500 (2.5% represents the yr/yr
change in the "core" CPI through 3/07).

The persistent upward momentum in the market over the past
nine months also obviously reflects positive investor assumptions
about the future. The market is in the process of discounting an
eventual re-acceleration of US economic and earnings growth and
the continuation of a moderate inflation rate.

Top line growth for both industry and finance has slowed
appreciably since mid-2006. The growth of wages has accelerated
modestly, but there has been just enough productivity growth to
avoid a broad reduction of profit margins. So, yr/yr, corporate
profits could be up 4-6% through the March quarter. It is not at all
likely that the market could hold a 17 p/e if investors did not
expect earnings comparisons to improve markedly later in the year.
Analysts expect earnings to rise serially in Qs 2 & 3 of this year,
but no major breakout to new highs in quarterly earnings is projected
until the final quarter of 2007, when the SP500 index earnings are
projected to top 25.00 for a 100.00 annual rate. To get there, it
sure would appear that the US economy will have to accelerate.

On top of this assumption, comes the idea that a re-acceleration of
US economic growth will not lead to a cyclical acceleration of
inflation. This latter assumption has looked dubious for some
months now, as US productive capacity has not kept pace with
production growth potential in a faster growing environment. I have
stayed cautious on the market until I see how well companies respond to
a resumption of faster order growth rates.

Another factor to keep in mind is that the average small and mid-cap
stock is trading between 19.0 and 19.5 x earnings. In fact my unweighted
universe of 1750 stocks is trading at an average of 18.5 x earnings. This
underscores the high expectations for future growth and benign inflation built
in to the market.

More on the fundamentals later in the week.

Stock Market -- Fundamental

By my Market Tracker, the SP 500 -- now around 1480 -- has
been fairly valued in a range of 1500 - 1550 since the latter
part of 2006. This is a broad range for the Tracker and it
reflects above average swings in analyst sentiment concerning
earnings prospects as well as continuing high volatility in
the inflation readings. At present, the Tracker is at the bottom
of its recent range for the SP 500 -- 1500.

The rally so far this year has carried the market closer to the
estimate of fair value. The strong surge in stock prices since
mid-2006 primarily reflects an upward adjustment in the earnings
capitalization rate reflecting the sharp drop of inflation pressure
since the middle of last year. SP 500 earnings are still seen as
rising this year, but the estimate is about 3% below the consensus
forecast for 2007 as of late 2006.

I am going to leave it here for the day, but will return to the subject
a few more times over the next several days as I figure out how best
to strategize with a foggy crystal ball.

Inflation Notes

The sharp uptrend in the broad CRB Commodities Index underway
since early in the year is starting to break down as a reflection
of developing weakness in fuel feedstocks. This index can be
volatile over the short run, so one does not want to make a big
deal out of a break in the short term trend. Even so, it is
worth noting.

US productive capacity growth continues to lumber along at a
modest 2.3%. This continuing low rate of growth is below US economic
demand growth potential and remains a sore spot in the US outlook.

It is good to see Def. Sec. Bob Gates spreading balm around in
discussing the middle east, particularly Iran. The Cheney Show,
which involves threatening talk in Iran's direction, is not smart
as such talk helps kite the oil price, suppress US consumer real
incomes and puts more dough in Iran's coffers.

The headline CPI advanced at a 4.7% annual rate in Q1 '07. Looking
short term, this has pushed the inflation adjusted, after tax
return on 90 day paper into negative territory and has led to
weakness in the US dollar. The dollar now needs the attention of
US officials since it is trading down near long term support. It
will be interesting to see if moderation in the broad commodities
composites might give the dollar a lift and stave off the issue of
whether the US is willing to allow the dollar to fall below support.

Stock Market -- Technical

The stock market is overbought on all measures for
the ten day short term. It is also on the verge of making
my intermediate term view the wrong view. I have argued in
recent weeks that 6-13 week breadth and momentum indicators
portrayed a developing topping process. But, at this juncture
I would have to say that unless there is a sharp sell-off
starting at some point over the next week or two, the idea
of a topping process may have to be shelved.

The last technically strong entry point I had was in June/July
2006. The rally that began then was a terrific one to trade or
ride. The rally that kicked off in the first half of March, 2007
did not have the deep oversold pedigree I prefer and I have passed
on it. The tough thing for me is that viewed short term, this is
a respectable run-up, nonetheless.

So, from a technical perspective, I am on the beach for the next
two weeks, left to hope we get a sharp correction to a stiff
overbought. Now the existentialists out there will chuckle at
this, remembering as they will that Albert Camus was fond of
saying that "to hope is to despair"....

Liquidity Factors

This is an update post which builds on the original "Liquidity
Factors" memo posted on 2/14/07.

Monetary Liquidity
The Fed continues to maintain basic monetary liquidity growth
at low levels. M-1, the basic money supply, has shown barely
any growth for some time now. Monetary policy remains firm.

Credit-Driven Liquidity
This wide measure of money remains in a strong growth pattern,
although yr/yr growth has leveled off at about 9.0%. The growth
of bank lending to key sectors -- mortgage and real estate
development, home equity and C&I loans has moderated in recent
months, although the real estate and C&I books are still up
smartly yr/yr. The real estate loan book did dip in March reflecting
the turmoil in the mortgage market. Bank funding remained aggressive
and sales of asset backed paper resumed growth. Funding tends to
follow loan growth, so there could be some moderation of broad money
growth ahead. The slowing of the economy since mid-2006 is beginning
to be reflected in asset generation and funding.

Economic Liquidity
With a more sluggish real economy and still high broad money growth,
there is surplus liquidity in the economic system to support financial
and real asset investment and speculation. There is a liquidity
tailwind for areas that are viewed positively. Unfortunately for the
Fed, commodities speculation has picked up some, which reduces the
efficiency of monetary policy management. The loss of Fed control
traces directly back to the Greenspan Fed liberalization of reserve
policy implemented in late 1992 and never reversed.

Trade-Driven Liquidity
The outflow of dollars through the trade window remains high but
relatively static. The leveling off of dollar outflow will negatively
impact offshore growth with a lag.

Crude Oil Quickie

After a bizarre meet with Pres. Ahmgonnabebad, the 15
Brit mariners were sent home with pink goody bags late
last week. Today, Iran started hyping its ability to
produce larger amounts of enriched uranium. The market
ignored this latest price kite job, and continued to
sell off crude in the wake of the capturees' release, with
oil down over $5.25 bl. to $61.50.

April is a strong seasonal month for crude and I am hoping
the geopolitical bunkum will stay quiet long enough to get a
good fix on supply / demand fundamentals. Tame fuel prices
would take pressure off the global economy, so let's see if
we can get a clear read on these markets in the weeks ahead.

Jobs And Indicators

For Q1 2007, civilian employment gained an average of only
109K jobs a month, with all of it coming in March. Slow going
for the quarter. Measured yr/yr, employment is up 1.8% and
wages are up 4.0%. That would be fine, except that a bump in
inflation is cutting into the income growth. Fuel prices need
to settle down or else consumer spending in constant $ will be
undercut.

Leading indicators are sluggish. Breadth of commercial and
industrial new orders is still positive, but is at a three year
low and is trending down. Indicators suggest GDP growth of no
more than 2.5%.

Stock Market -- Technical

Gee, how often does the market do what you advise it to
do? Last Tuesday the technical post hinted at immediate
weakness -- the market obliged -- and opined a drop in the
SP500 from the 1428 level down to 1420-1410 could set the
market up for a more reasonable rally. Again the market
obliged. The market now features more stability, is in a
short term uptrend and has solid enough technical credentials
although it could be getting a little overbought short term.

