Stock Market -- Technical Observations

Short term, the market is in steep descent. Reminds one of
the adage: "Don't try to catch a falling knife".

If you are charting the downtrend, the DJIA seems easiest to work
with.

The "average stock" is down 9.8% from its July peak, in line with
an ordinary, mundane 10% correction.

The market is getting strongly oversold on a short term basis, both
on price momentum and on breadth. The 21-day TRIN is also showing a
moderate oversold.

The market is just slightly oversold on an intermediate term basis.
Even mild price weakness, net / net, over the next week or two would
create the technical underpinnings for a rally.

My selling pressure gauge has been on the rise since early in the second
quarter, reflecting deteriorating market breadth. The uptrend in selling
pressure is intact, but is now signaling the market is getting oversold.

The major price indices have broken trend based on the 6/06 interim low.
My Basic Trend Index (NYSE A/D line adjusted by daily TRIN) is on the
verge of a breakdown but has not given up the ghost quite yet.

The SP500 closed Fri. 08/07 at 1433. A further decline to 1395 would
amount to a 10% correction. A decline below that 1395 level would create
concerns as it would trigger a break in trend from the 2002 - 2003 lows.

Link to the SP500 weekly chart.

Emotion is running very high with plenty of chatter about a credit
crunch or enough weakness from a weak housing sector to create a
recession. I'll pick this up later in the week. Note though, that
the FOMC is meeting this week. No doubt there are folks of influence
out there trying to push FOMC to ease up, either via a cut in the
FFR% or more benign language in the statement that attends the
decision.

Stock Market -- Cliffhanger Resolved

This week the bulls had a three day window to reverse the
slide and could not pull it off. Bear Stearns, apparently up
to its ass in alligators, got its ratings cut, and the bears
took over. The selling today was more emotional and
indiscriminate. So we have have another "feel bad Friday" when
folks head home to ponder their losses.

I have been cautious on the market this year and have stayed
away. As I pointed out back last December, the global economic
expansion has been strong enough and gone on long enough that it
was only logical to expect that some of its excesses and
deficiencies might start to haunt us and create more volatility.
So, I blew off the idea of a forecast of the market, with the
idea I would take a back seat and see how the year went.

I mentioned on this past Tuesday that a 10% price correction in
the SP500 down to 1395 might better wash out lurking fears, but
also pointed out that I did not have a good clue whether such
would happen. With the "500" closing today at 1433, we are within
hailing distance.

Growth potential for the US economy stands only at 2.8% in my book.
The economy picked up its pace this spring, but has not been strong
enough to present a case which would dominate the junk credit woes
that beset housing and the world of deals. So, legitimate uncertainty
has crept in, but so has emotional selling.

I am staying out of the forecast business for now, but I would note
that the uncertainty is being well handicapped as we go and that I
am getting my first inklings emotions are starting to get a little
bit raw.

Stock Market -- Cliffhanger

Well, today it was American Home Mortgage (AHM), writer of
Alt - A loans (scant credit underwriting required). Going,
going, gone. Now I guess the market could really have blown
out on this, but instead it fell to a rough short term
support area (low test zone), with key composites just near
the Friday, 7/27 close.

So, the boyz left it until tomorrow to decide whether we go
lower or whether enough is enough. More bad news of the sort
we had today should have led to a clean break to a lower level.
I call it a cliffhanger because the market held so near the
7/27 low, and like an adventure serial, we have to tune in
tomorrow to see whether the market holds.

1450 - 1460 for the SP500 is an interesting support area for
several chart reading reasons. My preference would be for a
healthy 10% shakeout from the highs seen earlier in the
month. But, I have seen enough technical surprises over the
past four months not to bank on anything.

Stock Market -- Fundamental & Technical

Funamental

The SP500 Market Tracker remains fairly valued at 1550 - 1560.
I doubt I'll review the Tracker again until Q2 '07 eps reports
are more nearly complete. With the SP500 closing today around
1483, the market is getting cheaper, with concerns about
decelerating liquidity growth a main concern. Data through
mid-July shows that my broad M-3 proxy has been flat for the
past six weeks. This kind of shortfall does not always bother
the market, but it appears to be a source of concern now.

I note as well that the Fed drained liquidity over the past
week, so sell offs in certain markets are not scaring Them, yet.

