Stock Market Fundamentals -- Earnings

First of a three part post on market fundamentals.

The recovery of profits began when expected, and has been strong
to date, also as expected. The initial surge of the recovery was
heavily influenced by cost cutting and the lower weight given to
failed major companies in the SP 500. Net per share just topped
$57 in '09 and about $10 of that reflects a much lower cost
structure going forward.

The lead indicators for profits suggest a strong recovery trend
well into Q3 '09. There is good potential for further improvement
in profit margins as higher sales and operating rates generate
efficiencies via rising productivity and even betters spreads over
fixed costs.

Analysts are raising earnings estimates as the ecoonomy progresses.
This is a normal development. So far, estimates for 2010 have been
increased by $3 per share or 4% for the SP 500.

The $ cost of production, a decent proxy for business sales, is in
an upswing and was up 3.8% yr/yr through Feb. Measured yr/yr,
profit margins tend to expand cyclically when the $ cost of output
exceeds 5%. The volume of recovery in goods and services this year
should exceed 5% over 2009, even without taking pricing into
account. Right now, pricing power remains narrow and limited
overall.

Analysts project SP500 net per share to top $78 this year, but that
number could well be bumped up to $80 over the next month or
two. The $80 figure compares to the revised record for 12 month
eps of $91.47 set in mid-2007. Sp 500 net per share on a 12 mo.
basis first topped $80 back in 2005.

At this stage, one should take 2011 earnings estimates as they come
out with double the normal grains of salt. This is because the US
and other major economies have been supported by the largest
fiscal and monetary stimulus programs ever, and because the
authorities will feel increasing pressure to exit these programs as
recovery progresses. Numerous program exits starting in late
2010 and running through 2011 will prove a drag on global growth
even if economic recovery is fully self sustaining.

Corporate earnings growth has accelerated over the past 20 years.
Companies manage balance sheets far more aggressively than
ever before. Strong pressures to boost performance have led to
higher profit margins and return on equity %, but have led to
ever greater volatility of cyclical performance as companies shed
losers and mistakes during downturns. As a consequence, ROE % is
up, but growth of book value has been stunted. Moreover, faster
growth is less appealing when growth visibility is reduced.

Financial System Liquidity

The banking system continues to contract as banks let loans roll off
the books and boost Treasury and other investment holdings. Thus,
banking system liquidity has improved sharply. The banks are still
recording a high level of loan loss reserves, although the momentum
in the system account is slowing. Businesses -- flush with cash --
have been steering clear of the banks and are using internal resources
to finance recovering sales. Businesses in desperate need of cash are
simply out of luck. Top quality borrowers with direct access to the
nonfinancial commercial paper markets do not seem to be paring back
further.

Over 90% of the increase in banking system primary funding levels
reflects growth in currency and checkables and this is directly
attibutable to Fed quantitative easing. The Fed is looking forward to
cutting back on this policy, but wisdom suggests that the situation
with bank private sector credit creation stabilizes first. (Keep in mind
that the basic money supply accounts for only 15% of primary bank
funding and that the Fed, rather than being profligate, has been
battling to curtail a deflationary contraction in private sector credit.)

Money market funds, both retail and institutional , are used to finance
capital markets transactions as well as purchases of goods and
services within the real economy. These balances built up sharply over
2005 -07, but have since been in substantial drawdown mode. Thus
liquidity from this sector although remaining substantial, has been
pared back.

The real economy is growing and the very broad measures of financial
liquidity have been declining modestly. Thus, by my approach, the
capital markets now face a headwind from reduced liquidity as the
real economy takes precedence.

The economy does tend to lead the broad measures of credit driven
liquidity in the system. As the economy continues to recover, it is
likely to become more credit dependent, which can, in turn, lead to
more liquidity on hand to finance the capital markets as well.

Monetary Policy -- Observations

The Fed left rates unchanged yesterday as expected and continues
to wind down its special liquidity provision programs.