The recent rally does not leave me in that happy a position. The
short term trend deserves respect, but my intermediate term
indicators continue to suggest the market remains in a topping
process that could run for several more weeks. So, for now, I'll
watch along and we'll see whether this rally has some staying
power.

Oil Price

After the big pratfall from the summer '06 high of $78 bl.
oil bottomed near $50 in January and has rallied strongly since.
Yearend through late April - May is a strong seasonal period
for oil as refineries switch over production to gasoline. It
is also clear that the price weakness seen in late '06 and early
'07 likely led to rebuilding already significant coverstocks.
The recent run-up in price to the $65-66bl area has to be very
much a reflection of perceived supply risk owing to the new
presence of two full US battle groups in the Gulf and the
realization that the flag officer, Admiral Fallon, commands the
whole shebang, Iraq included. That plus the Iranian promise to
engage in "illegal acts" in retaliation for further UN sanctions
on its nuclear development program set the stage for a strong
rally when Iranian special forces illegally took 15 Brits into
custody recently.

Now short of some further ugly and draconian actions, the Iranians
have about milked the value of displaying the captives, and the
pit traders would have to be a little dumb to rally off old news.
But it appears this will be a pressure area for awhile, with the
Iranians having to be careful not to overplay their hand. The US
has the Iranians very tightly contained militarily, and further
sanctions may well, in cumulative fashion, put more economic
pressure on Iran, which is now nearly a basket case.

Oil is getting somewhat overbought, and is due for a rest, but
could still finish out its normal spring rally. The trend off
that $50 low when projected out is ominous, so capital markets
players will have to watch the action in the pits carefully to
make sure oil settles down soon.

The Fed's Concerns

Fed chair Bernanke spoke to the Joint Economic Committee
of Congress today. His concerns:

1. The labor market is tight. Capacity Utilization for
primary processing of basic feedstocks and materials is
very high. Growth of capacity utilization in the US is
low across the board. This combo of factors pushes the
Fed to sit tight and say some prayers that cash rich
corporate America starts spending more on development.
(Europe has a similar problem with labor. The available
workforce does not have the skills needed by growing
businesses. The tech sector is on the verge of blowing
orders because they are coming up short in skilled labor.)

2. Inflation excluding food and fuels is high relative to
target and is proving stickier than the Fed thought it would
be. On top, fuel prices are rising again. The inflation
situation pushes the Fed to sit tight as well.

3. The subprime mortgage market fiasco has surprised them. Oh,
the Fed knew full well that the tightening of monetary policy
would prompt a rise in delinquencies and foreclosures, but
they likely did not bargain for the collapse of credit
underwriting standards and outright fraud that is putting so
much additional pressure on the market. The Fed and the FDIC
among other regulators now have no choice but to embrace
regulatory reform. This will add to the problems in junk credit
markets for the forseeable future, because financial organizations
tend to freeze asset generation until the new regs. are spelled
out and understood. The junk asset-backed credit markets will
suffer. The Fed would like to sit tight on this, too, but they
will have to monitor carefully for spillover effects to the general
economy.

This is the first tough stretch for the Bernanke Fed. We'll see how
they handle it.

Stock Market -- Technical

Readers of this blog by now know that my approach to technical
analysis is far more artful than mechanical. Being artful
involves working with principle and discipline and, in the case
of this type of analysis, idle tea leaf reading is hopefully
banished.

The approaches I use do not give buy and sell signals. But on
occasion I am struck by configurations that are worth mentioning.
The various market charts I follow all show a downdraft in the
25 day m/a. The market would look less vulnerable if the 25
day m/a had popped up on the recent rally. That simple dvergence
is a bright yellow caution light in my scheme.

Secondly, and again, artfully, the rally would have more of a
positive bias if the the SP500 were to fall from today's 1428
down to 1420 - 1410 before moving ahead at a reasonable pace.
That would distinguish it from the kind of madcap short covering
we saw last week.

Another factor is the ADX (shown on linked chart). The whipsaw
action there since late in December is a bit disturbing. Chart.

Stock Market -- Technical

To be upfront, I am not sure what to make of this market.
From my perspective, it still looks unstable, despite the
double bottom between the vertical down and the vertical up.

The internal supply demand indicators, the longer term
momentum oscillator and the buying and selling pressure
gauges leave me with the impression that the market could be
in the same topping pattern it started before the rude sell-off
at February's end. But, no table pounding from me.

First things first, and that suggests it would be nice to see
the market stabilize over the next week or two.

Posting Problems

There is an e-tag somewhere that I am working to have
removed.

Stock Market Fundamentals

The SP500 Market Tracker is about 1550 for March,'07.
The market is nearly 9% below the Tracker at 15.9 x
expected 12 mos. earns (through Mar.). With lower
inflation since mid-2006, the market should be at 17.5x.
The worry is more about the earnings outlook than
inflation. Earnings estimates have been cut, and first
quarter net per share could come in only 5% above prior
year for the "500" and below the Q2 '06 level.

The market model based on the monetary base remains
positive, but the appreciation in the market since the
end of 2005 is considerably stronger than the model
suggests. This is no longer an uncommon development and
reflects investor attention on the growth of credit
driven liquidity which had been accelerating steadily
until just recently. There are a couple of factors worth
noting here. First, money and credit growth most closely
tied to transactional demand within the economy has
slowed appreciably this year. Secondly, with bank funding
needs having eased some, broader measures of money growth
are slowing, especially finance company sales of asset-
backed paper (reflects slower economy and sub-prime mortgage
fiasco).

As I have discussed in a number of posts, the economy can
be very vulnerable once credit driven liquidity starts to
slow or recede, AND if the Fed chooses to let it unwind
and not add reserves to the system in a decisive manner.
The US is at that point now. It is a high risk point in any
US business cycle.

So with earnings estimates coming down and liquidity at issue
investors have moved to discount the earnings cuts and ponder
whether the shallow dip in the road might be a prelude to a
valley.

It would be a breeze here for the Fed to ease if capacity growth
was accelerating nicely and a dose of monetary liquidity would
push the economy into a higher but more balanced growth mode.
Such was the case in 1995 -- the last big "soft landing" play.
It is not the case now, as capacity growth continues to lag that
of demand growth potential. To ease now, the Fed would be
gambling not only that productivity growth would soar, but that
capacity growth would finally accelerate. Perhaps the FOMC will
shed some light on this issue at tomorrow's meeting.

I came into 2007 cautious on the stock market and I remain so. The
absence of balance between economic supply and demand remains and
continues to leave me with more questions than answers.

Gold

As discussed in the 12/27/06 post on gold and the USD, gold,
then $628 oz., was in a strong seasonal mode and could run some
if it could take out $640-650 resistance. It was also noted that
the positive seasonal window could run through Jan. Gold did
oblige, rising to close to $700 oz. in late February before
selling down to the current level of $643. Gold is now in a
seasonally weak period that could last through April.

Gold remains in a long term bull market, moving in nice tandem
with the broader grouping of industrial commodities pricing.
These markets have all enjoyed positive demand growth and very
high operating rates, as capacity additions involve long lead
times. The impetus to gold from the growth of monetary liquidity
has slowed appreciably from late 2004, but the strong liquidity
underpinning from the late 1990s through 2004 paved the way for
a powerful industrial economy that has only recently begun to
slow. The oil price was also a major factor in gold's rise, but
has likely been a drag since mid-2006, as the oil market
has moved into a better balance of supply vs. demand.