Remember, the bigger earnings estimates for 2007 are back loaded,
with a sizable step-up in earnings power envisaged for Q4 '07
and running into 2008. The economy needs faster growth and a
stable inflation environment to provide a big long side trade in
the months ahead. So far, capacity growth may be too small to
support faster growth without more inflation pressure.

Technical

The market did respond to the improvement in fundamentals from
06/06 through 06/07, but it strained technical measures and
rules of thumb in doing so.

Short term, the market is unstable and further weakness cannot
be ruled out. I think it would be dumb to think the SP500 just
could not sink 10% off its high down to the 1395 level with players
worried about liquidity and how to "properly" re-price assets for
more risk.

For now, the market is moderately oversold. A more interesting
oversold for the SP500 would be around 1460-65, where it briefly
touched today. A successful retest of that low would clarify the
outlook.

Since I have but a very few "turn on a dime" technical indicators,
I am willing to give the market a week or two to sort itself out
before considering positioning.

I have been cautious on the market this year, concerned that a pick
up in the economy might bring some re-acceleration of inflation that
would dampen the p/e multiple. That test is still ahead, and I have
passed up some good trades in the interim. But, I like to be on
familiar, comfortable ground when trading and so far this has not
been my year.

Long Treasury

I did close out a long position with an ok profit. Cannot
tell whether I am leaving money on the table or not. The
big oversold of a few weeks back that caught my eye is nearly
worked off. The economic fundamentals behind the Treasury are
deteriorating, with industrial commodities and now capacity
utilization both on the rise. I suspect a number of hedge funds
have unwound a major trade: long junk and short the Treasury.
Junk has moved up 100 basis points in yield since late May,
and Treasuries have likely benefited from short covering. The
renewed upward move in the 91 day T-Bill yield to close to 5.0%
suggests the panic in the junk sectors has eased some.

One factor worth noting is that bullish sentiment on the outlook
for the long Treasury price is rather subdued, as measured by
MarketVane. At 45% advisory sentiment bullish, this measure is
in the lower register and suggests keeping track of the bond from
a contrarian perspective.

Stock Market -- Fundamentals

The SP500 Market Tracker has the SP500 fairly valued in
the 1550 - 1560 range (now 1552). The upward thrust of
the Tracker has lost considerable momentum in recent months
reflecting a leveling off of yr /yr inflation readings (thus
leading to a flattening of the p/e ratio) and a projected
modest rising earnings trend. A look at the risk factors:

My forward inflation gauge is continuing to rise but has been
blunted over the past two months by a downdraft in gasoline
prices. Not enough of a break yet to signal relaxing one's
guard. Capacity expansion in the US continues too low relative
production growth potential. This remains a concern.

The leading economic indicators I track most closely have firmed
up substantially in recent months, suggesting a re-acceleration
of growth. My long term indicators -- real average earnings and
the monetary base, are still subdued.

On the monetary side, credit driven liquidity remains the primary
driver of stock prices. Viewed yr /yr, this indicator remains
strong, but growth is moderating.

Credit driven liquidity growth exceeds that of the real economy,
so for now, there is a good tailwind for stocks.

My top down earnings indicators are not impressive for the economy
as a whole. In Q 2 '07. The dollar value of all production was up
only about 4.5%. This suggests that many companies are struggling to
maintain profit margins. But there are important offsets: a weak
dollar, growing offshore operating earnings for US based companies,
strong pricing power in basic and heavy industry and better than
anticipated lifting results for the oils. Tech and export driven
companies are also showing decent comparisons. However, unless we
start to see the dollar value of production growth accelerate,
stock market breadth could prove quite vulnerable.

Widening credit spreads have occured in the junk markets, but spreads
have been maintained elsewhere. So far, crunch conditions have
been narrowly focused.

The SP500 has an earnings / price yield of 5.8%. With high quality
short term paper available at 5.25 - 5.50%, the e/p yield is nothing
to wtite home about.

The monetary policy indicators I watch most closely have turned up,
signaling that odds of an increase in short rates are rising.
Since the Bernanke Fed is less formulaic and more discretion prone
than the Greenspan Fed, take it as an advisory and not a prediction.

Feeling funny about this market? This is not an elegant mosaic of a
bull market. It is butt ugly instead, mostly because as a credit
driven market, it lacks the balances it needs to allow even bulls
to sleep that well at night.