About 70% of of key rate setting indicators suggest that the FOMC
not raise rates. The Fed is putting added emphasis on the large
degree of economic slack still extant in the system. Capacity
utilization is rising, but remains a low 72.7%. Historically, the Fed
has often waited until CU % rises above 80% to raise rates in earnest.
On occasion, the Fed has started the rate adjustment process sooner,
but the continuing large slack in resource utilization gives you a
sense of Their concern.

Note as well that the supply vs demand for short term business
credit remains rather depressed. Measured yr/yr, the growth of
primary funding (supply) has increased by a paltry 1.6%. But
shorter term business credit demand has declined by a large 18.6%.
The commercial paper market may finally be stabilizing as signs
of recovery in top quality paper issuance are being offset by
continuing weakness in the asset backed paper sector. It would be
inelegant to say the least to raise short rates while credit demand is
still falling. Note well though that as economic recovery proceeds, the
credit supply / demand situation can turn on a dime.

Massive inventory liquidation has led to a reduction in the all-
business inventory to sales ratio to a more normal 1.25 months
supply. Shrunken receivables will also recover with business sales.
Thus working capital may be bottoming finally. Business' cash on
hand has surged so a number of companies are now financing
recovering working capital needs out of internal funds.

The Fed has waved off the action in the commodities markets over
the past 2 years, believing that inflation is not likely to regenerate
on a sustainable basis in a depressed economy. Super low short rates
encourage commodities speculation, so the Fed continues to gamble
some here.

Stock Market -- More On The Technicals

After the market broke down in mid-Jan., I argued we would get
ourselves a tradeable rally. We got it. I also argued that a quick
breakout to a new cyclical high was an against-the-house bet. I
figured we would see a good several months of go-no-where action.
But, the long odds bet came through nonetheless. From a technical
perspective, I find this strong a rally to be odd from a timing
perspective. Odd doings are hardly bad or dangerous doings in the
market, but, for a guy like me, they are not comforting doings.

So, I am observing now not with skepticism but with wariness.
In cases like this I go strictly by the book. Right now, the book says
the market is overbought based on indicators of up to six weeks
duration and that the trend of momentum is starting to flag. The
market calls the next move.
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Chris E. of Red Dirt Trader inquired about ways to capture the
action of the Value Line Arithmetic equal weighted index other than
playing the KC future contract. The main problems with offering
equal dollar weighted index funds are cost and lack of consistent
interest. Value Line itself offers only actively managed funds that
do not have the breadth of their indices. There are SP 500 EW
ETFs and index funds and there might be a Russell 2000 offering.

Valuing small / mid caps against the large cap stocks is not an
easy proposition because of data accessibility regarding earnings
especially. But, I am due to look at this issue and will post on it
soon.

Stock Market Comment

Mid and smaller cap. stocks have been the way to play the US
market for a good decade now. Recently, the NYSE adv. / dec.
line hit a new all time high. With over 3,000 issues on the big
board, the NYSE is primarily a small / midcap exchange. So too
the 1700+ issues Value Line index. The equal dollar weighted
version of the index is now trading only about 4% below the
2007 all time high.

The Value Line Arithmetic or equal weighted index has been my
favorite for over 20 years now, and the Value Line research has
provided me with more stock ideas than just about any other
product. The Value Line Arithmetic is found as either $VLE or
^VAY.

The $VLE has been the market leader in this cyclical advance.
In the last couple of weeks, there has been something of a mini
blow-off in the smaller guys, and the $VLE is now getting
overbought on a relative strength basis to the SP 500.

Interesting relative strength chart here.

Longer Term Economic Indicators

I have developed a diverse set of longer lead time economic
indicators over the years. As a group, the indicators provided the
strongest positive reading late last autumn for the past 90 - 100
years. It was an arresting moment that underscored the potential
for the economy to recover. That reading was not sustainable, and
with some decay here and there, the indicators are now moderately
positive. There has been some slippage in the growth of measures of
monetary liquidity. The oil price has rebounded to a level that is
close to turning negative, and inflation and a weaker job market has
eroded the real hourly wage. On the plus side, a positive yield curve
has steepened, and banking system liquidity is repairing in good
fashion. The improvement in banking liquidity is essential to lay the
base for a new round of private sector credit expansion.