For the gold price to hold the accelerated uptrend underway since
mid-2005, gold must hold above $640 - 650 oz. over March and April.
A break below this rising support line would suggest gold might
return to the more modest uptrend it established from 2001
through mid-2005. It will be interesting to see how gold fares
during this period of seasonal weakness.

My macro indicator for gold declined from mid-2006 through October,
but is now trending up. The trend trajectory suggests gold could
be around $550 for the end of the year, and implies that the
gold price excess generated over the past fifteen months has not
been fully wrung out. The macro indicator prices gold as primarily
an inflation hedge asset and not as a geopolitcal play or as a haven
during times of financial stress. There is no shortage of gold bug
sites that play up the latter two avenues of interest.

The macro indicator has a modest positive trajectory now because of
a quiet oil price and also because the monetary liquidity
indicator component remains in a sluggish uptrend. As I have discussed,
I think the Fed would like to hold off giving the economy a goose
for as long as it can this year. Obviously, if the global markets
continue to reflect the slowing of global liquidity in place, the Fed
and other central banks may have to relent. There are no doubt gold
players who are betting strongly on that very point, while hoping their
baby does not go out with the bath water in the interim.

Economic Comments

The leading indicator sets are consistent with real growth
of 1.5 - 2.5%. Order rate measures for both manufacturing
and services signify mild growth, but remain in downtrends.
Employment, as measured by the larger, more current household
survey, shows no growth in jobs since 12/06, reflecting
weakness in construction and manufacturing. Measured yr/yr,
employment growth is up 1.8% and hourly wages rose 4.1%.
The 12 month employment and wage data support economic growth,
but the recent flattening in jobs growth is of concern. So, I
would conclude we are headed for a Spring showdown as far as
economic direction is concerned. When the economy is slow, mixed
readings from various data series are common, so it is not easy
to maintain perspective from one news release to the next. It is
not appropriate to be complacent but still too early to be alarmed.

Stock Market -- Short Term Perspective

Today's big up move extends the market's instability.

Can there be a "V" bottom -- a one day lead in to a positive
move without a retest or a period of base building? Sure can.
It is an against the house bet, but not a foolish or even
unreasonable one. Note though that investors have tended to be
more circumspect about jumping long on a significant dip since
the 2000 - 2002 bear.

The market remains oversold in the short run.

The market is also in a seasonally weak period, with sharpest
risk coming up over the second half of this month. Interestingly,
since the market nearly made a double bottom in early 2003 before
the big take-off, it is worth remembering that the four year cycle
low could occur in early in 2007 rather than 2006 as most players
had previously expected. If so, the SP500 could easily fall another
7-8% over the next several weeks. Cycles are usually too imprecise
to warrant being dominant in one's thinking, but the savvy player
keeps aware of them.

As I have said since near year's end, I am in 100% cash equivalent
because I seek some resolution regading how the economy might play
out over the eighteen odd months. I am not bearish, just cautious.
During periods like this, I usually sequester the spread between the
short rate yield and the inflation rate and play the options market
at hopefully opportune moments.

Stock Market

The Boyz on The Street tried to turn it around today by
purchasing signal baskets of stocks like the Dow 30, but
to little avail. The SP500 broke critical short term support
at 1380, thus ratifying the turn in the market.

The short term trend is down, but the market has developed a
substantial short term oversold condition. At this point, only
traders with acute timing sense should be trading ahead of the
trend.

My intermediate term indicators (30 days +) have turned down and
are flashing a strong caution. Moreover, the trends in the buying
and selling pressure gauges are still gradual enough to suggest
that any further correction and subsequent base building period
could take several months, although the depth of any further
correction need not be severe. The intermediate term technicals
have yet to reach comfortable oversold levels.

The fundamentals remain positive, but are more subdued as earnings
estimates may be trimmed ahead of the end of Q1 '07. Risk levels
remain elevated as the US economy continues to pass through the
slowdown phase. However, housing and business inventory corrections
have been well underway.

As discussed in prior posts since 12/06, I remain cautious on the
market and have stayed fully in cash since late last year. Unlike
many players, I am still most curious about whether a resumption of
stronger economic growth a little later this year will be balanced
enough to allow for continuation of a cyclical bull market into
and through 2008. I still think that will be the more important
question this year.

The sets of leading economic indicators I follow continue to point
to ongoing growth at a subdued pace. The one surprise with these
indicators has been the volatility recently seen in the services
sector. I suspect sensitivity to fuels and materials prices may be
especially important here.

Stock Market

It took no less than Uncle Al to remind players that trying
to soft land a maturing economic expansion carries risk. He
focused on weakness in manufacturing and production and to
point out that the economy is not immune from downturn. That
sent the export driven Asian stock markets into a tizzy and
knocked the US market off its smooth running uptrend. Yes, we
saw panic selling on Tues. and on the open today. Yes, there
is evidence of climatic selling. Yes, the SP500 tested important
support around 1380 today and bounced up nicely. Yes, the
market has turned down.

Got to be the first kid on the block to have THE right answer
for the short run? Go for it. Me, I am in no such hurry. I am
content to wait a couple of days for the market to exhaust the
furious bull vs bear fight and stabilize. Let's give everyone
the weekend to sort their thoughts out.

At this point my internal supply / demand indicators suggest
only that a shorter run overextended position is being corrected.
It is a down market, but the work does not suggest yet that it
is a broken market. The fundamental indicators are still tracking
positive, but business risk levels remain elevated as I have
discussed, and the recent sharp downdraft in stock prices indicates
a substantial hit to confidence. Again, my vote is to give everyone a
pass until Monday so we can assess the fragility of the collective
psyche. Too much zigging and zagging right now.

Uncle Al Warns.......

Mr. Greenspan, speaking by satellite hookup to a business
conference in Hong Kong, warned the US economy could surprise
and slip into a downturn in late 2007. My guess is that
Greenspan is reminding Fed chair Bernanke and the rest of
the FOMC not to fall asleep at the switch as the year moves
along. As recently posted, the time honored indicators of
Fed policy are currently pointing toward ease. These
indicators -- the ISM mfg. survey, production and the operating
rate and the balance of supply and demand for credit were
mainstays for the Greenspan Fed. As I have pointed out a few
times, The Fed would prefer not to have to ease until later this year
if then, as they continue to weigh the viability of the soft
landing of the economy. Greenspan did note that the housing decline
has not yet had substantial spillover effects on the economy. His
concern is with manufacturing. See further.

Inflation Indicator Ticks Up

The inflation indicator has ticked up in February, reflecting
higher crude price realizations and strength in the industrial
commodities composite. The crude picture partly reflects colder
than normal weather in the US but likely also belligerent talk
from both the US and Iran re: Iran's nuclear enrichment program.
Iran loves a higher oil price and the oil patch pals of GWB and
The Shooter do not mind it, either. 'Tis not smart for the US to
get too verbally nasty because these are tender moments for the
economy. The oil market is not overbought, and there is resistance
all the way up at $64. Yr/yr price momentum remains negative and
thus is a continuing drag on industry profits. Oil chart.

Stock Market Technical Note

The work I do with unweighted composites suggests that the
broad market is a little extended short term but not overbought.
The SP500 needs to end next week ahead of today's 1451 close to
hold a decent trend.

My intermediate term (13 week indicators) now clearly suggest the
rally underway since 6/06 has entered a topping phase. This need
not be cause for immediate concern, since, by these measures, a
topping phase can take up to 6-8 weeks to complete.