Stock Market -- Technical

Last week the market broke out of a month long period of price
compression to minor new highs. On a twenty plus year long term
chart, the SP500 remains in an uptrend. Ditto for the periods
measured from the cyclical 2002 and mid-2006 interim lows.
At around 1550, the SP is trading slightly above mid-range in a
1700-1300 long term range.

Some of my key intermediate term indicators have failed this time
out, signaling tops that turned out to be but very temporary
respites. Even my momentum oscillator, which keys off the 40 week
m/a and is very reliable, whipsawed once. This all tells me to be
careful what I say about the future. The rally has been a real ass
kicker for those interested in the significant squiggles.

At this point, I do think it is fair to say that although we are
tracking an up market on most all counts, it is a very elevated
market and one that could experience a rapid and substantial
price correction without breaking major uptrend lines. All the
guyz know this. If you're long trades now, you have to be not just
smart but quite diligent as a decline, should one come, could
easily be fast enough to shoot or blow up many of the trailing
stops in place. Armed with cell phones and laptops, the big hitters
are in the action even if at the beach (as many are).

I have linked to the weekly SP500 below. Note the elevation of the
MACD and the fact that the market is dancing near the top of a
20 week price channel. Chart.

Liquidity Update

Not surprisingly, the banking industry's real estate loan
book -- to include home equity loans -- has flattened out
since February, 2007. In typical lagged fashion, bank
funding growth has also slowed, with this huge measure of
liquidity actually declining slightly in the month of
June. Data on hedge fund lending capability is much harder
to come by, but the CMO sub prime and CDO junk markets have
been roiled enough to figure there is more caution. The
banking industry's C&I loan book is hopping. It is a safe
estimate that half of the volume gain here over the past twelve
months is deal related. On balance, credit driven liquidity,
which has supported all markets, is just starting to show some
growth momentum loss, with the riskiest markets paying the
heaviest price to date.

Keep in mind also that monthly data are showing a pick up in
industrial and commercial output and order flows for the US.
Since real economic activity lays first claim on available
liquidity, there could be some more pinching of flows available
for markets investment and speculation in the months ahead. It
is early in the game, but stay focused and do not automatically
dismiss the idea that your favorites will be exempt. Remember
the old Wall Street adage : "When they raid the whorehouse, they
arrest the piano player, too."

Stock Market -- Technical

The price compression period underway for the past several
weeks has eliminated the shorter term overbought and
extended conditions for the market. Despite flashing caution
lights, the market has been bending, but has not broken.

So we find we have a US market that is still trending higher
from its mid-2006 interim low, but one which is still elevated
enough to suffer a sharp correction without losing the trend.

To make matters more interesting, periods of price compression
in the market can last for a good several months and need not
be wound up quickly with a break out or a break down in price.

Stealing Time

The wife and I are on a working vacation. The wind-up comes
this weekend when we finish helping our youngest set up shop.
My daughter is just zipping along, but I must confess that
wife and I are pooped by about 7pm each evening.

The stock market has entered a period of price compression
so I doubt I am missing anything too much. Most of the
overbought that accumulated in late spring has been worked
off.

I expect to be back on line this Monday, July 9, if not a
day or so sooner.

Bond Market At Mid-year

As I have previously discussed, the US bond market is very
sensitive to the momentum of production plus sensitive materials
prices. The latest upturn in bond yields started around the
end of November, 2006 and it remains intact. Over this same
period, the six month annualized rate of change in cyclically
sensitive industry has risen from 3.0% to 10.2%. Since US
production has been sluggish, the damage to yields has come
largely from strong industrial commodities prices, reflecting
high capacity utilization rates and strong international
growth.

Although I was surprised by how weak May durables orders were
(as reported today), the lead indicators I follow closely are
still signaling a stronger second half for the economy. So I am
stuck with the view that bond yields may well trend irregularly
higher as the year progresses. Interestingly, there is usually
at least one period each year when industrial commodities prices
turn weak. That tends to occur around mid-year, perhaps because
smelters, mills and other smokestack production may elect to take
a little downtime in the warmer weather. At any rate, normal
seasonal weakness in sensitive prices could bring some improvement
in the bond market near term.