My measure of capital slack, which is helpful in assessing prospects
for the duration of an economic expansion, remains quite low and
suggests there is sufficient idle plant, labor and lending power to
sustain a lengthy expansion.

I think it is still early to tell how conservative consumers and
business will be regarding consumption and investment in this
cycle. Various measures of sales and production fell 10 -15% in
the recession. We came very close to depression readings. In a
rapid economic decline, folks move to get liquid by saving and
deferring use of credit. When a decline gets as steep as 2008 -
early 2009 was, getting liquid covers the paydown of debt where
possible as well.

We are seeing rebounds in key economic output data, but with
confidence having been shredded in recent years, some patience is
required to see how folks all let themselves back into the game.

I still support the idea of a lengthy moderate economic expansion.

Junk Bonds

In my view, if you are interested in junk bonds as an investment,
you have every right to demand a 10% annual return on your
money as a minimum for your trouble. It helps when yield to
first call is equal to or exceeds 10%, as then you do not have to rely
so much on shorter term price appreciation. Junk funds are best
for those who do not possess professional credit analysis skills and
experience.

In the early autumn of 2008, as the financial panic got into full
swing, junk bond composites topped 15% in yield. I mentioned back
then that this was an attractive deal because you could basically use
the current income to fund your outlay within 5 years. Of course,
the market got much worse for a brief period, but you do not often
get opportunities to earn out your capital in a short period of time
with the issuer's own money.

Now, the Bloomberg 'high yield" composite yield just broke under
9%, so I would rate the market as less interesting and see this
sector as mildly overpriced for players with something of a longer
term horizon.

There is of course a momentum element to the junk market.
Investors tend to chase yield in post-recession periods when short
term rates are low, and may well pursue the junk sector well after
short rates have turned up. A major vehicle of pursuit here would be
the sector swap, where players sell Treasuries and top quality
corporates to rotate into junk and hedge funds short the Treasury
and go long the junk. There's enough hedge fund money in play to
have sector swapping as described bring the Bloomberg composite
down to 8%. Should such occur, I would add the junk sector to my
list of prospective short sales.

If you are more comfortable thinking price with bonds, view the
iShares "high yield" corporate fund chart here.

Economic Indicators

Coincident Indicators
There are different sets of coincident indicators available, but I
prefer a stripped down version: real retail sales, production, civilian
employment and measures of the real wage. With two straight
months of gains in total civialian employment on the board, this
set of indicators is finally positive in all categories. Since the
household employment survey is more timely than payroll data, it
appears that payroll numbers will soon turn positive as well.

Inventory Accounts
GDP data show that inventories have been liquidated for 7 straight
quarters and massively so. With sales now rising. production is
following more rapidly, and we should expect to see a positive turn
to inventory restocking which should have a significant plus effect
on GDP growth over the first couple of quarters of 2010.

Longer Term Fixed Investment
The capital stock is shrinking modestly, and as you would expect,
spending for new facilities is still falling. On the plus side, businesses
have turned to heavier investment in equipment and systems to
upgrade productivity of existing plant.

Residential construction remains depressed and is bottoming at best
and with idle space available after such a deep downturn, commercial
construction should remain subdued.

To summarise, the recovery is regaining balance, but a large
stock of unsold homes and slack in business operating rates will slow
progress in longer term fixed investment.

Leading Indicators
The leading indicator sets I follow have been in exceptionally strong
uptrends from very depressed levels for a year now. By my reading,
this suggests above average gains in real GDP out through the middle
of 2010. Since the uptrend in the indicators appears to be set to
moderate, it may well be that the progress of the economy will also
be more moderate over Half 2 '10 (not an unusual development).