Stock Markets

US Fundamentals

My Market Tracker implies the SP500 should be trading at
1535 rather than the 1460 it closed at today. The Tracker
has risen rapidly since June '06 reflecting rising earnings
and a sharp bump up in the p/e ratio owing to a substantial
deceleration of inflation. The p/e on the "500" should be
around 17.5x but is down at 16.6x (12 mos. eps through Jan.).
However, the p/e on my larger 1,750 popular stock universe
is 18.9x. So, I conclude the market is a little richer than
fairly valued. In turn, the SP500 is trading about 11.5%
above my long term dividend discount model. Not a big
premium, but a premium nonetheless. I also look at the
market against the progress of the monetary base. The base
is rising -- a positive -- but not nearly as fast as the
market. This means investors have become increasingly
comfortable with an economy and market riding heavily on
credit driven liquidity, which happens to be rising
faster than the economy itself -- another positive. By the
same token, the risk level in the market is rising owing
to that increased dependency on liquidity, since it can
evaporate in a slow economy. I conclude that although the
fundamentals are tracking positive, there is little
value and rising risk.

The Shanghai Express

I have received over twenty e-mails since year end 2006
alerting me to a parabolic rise for the Shanghai Composite.
Most of the guys who sent e-mails along are greybeards like
me and are getting a big kick out of it. For a peek, check
here.

This parabolic looks very nearly complete. Most parabolic
trends end in a blowout, although such need not be fatal
as there can be a bounce back. Interestingly, the Shanghai
could fall 40 - 50% over much of the rest of the year and
still be in a longer term bull market. This market is not
one I follow closely, but it sure looks like there
could be some volatility ahead. It will be fun to watch.

Monetary Policy

Weakness in production, declining capacity utilization,
a narrowing of producers with a positive outlook, a
flattening of short term business credit demand. It's
what the US has now and long term Fed practice clearly
suggests a cut to the Fed Funds Rate. The tenor of recent
comments by chair Bernanke and others on the Board point
away from a rate cut. Current Fedspeak says rates may have
to be raised if inflation surprises to the upside.

What gives? My guess is the Fed sees the run offs of excess
housing and goods inventories as the prelude to eventual
recovery of production and later, housing investment. So,
the Fed is forecasting that rising final demand for
consumer goods, services and exports will lead to this upcoming
recovery of production and housing. Implicit of course, is the
notion that weaker production and housing will not produce
increases in joblessness and weakened confidence that could
bring the economy down. The Fed may also not mind if the economy
stagnates for a few months, if it makes it easier to squelch
inflation pressure further and create enough slack to goose the
economy later this year for a clean run through 2008.

Whatever, the Fed may be waiving off long standing practice and
you should keep that in mind in assessing the outlook for both
stocks and bonds, since the dynamics of the US economy can
fool the best of us at moments like now.

Liquidity Factors

With new bank concerns having surfaced regarding the sub-prime residential
mortgage market, it is timely to benchmark the various liquidity factors.

Monetary Liquidity -- Here we look at the building blocks of the basic money supply: Fed Bank Credit and the Monetary Base. The Fed has kept a tight rein on these composites for over two years to enforce the raising of short term rates and to maintain the current structure. Over the past year, Fed Credit has increased by 3.7% and the monetary base has risen but 2.2%.

Credit Driven Liquidity -- I use an M-3 analog to capture bank system funding. Since early 2005, this composite has increased from a twelve month growth rate of just under 5.0% to 9.4% through Jan. 2007. the major step -up in the growth of time deposit and commercial paper issuance has been to fund a sharp acceleration of commercial and industrial loans ("C&I"), but banking system real estate lending exposure has also continued to grow at a 10%+ rate as well. The slowing of the C&I sectors of the economy over the second half of 2006 resulted in reduced working capital requirements and has resulted in a flattening of C&I loan demand. It will be interesting to see whether concern over lending exposure to the residential mortgage market triggers a slowing in the growth of the banking sectors' real estate book. If the latter were to occur along with a more leisurely pace of C&I lending, funding requirements would slow, credit driven liquiditywould decelerate and the Fed might be forced to add more monetary liquidity to the system. A transition of this sort can be risky business for the general economy if the Fed delays too long.

Economic Liquidity -- I derive this measure from comparing yr/yr rates of growth of the M-3 analog with the $ cost of production growth. When the broad money supply grows faster than the $ cost of production, excess liquidity is generated in the system, and this excess can fuel speculation in financial markets where there is already positive interest. There has been a surge of excess liquidity since mid -2006, reflecting a modest pick up in broad money growth and a sharp deceleration of current dollar production growth owing to downticks in unit production growth and a sharp deceleration of inflation pressure. This development has no doubt helped the stock and gold markets, but since the money and production growth measures are dynamic measures, you have to monitor their interplay continually and be careful to watch for trend inflection points.

Trade Driven Liquidity -- This is a simple measure to monitor the gross dollar outflow from the US as a result of the trade deficit. When the dollar outflow is rising, it provides additional liquidity to the international economy and markets, and when it contracts, the opposite occurs -- all with a lag. The dollar outflow through the trade window remains very large but has not increased over the past fifteen months or so. This development suggests it is fair to temper one's thinking somewhat concerning international economic and market prospects.

Economic Indicators

The leading indicator sets I follow point to continued
economic growth paced by consumer spending, export sales
and the service sector. The housing sector is continuing
to work off a still sizable inventory overhang, mortgage
applications remain range bound, and new concerns about
the sub-prime mortgage market will no doubt lead lenders
to tighten standards further, at least for the short term.
The manufacturing sector has shown an improvement in $
order levels, but only about half of the group is recording
improving order flow. On the plus side for goods producers,
distributor inventories have accelerated a run - off which
can set the stage for a rebound. On balance, growth potential
looks to be about 2.8 - 3.0%.

The longer term inflation indicator fell sharply again in Jan.
but is bouncing up here in Feb. on the sharp rise in oil prices.
A turn to unseasonably cold weather this month is helping this
market, and requires close scrutiny as a run up in oil cuts
into real consumer incomes -- the bedrock of the current period
of economic growth.

Stock Market -- Technical

The powerful, compact uptrend that began in mid-July '06
was destroyed by a brief, fast sell-off in late Nov. But
the market righted itself and has embarked on a new uptrend
running from 11/27 through the present. The momentum is
decent but less ambitious than the Jul.-Nov. run. In
both runs, the dips have been bought quickly and so have
been shallow. The surges up are moderating, as profit takers
are moving in more quickly as the rally goes along. On
balance, the advance has been orderly and disciplined, with
none of the divergences evident that would signal a speculative
blowoff. Sentiment measures are bullish enough to warn, but
are not yet egregious.

The rally blew right through the seasonally shaky days of Sep.
and Oct. February is a seasonally weak month, and attention
should be paid. From a cycle perspective, the latter part of
March may hold even more risk of some damage.

An intermediate term overbought condition developed in late
autumn of last year, but this was largely relieved by the
sideways action running from mid-Dec. through mid-Jan.
However, the strong price action in the composites since
the end of January has re-introduced an overbought and has
turned my breadth model and my favorite non-cap. weighted
index, The Value Line Arithmetic ($VLE), short run over-
extended.

Short term, I like to watch the market against its 10 and 25
day M/A's. In a rising market, a break below the 25 day M/A
catches my attention, particularly if the "10" follows suit.
See here.

The Fed, Economy and Stock Market

The FOMC's decision to keep the FFR% at 5.25% was widely
expected and was well discounted in the markets.