My super long term model, which regresses the Treasury bond yield
with inflation, suggests the bond should now be yielding between
5.75% and 6.25%. Trading around 5.20%, the long guy is well below
the indicated range. So, the premium for interest rate and inflation
risk has trended down in the new century. I attribute it to the
combination of strong financial liquidity coupled with moderate
inflation levels as well as the role of Treasuries in a variety of
swaps and other derivatives programs. I am not happy with this
explanation because Treasury yields do not correlate that well
with liquidity trends. I am also figuring that a combination of
eventual faster US production and ultimately higher sensitive
materials prices might bring the long bond yield closer to the
indicated 5.75 - 6.25% range.

The long Treasury yield is however high enough to trade now, which
I did recently. The investment case remains unappealing, especially
since there is decent grade short paper out there at 5.25 - 5.50%.

I note that the spread between high yield or junk bonds and Treasuries
is an exceptionally narrow 300 basis points. Since junk trades like
junk in more stressful economic times, no one is being adequately
compensated to own the stuff now. As the economic expansion
matures, the eventual migration to quality will begin....

Monetary Policy At Mid-year

The best economic trackers of monetary policy have been
trending down in concert since mid-2006. There was
sufficient weakness in the data around year end to trigger
a decision to cut the FFR%. The Fed passed on this option
and triggered the Greenspan commentary about a one in three
chance for a US recession by late 2007.

Now, the data is perking up, particularly for manufacturing.
With the basic trends still down, the Fed is expected not to
change the level of the FFR% on 6/28. However, if the economy
does continue to firm up as we move through 2007, those down
trends in the data series will likely reverse to the upside,
and change the psychology of expectations concerning short rates.
I continue to remain keenly interested in the balance between
production supply and demand as the US moves forward. Rising
capacity utilization normally creates cyclical inflation
pressures.

The Fed will also have to monitor oil and petrol prices closely.
Soon, oil will move into a seasonally strong price period which runs
into autumn and is already in a potent price uptrend from the Jan. '07
low of $50 per bl.

Inflation Situation

Headline inflation -- which is what people experience--
headed up sharply through the first five months of this year
reflecting not only a rebounding oil price, but a sharp
rise in gasoline realizations as well. The momentum of oil
producer crude lifting or downstream profits has been fading,
so focus has shifted to uptream profit generation via product
refining. In addition, there are increasing signs that US
economic growth will accelerate over the second half of this
year, and factory operating rates can be expected to rise.
This development can put further upward pressure on materials
prices. The growth of productive capacity has dropped to a scant
2.1% measured yr / yr through May.

My longer term inflation indicator -- a combine of selected
commodities and operating rate composites -- fell sharply over
the second half of 2006. The decline was steep enough to be
reminiscent of recession primarily because of the blow out of
the oil price as industry carry stocks mushroomed. Now, the
indicator is moving up, although June has been a quiet month.

There is no indication yet that a more prolonged acceleration
of inflation is set to occur, but with econ. output poised to move
ahead more firmly, the economy may regain an inflationary bias
beyond developments in the oil and petrol markets.

Stock Market -- Technical

Back from the precipice came the market in
a blistering rally to end an interesting week. The technicals
had the SP500 poised to fall. The 10 yr. Treasury rallied,
the boyz covered their stock shorts and the buy-the-dip
crowd finished it up. I mentioned there could be a surprise
with the Treasury so oversold, and that's what we got.

For the short term, I do not have much to say on the technicals.
The market still looks vulnerable, but what the hell, we've
had one surprise, so I am not going to argue with the tape.
Not good for one's nerves.

Correction To Entry Just Below

The link to the weekly chart in the prior 6/12
"Stock Market -- Technical" note below is not working right.
So a new link to the weekly chart for the SP500 has been
established in this note and should be viewed in conjunction
with the note below. Weekly chart.

Stock Market -- Technical

Well, the amber caution light is now glowing more
brightly for the market. The SP500 daily now has
its 10 and 25 day moving averages turning down.
This is not yet the case for my NYSE internal
supply / demand model, but the SP500 commands respect.
There is a link to the chart just below. Note also
the negative head of steam for the MACD. Daily chart.

The weekly SP500 chart is on a link below. Here we see
that both the weekly stochastic and the MACD are closing
in on breakdowns. Weekly chart.

Both charts are signaling that the market is getting close
to turning down. They are not sell signals, but warning signs.
As such, one should pay heed, while recognizing that the
market can dish out surprises. I am edgy about this situation
because the Treasury Bond -- a driver of this spate of stocks profit
taking -- is getting quite oversold short term.

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.