Global
The global indicators have not exhibited the strength seen in the US.
For example, there has been no increase in the % of companies with
a rising order book since 10/09, and the % of companies with
rising new orders has been quite moderate (53.6% global vs. 57.3%
US in Feb.).

The lack of a stronger rebound in many foreign economies has
been a cornerstone of the increase in investor concern re: sovereign
credit risk in that rising counter-recession fiscal spending has
exceeded the recovery of the revenue take.

Downgrading China

I am putting the China stock market on furlough for a while. My
primary concern is that with wages rising at a far faster rate than
the inflation measures, and with pressure continuing to find new
hires on the policy front, the "safety valve" for containment is
likely business profit margins, which are sure to contract in such an
environment. The broad macro data clearly point to a price/cost
squeeze for companies. Continuation of this process over a period
of several years will prove debilitating for corporate China.
Rectification of the squeeze will involve some combination of wage
growth restraints and stronger pricing. Such would help out the
business sector, but would also put pressure on social and state
economic policies.

I am well aware that China's economic statistics lack transparency
and that its stock market does not always conform to custom when it
comes to economic fundamentals. But, if China wants my money,
then they can play the game my way. Such is the freedom a
discretionary player like myself enjoys.

I like the volatility of the China stock market and with new funds and
ETFs available, the market presents a high growth, high beta profile
that has its uses. I know I will return to it.

Shanghai Composite Chart.

Stock Market -- Technical Quickie

The market is in a confirmed short term uptrend. Ditto breadth,
which looks even better because of a rotation back into mid and
smaller cap. stocks. Volume continues unimpressive. The bulls
are pushing the envelope in a tentative fashion. The SP 500 has
moved up this week from neutral to modestly overbought and
has yet to evidence the strong push on good volume that would
signify a new upleg as opposed to a bounceback rally from a nicely
tradable oversold.

The market has spent 2010 so far working off a massive longer term
overbought condition and this "work off" has proceeded far enough
where the odds of further consolidation have dropped from 90%
down to 50/50.

The market did correct earlier this year during the 13-15 week
cycle low and we are moving up out of that. The 80+ day daily
cycle I have been tracking is running out of time to see a low.
So, mixed bag here so far.

Chart.

Inflation -- Long Term

To study long term inflation potential, I derive a base inflation
rate by taking the 10 yr. growth rate of money M2 minus my
estimate of economic growth potential. Inflation potential did rise
over the past 10 - 15 yrs to roughly 3.5% per annum on a moderate
acceleration of money growth and a reduction in economic growth
potential, with the latter reflecting a slowing in the growth of the
labor force.

Inflation averaged about 2.6% over the past 10 yrs. compared to
inflation potential of 3.5%. The shortfall obviously reflects bookend
recessions, which impaired demand growth. But it also reflects a long
term downtrend in the rate of capacity utilization. In fact, the last
times the economy operated at effective full capacity was in the 1994-
98 interval. With low output growth over 1999 - 2009 also came a
substantial increase in the trade deficit reflecting in significant part an
influx of lower priced goods from abroad. This development coupled
with a sharp net increase in the off-shoring of jobs contributed to
lower labor costs. Even commodities prices, which did put upward
pressure on the inflation rate after 2002, collapsed over the back half
of 2008 before commencing to recover.

We start the new decade with very large excess slack in the US
economy and globally as well. Inflation potential over the next several
years will remain around 3.5%, but to sustain that kind of elevated
level will require a substantial increase of operating rates and
enough of a recovery in the labor market that workers can begin
demanding and getting stronger wage gains. Upward pressure on the
inflation rate from the occasional flare up of commodities prices is not
likely to prove sustainable without significantly higher levels of
facility and labor utilization.

Inflation Potential

I am looking for the 12 month CPI measured yr/yr to be about 2.5%
for 12/10. It was 2.7% for the comparable period over 2009, but
that is primarily because of the slide in prices over Half 2 '08 that
brought the CPI to depressed levels.