The preliminary GDP report for Q 4 '06 was better than
expected, featuring moderate real growth and a low inflation
number. The markets liked that. Measured Q 4 yr/yr, real GDP
rose 3.4% and real final demand rose 3.5%, reflecting an
acceleration of inventory run-off. Final sales to US purchasers
rose 2.8% -- in line with underlying demand. Real GDP topped
sales to US purchasers reflecting substantial improvement in
the balance of trade in recent months. Personal consumption
advanced 3.7% -- on the strong side-- compared to real disposable
income growth of 3.1%. Dis-savings shrunk but not as much as I
had hoped, now that short rates are well above inflation.

Final demand growth has pulled ahead of production growth and
this could continue into the first quarter, but the US now may
be setting up for stronger production growth. Capacity growth
in the US continues to lag both production and final demand,
which keeps the internal inflationary bias of the economy in
place.

It was a "goldilocks" day for stocks as investors moved in on
the moderate growth / low inflation combo.

To add zesty irony to the day, GWB, the ultimate plutocrat, came
to Wall St. and admonished the captains of corporate America
about over the top fat cat compensation practices.

Monetary Policy

There is broad consensus the Fed will leave the FFR% unchanged
when the two day FOMC meeting wraps up tomorrow. Last month, the
data veered a bit toward ease, but the Fed ignored it as expected.
this month the key data series I follow have firmed modestly, so
I do not see any reason for change, either.

Based on my super long term model, the FFR% should be around 4.5% -
4.7%. The FFR% is 5.25%, and it is above "target" primarily because
of the rapid drop off in inflation pressure over Half 2 '06 and
the Fed's reluctance to respond immediately in kind. As I have
discussed, the Fed needs to take full measure of the effects of
earlier FFR% hikes on the economy (negative) combined with the
beneficial effects of a rapid deceleration of inflarion upon
real incomes and consumer confidence.

Over the last few weeks, the Fed has drained the extra liquidity
provided for the holiday season from the system. Noteworthy is
that currency and gold traders reacted in a more tame fashion
to the holiday inflation. Noteworthy also is that with short term
business credit demand having flattened out in January, the
Fed drew down heavily on official reserves to maintain the
FFR at 5.25%.

S&P 500 Earnings

Quarterly "operating" net per share made a recession bottom
of $9.02 at Q2 2001. Since then, quarterly net has progressed
sharply and fairly evenly to an apparent interim cyclical
peak of $23.03 for Q3 2006. That translates to about 16.5%
annual growth off the trough -- impressive.

Over this period, companies saw profit margins widen as unit
sales growth outpaced unit cost growth reflecting rising
productivity, modest compensation increases, lower interest
costs and translation gains from a weaker dollar. In addition,
energy and industrial materials companies generated large
inventory profits as pricing rose strongly in these categories.
Finally, US companies saw profits from foreign subs and
affiliates rise sharply in the context of strong international
economic growth.

It appears profits fell in Q4 and projections indicate that no
major upside breakout in quarterly net can be expected until
Q4 2007, when operating net is seen rising above $25. Recently,
a slowing economy has cut yr/yr sales growth from a peak
level of 9.5% down to about 5.5%. Wage growth has picked up
and productivity gains have decelerated noticeably. This means
an increasing number of companies are experiencing profit margin
erosion. Moreover, oil and gas prices are well below peaks
and sensitive materials prices have been on a plateau. These
developments eliminate the vast bulk of inventory profits.
Note also that funding costs are up for non-financials and that
dollar translation gains have narrowed. On the plus side,
foreign ops continue strong.

The financial services sector has also been a strong performer
during the current expansion, with revenues growing 10 - 12%.
It was only Q4 2006 when there was some slight slippage.

This is not the most congenial environment for investment
managers. The US economic slowdown has brought pressure on
company profit margins and analysts are not expecting a strong
lift to earnings until late in the year. Managers also know
that a sluggish economy and a smaller trade deficit may also
herald slower business conditions in foreign markets. If it
was a sold out stock market, there would be little edginess.
But the market is only modestly below fair value, so managers
should not be sanguine.

It appears that to get operating net up from the Q4 2006 level
of about $21.50 to over $25 by late '07 / early '08, the
economy will need to strengthen appreciably, and this may
imply that Fed easing is also part of the expectations game
plan. On the plus side, note that the leading economic indicators
are starting to firm up.

Viewed long term, a rise in quarterly operating net above $25.
by late 2007 would signal the advent of the arrival of the
cyclical earnings peaking process which could carry over into
2008, but which would put me on notice as well as some other
old hands. A goodly volume of water will flow 'neath the
bridge before then, but at that time, it will be critical on
this hypothetical to look at the balance between economic
supply and demand.

Stock Market -- Technical

Not much change in the technical situation for the
past week or so. The market remains in an up mode, but
has taken to grinding slowly higher. The favorite internals
are pointing up, although momentum measures are flattening
out. The link ahead to the SP500 chart shows RSI (overbought)
and MACD. Click here.

The MACD (12/26/9 --weeks) is a longer measure than I usually
use. It is deteriorating along with momentum, but what is
also interesting is how extended it is. That attests to the
power of the rally overall for the past seven months, but it
also serves to put one on notice how carefully one needs to
proceed near term.

Oil Market

Over the past four years, my analysis has seen the equilibrium
price for oil rise from $37.50 bl to around $45.00 bl. The actual
price was far stronger than the equilibrium price reflecting
healthy underlying demand growth, a very tight supply situation
and powerful speculative purchasing based on the dimunition
of spare production capacity to an exceptionally low 1 million
barrels a day. The bear market, which began last summer when
crude topped out at $78 bl., has seen the price drop to just
a tad above $50 bl. Cover stocks were built to multi-year highs,
demand growth has moderated, and supply growth has picked up,
creating up to 2.5 million bd in spare capacity currently.

In short, the market has begun to return to balance, and because
new supply comes on in size and not in drips and drabs, there
may be a moderate build up in spare capacity over the next few
years, even as demand grows. These developments have led to a
groundswell of comments by industry observers about how low the
price of oil could go over the next year or so. I'll have none
of that. With demand now over 85 million bd worlwide, the
industry needs a higher margin of excess capacity to provide
assurance to economic growth. Moreover, I could be on the low
side with my cost estimates, as new supply will come on with
higher finding, development and lifting costs embedded. So, oil
at $45 bl. is fine by me as a working assumption.

Ever since the US moved against Saddam's regime in Iraq in 2003,
a number of geostrategists and pundits have been speculating
about a US strike on Iran to cripple its nuclear dvelopment
capabilities. I have viewed this as a crock of BS. However, there
are now two full US battle groups in the Persian Gulf and the
entire theater is under Admiral Fallon's flag. I still doubt that
the US plans a pre-emptive strike on Iran, but the US may go
after overland and ratline supply routes leading from Iran into
Iraq, and such action, should it occur, might give a substantial
goose to anxieties about oil supply from the region at large. So,
we will have to watch for this little saga as the year unfolds.

In the meantime,If oil gets down into the $40's, it will be time
to dust off the oil stock groups for a look. I have avoided this
industry for a couple of years now because the crude pricing
assumptions have been on the generous side. There has been lots
else to trade, so I have not missed it.

Stock Market -- Technical

It remains an up market, obviously. But the uptrend is
more tentative. There have been some short term price
and breadth breaks of trend, momentum has slowed
noticeably, and there is a hint in the longer term
momentum work that the market may be entering an
interim topping phase. The strong intermediate term
overbought condition I have discussed in recent weeks
has eased some, but the market is near enough to being
overbought that it is hard to justify an expectation of
a sharp short term advance from the current level. In
sum, the market is rising but the trend is far less
assured and it appears to be maturing.