The inflation pressure gauges I use did recover strongly over the
course of 2009, but will have to rise much further over the course
of this year for the CPI to reach the 2.5% by year's end. The CPI,
when measured without food and fuels prices, is in a significant
downtrend presently, and this trend could last through at least Q 2
'10 if not longer (The yr/yr reading through 1/10 is 1.6%). Post
recession downtrends of inflation excluding foods and fuels can wear
on for 15 - 24 months. As matters presently stand, it appears that
commodities prices are going to have regain substantial upside
momentum as 2010 progresses to offset the drag effects of other
components if the 2.5% target is to be reached.

The broad CRB commods. composite rose sharply over much of
2009 but has been on a plateau since Nov. and has been losing price
momentum since mid-2009. Chart. So, we are going to have to see a
revival in the speculative juices of commodities traders to get this
index moving up again.

Another measure I watch closely is capacity utilization. That has been
rising sharply in recent months from very low levels to reflect
inventory rebuilding and strong export sales. Hefty rebounds in
both US and China maunufacturing remain in force and that is a
supportive force for inflation. Heavy inventory speculation in China
helped power commodities prices in 2009. A recent tightening of
credit standards by China banking authorities has cooled speculative
interest in raw materials both within and beyond China, but the
mandate from the top is to maintain strong growth there.

The CPI made its all time high in Jul. '08 and has yet to surpass that
level. So, technically, the US is still experiencing deflation. I use a
smoothed calculation of the CPI to drive my 91 day T-bill interest
rate model. The deflation the US experienced has not been steep
enough to warrant a ZIRP policy. The model currently implies the
"Bill" should be 2.1%. Clearly, then the Fed has waived off a
recovering CPI to support the financial system and an economic
rebound.

Stock Market & Liquidity -- Update

As I have discussed over the past six months, when the real
economy grows faster than the broad monetary/credit liquidity
aggregate, a type of liquidity deficit develops, as the real economy
drains liquidity available to the capital markets, especially the
stock market. When this occurs late in an economic expansion cycle,
it is usually because of monetary/credit tightening by the Fed and
is normally fatal to a cyclical bull market. But a liquidity deficit can
occur during an economic expansion if economic momentum is
strong and credit growth is modest or deteriorating. We last saw
this kind of liquidity deficit from y/e 2003 through mid-2005.

When a deficit occurs as in the 18 months out from y/e 2003, it can
act as a headwind for the stock market even if earnings are
progressing well and short term interest rates are not threatening.
In the 2004 through mid-2005 case, the SP 500 advanced about
6.5% or roughly 4.3% on an annual rate basis. That is sub-par
performance.

I do not think a liquidity squeeze of the sort described above is
necessarily going to retard the stock market's cyclical progress,
but it is logical to think that it will, especially if ready portfolio
cash levels among the various funds are low. Since the latter
situation probably obtains today, it seems wise to keep the
liquidity deficit in mind.

It is likely that the current economic recovery will lose some of
its growth momentum by mid-2010, as low inventory levels are
finally replenished. Moreover, later in this year, we may see
a positive turn in private sector credit demand. Both developments
will ease the squeeze on liquidity and lessen its headwind effect on
the stock market.

Measured yr/yr, the $ cost of US production is up 1.9% after
months of deep negative readings (which created a liquidity surplus).
Looking yr/yr, my broad measure of credit driven liquidity is a
-3.7% through Jan. Thus the liquidity barometer I use is a sharp
-5.6. The deficit should increase in the months ahead before there
is a good chance for reversal.

Stock Market -- Short Term Technical

In the market technical post back on 2/1, I opined that the market
erosion had yielded up a tradeworthy oversold. We wound up with
an interval of choppy waters suitable for day traders, but a more
solid rally did start up last week. The significant short term oversold
has been eliminated. There is now upside to 1130 -1140 before a
challenging overbought would be in place.

Thanks for the rally. I'll leave the remaining short term upside to
others as I am curious whether some cyclic themes will play out
which suggest a more definitive shorter run bottom over the next
5 - 10 odd trading days. And, "curious" is the operant term here.
I have seen cycle action get busted enough times not to get
religious about them. But, since this cyclic play is one I happened
upon without any coaching, I look forward with enjoyment to see
if it plays out or if it is a mere passing phase.

S&P 500 chart.

Investment Grade Corporate Bonds

A cyclical uptrend in corporate bond yields turned into a rout in
the latter part of 2008, as economic free fall spread fear rapidly
through the corporate bond market. However, by late in the year,
investors began to recover confidence that strong companies and
their bonds could weather the storm. It was not smooth sailing
though as another wave of fear gripped the market over Q1 '09
before bond prices firmed again and yields fell.

In the early stage of an economic recovery, investment grade
corporate bonds can fare better than Treasuries as investors
gain confidence in the business outlook and do sector swaps from
Treasuries into high grade corporates and subsequently into lesser
quality credits. Moreover, the willingness to assume greater
credit risk can lead to rising corporate bond prices even as Treas.
prices fall. This rotational process can go on for an extended
period, especially if short rates are so low that investors push
extra hard to pick up yield.

So, it is interesting that high grade corporate yields have
stabilized and advanced in recent months. Top grades trade at
a roughly 200 basis point premium to 10 yr Treasuries when
it would not be surprising if they traded at only 100 bp over the
10 yr. Note also that yield spread between high grades and lesser
light BBBs is also still relatively wide. This does suggest that there
remains residual investor fear about how solid and durable the
economic recovery may be. The fast answer is that as the economy
proceeds with recovery, confidence will grow and yield spreads
will narrow further in the bond market. That is not a troubling
response as it stands. However, because high grade yields have
been moving more sympathetically with Treasury yields, players
have to keep in mind that further swapping out of Treasuries
into corporates could be accomplished as both yield levels rise
and that further swapping need not produce rising prices for
corporates and falling yields. In short, narrowing yield differentials
in quality may not assure the elimination of price risk as you
purchase corporates. If you are using bonds in your investment
portfolio, keep this issue in mind since an upturn in corporate
yields could accompany the same in the Treausry market.

Moody's BAA chart here.

Long Treasury Bond -- Strategy Issues

As I mentioned in the 2/9 post, I use a momentum indicator based on
the $ cost of industrial commodities production (6 mos. Ann./rate). I
long ago rolled this into a much broader macro measure and use the
latter, broad measure as a long Treasury direction measure as well.
Both guides are trending up, but momentum is slowing because
both industrial commodities and the broader CRB index have lost
thrust.

Interestingly, since 2004, the Treasury market has been less
sensitive to upsurges in the CRB commodities index as well as the
CPI. My guess here is that the Treasury market players regard a
fast rise in oil, petrol and natural gas prices as a tax on consumption,
figuring that it will penalize real incomes and confidence and thus
bring about slower real economic growth. This could be an instance of
a broader issue, namely that an acceleration of inflation which quickly
outstrips wage growth will eventually punish the economy, not to
mention force the Fed into tightening moves. So, in deciding about
the merits of the bond market, you may have to study the inflation
drivers and not just the CPI overall.

I also plan to watch the Treasury yield more closely compared to the
momentum of the leading indicators, since bond players clearly
now figure that once growth momentum fades, inflation pressures will
abate and the Fed may ease credit. Leading indicator momentum
here (Scroll down).

In summary on this point, bond players now regard inflation as both
limited and cyclical. That could all change in the future, but you will
need evidence which contradicts first.

The long Treasury yield has taken off rapidly against a ZIRP for
short rates. Bond players are figuring that sooner or later, the Fed
will push up rates as economic recovery proceeds and are not
waiting. By super long term historic standards of positively shaped
yield curves, a 4.60% long term Treasury implies a 3.0% 91 day
T-bill. Here, it is possble that once short rates lift, the Treasury
yield may exhibit below average sensitivity to it. Something to
consider. You also have to keep in mind that if economic momentum
slows during the ZIRP interval for short rates, bond traders could
anticipate a fast long side trade with Treasuries, reasoning that less
monetary accomodation will be postponed.