Inflation

My primary inflation gauge has dropped as rapidly as it does
when the economy is entering a period of recession. As all
must know by now, the primary culprit behind the blowout is
energy pricing -- oil, petrol products and natural gas. In
fact the weakness in energy prices dominates the fall in
commodities, especially on a usage basis. So we do not have
the kind of broad based erosion in materials pricing that
attends a business downturn.

Spare capacity in oil at the wellhead, which might have dipped
slightly below 1 million bd at its nadir, has now advanced to
around 2.5 million bd. Demand growth has moderated, first because
of how high the oil price went, and now because of a strong
contra-seasonal factor in the form of warmer weather. Supply
capability is expanding as expected and there is word that OPEC
is cheating on announced production cuts, again as expected.
As discussed in earlier posts on oil, carry stocks had reached
multi year highs this past summer. So I see the weakness in
oil primarily reflecting the unwinding of speculative excesses
and the return of the market back toward equilibrium. Much the
same can be said for the collapse in natural gas over the past
year as well, except that gas is a tougher call because of the
continuing tightness in storage and pipeline throughput capacity.

I have equilibrium pricing for oil in the mid-$40's per bl and
for gas at $4-5.00 per mcf. Whether either commodity will trade
down to and remain at those equilibrium levels for a while is
anyone's guess as far as I am concerned, but I suspect there are
enough sadder but wiser beavers out there to leave these markets
tamer for a spell, once the proverbial dust has settled.

Since the leading inflation index has not bottomed yet, odds are
that so-called "core" rates of inflation may not have either.
Discussion of the outlook for inflation does need to be tempered
by the fact that the leading indicators rarely make extended
bottoms, but tend to turn up quickly when they turn. What is
interesting here is that we have witnessed blowouts in certain
commodities composites not so much because final demand has
tumbled, but more because of the unwinding of speculative excess.
The re-energizing of the speculative appetite could take a bit
longer in such circumstances.

There are a couple of other factors to keep in mind regarding
inflation. The Fed remains tight with monetary liquidity. Measured
yr/yr, Fed Bank Credit has advance by only about 3% a year since
the end of 2004. That is a "disinflationary" factor to say the
least. Secondly, with the US trade deficit appearing to stabilize,
a primary source of incremental dollar liquidity to the global
economy has dried up. That is both an economic growth and inflation
headwind factor.

Stock Market Discussion

MY SP500 Market Tracker puts fair value for the index between
1450 - 1480 as we move into January. The mid-point of the
range, 1465, is up nearly 16% from the 6/06 Tracker reading of
1265. About 2/3 of the gain reflects imputation of a higher
p/e ratio reflecting the very rapid deceleration of inflation
since mid-2006. The market had a strong second half, with
closing prints at 1427, but it has tailed off in recent weeks.

Mainly, I think this reflects the fact that the rapid run-up
in the Tracker was a bit too fast for a market that retained
a reasonable amount of discipline and did not chase stocks
willy-nilly. As it was, the actual run-up in prices produced a
strong intermediate term overbought which was likely corrected
this week. But today's sell-off introduced more into the mix,
as improving economic data, highlighted by today's stronger than
expected jobs report, has weakened investor conviction that
the Fed would cut the Fed Funds rate before long.

As discussed in postings over the past month, I have expressed
the view that the Fed would resist cutting the FFR for as long
as it could, and that it would tighten instead if the economy
firmed up. I took a cautious, but not bearish view toward
much of 2007, because the case simply has not been there to
support a rate increase. Higher short rates would cut the
positive differential between the market's earnings/price yield,
now about 6%, and the T-bill yield, to a very narrow 50 basis
points, which would bother a fair number of players. To
make matters a bit more confusing, consider also that a sluggish
economy in the recently ended final quarter, may produce an
increase in the volume of earnings disappointments even as
the shorter term and longer run economic leading indicators are
in the process of firming up.

In summary, there's enough uncertainty in the economic outlook
to make it understandable that investors might not eagerly
embrace the 1450-1480 range for the SP500 envisioned by the
Tracker straightaway.

For now, I am just along for the ride. My powder is dry and my
conviction this is not the kind of year for a guy with my
type of approach to be running around making forecasts, remains
undiminished.

Stock Market -- Grumpiness Prevails On Day 1 '07

As discussed yesterday, there was good technical reason
to be grumpy about the start of the new year. The edgy
money moved quickly out of stocks today when the SP500
again failed to break out to and sustain a new high
above that 1427 resistance level. The release of the
FOMC Dec. minutes only helped grease the skids.

Today I have included a six month daily chart for the
SP500. Note how as the market rose, the 10 day MA was
the first line of support followed by the 25 day as the
primary support. The market tested the "25" today and
closed above it. Keep an eye on the action relative
to the "25" in the days ahead. Click it.

Stock Market -- Technical

In recent weeks, the stock market has been working off a
powerful overbought based on internal supply / demand
fundamentals. It still looks like this process is not
yet complete.

Internal fundamentals -- varied measures of breadth -- show
a positive bias to the market with fading momentum as this
overbought is worked off. The weekly SP500 chart looks less
healthy based on some conventional technicals. Click it.

Note the overbought on the 10 week RSI, and the downturn on the
short run MACD. Note also that the current MACD at around plus
20 equates with recent tops that ushered in very sluggish
intervals. On balance, I am not bearish, but I am grumpy about
the set up for the opening gambit of the new year. The grumpiness
is elevated by the fact that the SP500 has twice failed to take out
the cyclical high of 1427 in recent sessions as well as recent
strongly bullish sentiment in the advisor sentiment surveys
such as II, Consensus and Marketvane.

2007...Part 5 -- Gold & The US Dollar

Gold

The gold price ($628. oz.) is in a seasonally strong period
presently. This interval normally lasts through late Jan. /
early Feb. of the succeeding year. For the current rally in
gold to have any real "pop" short term, it needs to take out
overhead in the $640-650 oz. area. Sluggish oil and industrial
commodities prices probably have inhibited speculation so far.

My gold macro-model has gold fairly valued now at $520. I can
make a decent case for gold to go to $550 by yearend 2007, so
gold bugs and bulls will have to look elsewhere for a rationale
for the current price, much less a sharply higher one. Reasoning
from my model, gold made a blow-off top just above $730 this year
reflecting the culmination of a lengthy period of inflationary
monetary policy by the Fed that dates back to the late 1990s.
Since the end of 2004, monetary policy in terms of monetary
liquidity growth has been tight. My view is that the Fed will
keep policy firm for as long as it can next year, before easing
to pave the way for a stronger economy in 2008. So, that leaves
me suggesting that there could be large but temporary downside
price risk in gold after the seasonally strong period winds up
later this winter.

US Dollar

I have a simplistic view on the dollar: If folks in the US should
not hold dollars, neither should foreigners. You can put dollars
to work now at no or nominal risk and earn 5.25%. That translates
into a positive after tax return adjusted for inflation. Moreover,
the Fed has kept the printing press in the "slow go" mode now
for nearly two years. Domestically, the dollar is fine. This
contrasts sharply with mid-2004, when short rates were 1.00%,
inflation was accelerating and the Fed was only just entering into
tightening mode. From my perspective, it makes little economic
sense for foreigners to dump dollars now.

Looking at 2007, it may well be that dollar fundamentals slip some
later in the back half of the year, but this slippage may be
modest.

2007...Part 4...The Stock Market

In a 1/20/06 post on the stock market, I opined that the
market had the potential to rise significantly in 2006, with
the SP 500 reaching 1380-1405. We are up through that level
and did see some closing prints slightly above a revised
projection of 1425. All in all, it was a good call.