It is possible that with the large budget deficits on tap ahead, the
Treasury yield could develop a "supply premium" as investors
demand a higher yield in lieu of upcoming heavy new issue volume.
Too early to tell on this I think.

Bond analysis has become more complicated and dynamic, but I
think it is still manageable. I hope these additional comments prove
helpful.

The Fed's Exit Strategy

Today, chairman Bernanke presented to the House a plan of phased

withdrawal of the extraordinary monetary stimulus from the

financial system. I have linked to it here. It is an important

document and has the merit of being easy to follow. I discuss some

of my impressions below.

The plan is to end all stimulus programs by the end of Q1 '10. The

focus then will be on managing down the $1.1 tril. of excess reserves

as the economy continues to recover. The control levers for the

plan are term deposits offered to banks which "lock up" reserves,

the rates paid on reserves and on the deposits and a return to

normal discount window function. The Fed will also use "reverse"

repurchase agreements to drain reserves as needed to keep the

management of the special CDs to banks in trim. At the same

time, the Fed will conduct normal open market operations in

the overnight market. So, you will have to watch Fed Funds rate,

the rate paid on reserves, the term and rate structure of the CDs

and the discount rate as well as the repo operations.

It would be wise for the Fed to put this approach into practice

before the banks begin to lend more aggressively, although it is

not necessary. As short term credit demand expands, the Fed

plans to drain excess reserves permanently in an orderly

manner underneath the structure it has in place to manage the

reserves. I am guessing the Fed will ultimately drain about

$900 bil. of excess reserves, and allow the remaining $200 bil.

to flow into permamnent reserves as private sector credit demand

expands. Timing is uncertain.

Should banks exit the CDs at a rate faster than the Fed plans, it

will have the reverse repo facility at hand to counter the move.

The Fed will expand the dealer network it uses to engage in the

repo program and It appears confident it can generate large

enough volumes to do the job.

So, we are in for a period when there are more important moving

parts in the conduct of monetary policy, and my concern will be

how well the Fed balances the need to keep the system liquid

against eventual constrictions on credit. It is all well and good

to fight inflation, but not at the expense of too heavy a drain on

simple monetary liquidity. We've seen enough of that.

The operatiion of the plan will be reported on a timely basis and

will be sufficiently transparent to allow interested parties to see

just how the Fed is proceeding. Much of the dumb stuff published

about the alleged consequences of the Fed's actions for inflation

etc. can be safely ignored in place of observing what the Fed is

actually doing.

30 Year Treasury Bond

I want to post some work on the bond market, so I thought I would
start with my favorite -- the long Treasury. Inflation has been in a
long term downtrend for around 30 years. So has the long Treasury
yield. Moreover, as investors have gained confidence that inflation
was staying in its downtrend, they have demanded a smaller
premium in yield over the inflation rate as time has passed. To top
it off, the Treasury bond has been a good forecaster of the inflation
trend over time, and as investor confidence in the market has
increased, the bond yield has become less sensitive to shorter term
swings of inflation.

The bull market in Treasury bond prices that has accompanied the
long run downtrend of yield has been one of the great fixed income
bulls of all time. And, since inflation pressure has subsided by such a
large margin over the years, it would be flippant simply to proclaim
the demise of the bull.

Over the 1988-98 period, the premium in the yield of the long Treas.
over the CPI (yr / yr) ranged primarily between 300 - 500 basis
points (3% - 5%). Since then, the premium has eroded to a range of
200 - 250 bp when monthly extremes of inflation / deflation
readings are X'd out. When I use a constant 3% inflation rate, the
range in premium is 130 - 230 bp excluding the outliers.