I also indicated I thought the market could rise into January
of 2007, before a nasty and substantial correction of 15-20%
ensued, primarily as a result of an acceleration in economic
growth and concerns for higher short rates and inflation.

At this point, the economic outlook is more muddled than I had
hoped. The inventory corrections that follow a slowing of final
demand may not yet have run their course, and the improvements
to real consumer incomes I anticipated as inflation waned may
not yet have boosted confidence and spending as much as I had
hoped. In fact, my macro profit indicators have clearly flattened
out as of late, and are not confirming general expectations for
final quarter 2006 earnings.

I am cautious about the outlook for stocks in general over the
first nine months of 2007, but I am not in any position now to
lay out a strong case for a 15-20% decline. So, rather than
push the conjecture, I am now content to forego the decline
projection and track developments as they move along until
I get a better sense of fundamentals and emerging trend.

I would say at this point that my caution extends well into 2007
because It is still early to say how good the balance between
economic supply and demand may turn out. In this cycle, growth
of productive capacity has proceeded slowly relative to output,
and even with recent modest upticks in growth, capacity is still
trailing output growth potential, which gives the economy an
inflationary bias.

There is another difficult issue which concerns me regarding
corporate profits and the stock market. This has to do with
the US trade position which has recently improved. If the trade
deficit is set to level off, as may occur, then the flow of
dollar liquidity abroad will flatten out, and this could
eventually stunt the profit growth of US multinationals as
the global economy adjusts.

2007...Part 3 -- Interest Rates & Bond Market

Short Term Rates

Well, it is a 5.25% market at the short end. My super
long term short rate model pegs the Fed Funds Rate at
about 4.25%. The current FFR 100 basis point premium
reflects both the recent rapid deceleration of inflation
coupled with fundamentals which support a continuation
of a 5.25% FFR, recognizing that said fundamentals do
now tilt slightly toward ease. I continue to expect the
Fed to hold at 5.25% with a bias toward tightening if the
economy holds up as I anticipate. For the short run, we
still have to see how much of an inventory adjustment will
take place in the wake of the slowing of the economy.

Short rates at 5.25% offer a positive after tax, inflation
adjusted return. There is now no economic compulsion to
spend or invest money. Maintaining a positive offering to
savers is important if the US is to regain better balance
between savings and spending, as it keeps the internal value
of the dollar stable. I suspect this is a secondary objective
of the Fed.

As mentioned in the previous post on monetary policy, I think
the Fed wants to avoid easing for as long as it can. However,
I plan to follow the financial market fundamentals closely and
will point out changes as they occur.

Bond Market

I have paid scant attention to the bond market over the past
eighteen months. By my lights, the market has been overvalued,
and not worth the time. I have missed a couple of good trades
but trades in equities more than made up for it.

The long Treasury at 4.70% provides a modest premium over
inflation of 2.0-2.5%. So, the market is ok to trade now, but
investors need a solid 300 basis points minimum over the CPI to
warrant long term positions given the uncertainties of interest rate
risk in the long run. You can earn 5.25% now nearly risk free,
so why saddle yourself with pre-maturity risk to principal that
comes with extending out? One can sing a different tune if the
economy is headed for a lengthy period of price stability or
some deflationary pressure, but that is not the view I support.

The bond market has proven to be most sensitive to the momentum
of industrial production and industrial commodities prices. I
use a combined measure computed on a six month annualized rate
of change basis. This measure had readings of +10 - 12% over the
first half of 2006, but has tailed off to a 2.7% annual rate over
the second half of the year -- hence the strong rally in the bond
market since May. Since my best guess is that this measure will
strengthen significantly later in 2007 and especially in 2008, I
would expect bond yields to trend up certainly by the third
quarter of next year if not sooner.

The powerful rally in high yield or junk bonds over the past six to
seven months coupled with an ongoing small spread between top quality
and intermediate corporates suggests the bond market is not concerned
about recession, inverted Treasury yield curve notwithstanding.
Rather, it appears there is considerable speculation that the US
economy is losing its inflationary bias in the intermediate term.

2007...Part 2 -- Monetary Policy

Best here to briefly fast forward to 2008, first. This
upcoming national election year in the US currently looks
to be wide open across the board. All the more reason for
the Federal Reserve to desire to fly under the political
radars and not have either growth, inflation or the Fed Funds
Rate become "hot button" political issues. Thus for the Fed,
2007 is the year to do what might be necessary to have the
economy straightened up and flying right through 2008.

Working backward, the Fed would prefer to tighten in the early
part of next year if needs be, and it would prefer to loosen
up on the monetary reins in the second half of '07, provided
a "goose" to the economy would usher in a more balanced 2008.

The growth of industrial production and the strain it puts on
capacity utilization and resources at large is a key factor
in the setting of monetary policy. The Nation's operating rate
is likely to finish out 2006 around 82%. The growth of US
capacity has been inching up, but is still a little below 2.5%
yr/yr. The Fed wants the economy to grow but not reach effective
capacity of 85-86% until very late in 2008. Now since inflation
pressures tend to accelerate when the operating rate exceeds
82%, the Fed would likely most prefer to see production growth
stay modest for a while in the hope that nudges up in the
operating rate would push business to expand capacity
sufficiently to keep a reasonable balance, particularly in 2008.
Can the Fed fine tune with such precision? Do not bet on it.
However, since I believe this bit of analysis of Fed intent
is as right as rain, I suspect if policy tweaks are needed,
tight comes before loose.

2007...Part 1 -- Environment Overview

It's a "backseat year" for me...

There are years when it is fun to be out front and make
economic and financial forecasts and predictions. I did
pretty well on this score over the 2003-06 period. The
truth is that being in the forecast game is a pain in the
ass as it tends to force you to keep thinking about what
you said as events unfold. For 2007, I am slipping into
"humble" mode -- just a simple seeker of truth. So, I
take a back seat to those braver than I. The key here
for me is to make projections and forecasts when it is
easy to do so, ie. when you have a compelling case. Not
so for me as I look at next year.

I peg US economic growth potential at 2.75% on a longer
range basis. That'a low number for me, and it reflects
my expectation of slow labor force growth ahead and a
more moderate pace of productivity growth. It might not
be so easy to to hit 2.75% next year. The US may go into the
year with housing and commercial inventory overhang and a
consumer whose real wage is just beginning to recover. The
areas of positive intrigue are trade and business technology.
US exports have been sloppy in recent months but remain in
a strong uptrend, and the recovery in technology is just
now approaching levels where it might be wise for producers to
expand capacity. For now, I am content to view the outlook
conservatively.

The macro-indicators I follow to track profits growth are
deteriorating as the year comes to an end, and although
still in positive territory, are close to levels that
normally suggest a flattening of profit margins and the
potential for some negative surprises. Since I do not have
a strong case for a rapid, positive turnaround, I currently
view profit prospects for 2007 as much more subdued than
in recent years.

My longer term inflation indicator has tumbled since 2006
and is in a firm downtrend as we roll toward 2007. This
suggests we should go into next year with a benign inflation
environment. Even so, there are issues. US productive
capacity growth has picked up a little more to 2.4% yr/yr
through Nov. '06. That is nice, but capacity growth still
trails longer run economic potential which, in my book,
adds inflationary bias to the economy, despite productivity
gains. Moreover, capacity utilization in the extraction and
primary stage processing sectors is running high, with little
capacity growth yet in evidence. Couple these concerns with
a backdrop of firm global growth and rising capacity utilization
and you have inflation "in potentcy" as Thomas Aquinas liked
to say. So, I do not see a clear shot at saying inflation will
not be a problem next year. Hence, I am in the back seat on
this one, too.

We have completed nearly five years of economic recovery. The
years when business around the world is easily building its
book of business are the pleasant years of rising confidence
and expectations. But history suggests these periods have
rather finite durations, and I suspect 2007 may usher in an
interval when a maturing global expansion may produce some
events that begin to challenge confidence. I do not have
a bag of "surprises" to lay out, just a sense that it might
be wise for business and financial / capital market players
to switch off of cruise control and get back to day to day
manual operation and vigilance.

I am planning several more posts on the 2007 environment for
the various markets before '06 runs out.

Trade, Oil And China

The jump in the US trade deficit over the past two years
primarily reflects a rising oil bill. Not only did oil
rise sharply in price since 2004, but the US also added
substantially to its strategic petroleum reserve. The
sharp drop in the monthly deficit in October reported
yesterday resulted from the recent weakness in the oil
market. The chances now seem reasonable that the
deterioration of the US trade position will either end
or be substantially ameliorated for the next several
quarters as US growth may trail global growth in a world
with the oil supply / demand balance still in favor of supply.
A continuing sizable trade deficit will provide ample
liquidity to the global financial system, but the growth
of such may be at a trickle compared to the $100 billion
annual increments witnessed in recent years. This
expected slowing of liquidity increments may start to
affect marginal offshore credits adversely as 2007 progresses.

Control of the US Congress has passed back to the Democrats.
Old hands will hold leadership posts, but the new arrivals
are far more skeptical of the economic policies of recent years,
particularly free trade and globalization. I doubt we are
looking at a new crop of wild eyed populists, but rather a
group more intent on sensible inquiry into policies that may be
seen as hurting US jobs and wages. Moreover, small business, whose
views on the US trade stance have been continually rebuffed by
the staunchly plutocratic Bush administration, may find a more
sympathetic ear with Democrats. Couple this with a high oil
import bill compared to just a few years back and you have a
recipe for a far more prickly period regarding trade issues.

Treasury Sec. Paulson (good cop) and Fed chief Bernanke (bad cop)
are off to China this week with a high level delegation to
discuss economic and political issues with senior Chinese officials.
This could be a strange series of meetings, since the Chinese have
to admit that both Paulson and Bernanke could be lame ducks in
what is shaping up as an open race for the roses in 2008. Moreover,
antagonism toward China's economic policies has increased
substantially here in the US, and will receive greater voice in
the next couple of years unless China and other Asian mercantilists
suddenly reverse course and accelerate the opening of their
markets and push for stronger consumption at home. To add to the
tension, Europe, no slouch when it comes to protectionist policies,
is also voicing some concerns about Asian economic policies.

I bring all of this up because as Bush 43 fades into the sunset,
there could be some interesting and provocative discussions of
trade policies over the next couple of years that could just
be raw enough to upset the capital and currency markets from
time to time. Major Asian economies are well past the "take off"
stage, so mercantilism is now pointedly self serving. If all
the players, US and Europe included, are interested in cooperation
and compromise, a transition to a more balanced global economy
is feasible without substantial destabilizing events. Otherwise,
the road through, say 2011, could have some unhappy bumps.

Monetary Policy

The Fed meets this Tuesday to discuss monetary policy.
The FOMC is widely expected to leave the Fed Funds Rate
at 5.25%.

The short rate indicators I track most closely are starting
to tilt toward ease, but not persuasively. Short term business
credit demand momentum is slowing but is still strong. Production
is slowing but services have perked up. Upward pressure on
capacity utilization has eased, but development of slack is not
assured. Finally, my short term credit demand vs supply pressure
gauge has eased some, but a fair portion of the easing up in
the reading reflects faster growth in the supply of loanable
funds. I guess if I was in the Fed's shoes now I might want
to leave the FFR% unchanged just because it looks easy to make a
mistake or a misread that could result in whipsawing the markets
within a few months. In short, a change here might involve too
fine a call.

The FOMC has expanded basic monetary liquidity for the holiday
season. It started the process late in the year and It may have
acted with even more forbearance had not cash and checkables
fallen to such low levels in the system.

Economic Notes

Employment

The US employment report for Nov. shows continuing
moderate jobs growth, a 4% yr/yr hourly wage increase
and a slightly faster weekly wage take. With inflation
now low, the real wage has again moved up modestly. The
labor market remains tight reflecting the ongoing slow
growth of the labor force (0.8% yr/yr). The improvement
in the real wage since this summer reflects a move up in
the nominal wage from a 3.5%AR to 4.0% and a break from
the sharp fall off in fuels prices.

A firm employment picture is helping to cushion the effects
on the economy of slowdowns in construction and manufacturing
output. An improving real wage is a decent leading indicator
of consumption growth. No guarantees obviously, since
confidence needs to hold up so that consumers do not seek to
bank all of the wage improvement.

Leading Indicators

The leading indicator sets I follow are consistent with the
notion that the economy should continue growing, but the
data is mixed with regard to the pace of growth. The broad
services sector seems to be gaining some momentum, while
construction and manufacturing show no turnaround yet,
reflecting inventory excess. On balance, it looks like more
slow-go ahead.

To see a view of the outlook for global economic growth
based on a weighted compilation of purchasing manager
reports, click here.

Stock Market

The intermediate overbought condition of the market I
have been discussing in recent weeks has eased slightly
but remains very much in force. Since I give this
kind of overbought six to eight weeks to work off, it
looks like the caution light could be on until year's end,
barring a sharp sell-off that is tightly time-compressed.
Now, my primary indicators are proprietary internal
supply / demand measures, but the weekly chart of the SP500
shows the overbought in more conventional technical terms.
For a view of this chart, which features RSI and MACD
indicators, click here.

Stock Market & Other Thoughts

In a Nov. 13 note on the market, I opined that it would be
ripe for a correction this week reflecting the very low
level of selling pressure. Exceedingly low selling pressure
reflects investor ebullience and an overbought condition.
Instead, we got volatility and a slight decline week over week.
So, from my perspective, the market still needs a breather.
It can come with a sharp correction or a couple of weeks of
range bound movement. I am looking for developmet of a better
balance between advancers and decliners.

This week revealed increased player apprehension regarding
prospects for an economic "soft landing". Investors were jostled
by negative construction and manufacturing data as well as a
slow early-mid November showing for retail sales. To have a
soft landing this time out, the benefits to incomes and non-
energy corporate profits from a marked deceleration of inflation
need to kick in on the spending side to arrest faltering
demand before it hits employment and confidence. I have not
abandoned the soft landing scenario yet since the regenerative
capabilities of the economy are still intact, especially the
positive liquidity picture. There is no squeeze on.

Last weekend, the first Siberian Slammer engulfed most of Alaska
in below zero weather. The Slammer has moved east and southward,
sending temps down along its path and helping crude oil to kick
off a seasonal strong period with a 7% price gain. This too is
a nettlesome issue for stock players since it's too early to tell
how strong an oil seasonal we will get. It can help energy issues
but it can impair the market's p/e and economic confidence if it
gets too zippy to the upside.

My SP500 Tracker suggests a market of 1425 based on near term
earnings and inflation prospects. At a current discount of 2% to
the Tracker, the market has not caught up with the acceleration
up in fair value that came with the break of inflation pressure.
Moreover, since an intermediate term overbought has developed
in the "500", the market could lose more ground to the Tracker
over the short run. We'll see.