Short term changes to the inflation rate have heavily reflected the
swings in the commodities market over the past 10 years, most
notably oil, petrol and natural gas. So, in looking at the Treasury
market, I have grown more comfortable with the idea of a constant
3% inflation assumption. On this basis, the 30 yr. Treas. -- now
4.55% -- should yield between 4.30 - 5.30%. Since the present
yield is at the lower end of the range, I conclude inflation
expectations are subdued.

On a short term basis, the Treas. bond yield is most sensitive to an
index of the momentum of the $ value of sensitive materials
production. When the economy went into free fall starting in mid-
'08, that index stood at 117.9. It plummeted to an extraordinary low
level of 40.0 by 1/09. It has since shot back up to about 130. The
bond yield followed the same "V" pattern as you know. Since the
heavy industry momentum index is now at an unusually high level,
I suspect the upward thrust on the Treasury yield has seen its peak
in the short run.

I do not see much reason for upward pressure on the long Treas.
yield in the short term. However, as the economic recovery persists,
there will be a couple of more upswings in sensitive materials prices.
On top of that, the Fed will eventually push up short rates, and
broader cyclical pressure will lead to more acceleration of inflation
pressure. So, over the next 12 mos. it seems reasonable to expect
a cyclical rise in the long Treas. yield up toward 5.25 - 5.50%.

From a technical perspective, the bond market now has a slight
downward tilt to yield when measured by 26 wk. momentum.
It is neutrally priced against the 40 wk. yield m/a. 30 Yr. Chart.
Since I like to trade extreme readings above / below the 40 wk. m/a,
the bond is not interesting now.

Economic Indicators

Leading Indicators
The weekly leadings lost a little ground in recent weeks but remain
in strong uptrends. There were negative short term reversals in
unemployment insurance claims, sensitive materials prices and the
stock market. My reading of the weekly indicators is that they are
probably due to come off the powerful trajectories they have been
on. However, there has yet to be a break in % momentum of the
indicators when viewed yr/yr.

The monthly indicators -- heavily weighted to new orders -- did
hit a new cyclical high in Jan. Momentum here is strong but is
slowing. The services sector is on a moderate track and trails the
strong manufacturing sector by a significant margin. (The services
sector did not experience the inventory liquidation led free fall seen
in manufacturing over H 2 ' 08.)

Key $ Series
Retail sales, production in $, new factory orders, spending for
capital equipment and tech. and exports are also advancing with
exports the clear leader. Housing remains in the doldrums with
only a hint that new purchase mortgage applications could finally
be bottoming after a 50% decline over the past five years. Profits,
as mentioned yesterday, are also recovering rapidly.

Business Strength Index
This index has improved rapidly over the past year and now
stands at 130.6. The Fed normally raises short term rates when
the index breaks through 130 and gets into the 130 - 140 range.
An issue here is that capacity utilization is still low. Moreover, the
capital stock is now shrinking. If policy is for exports to be a
leader for the US as Pres. Obama insists, the Fed will have to be
even more mindful of operating rates going forward. After a boom
in the 1990's, the US is due for a new round of greenfield expansion
to put more productive equipment on line if it is to stay competitive
down the road.

Economic Power Index
This index gives a quick look at underlying consumer purchasing
power. Persistent decay over 2007 - mid-2008 helped underwite
the deep recession. When inflation fell away in latter 2008, a large
spurt up in the real wage saved the US from an even deeper
downturn. The index lost ground again over Half 2 '09, but did
improve sharply in Jan. as the real wage held up better, and as
total civilian employment increased. further improvement will
be needed over 2010 to secure continued economic recovery.

Capital Slack Index
This measure is improving from the lowest levels seen since the
end of WW2. With slack this ample, the odds favor a lengthy
period of economic recovery / expansion that could easily run
out to 2016 or longer before full tilt is hit.

Global
The rest of the world went off the economic cliff with the US over
Half 2 ' 08. Global recovery is underway, but its momentum, when
measured in new orders data, has leveled off. I would have to say
this is a disappointing development as weaker foreign credits like
Greece and Spain need to see rising business and household cash
flows to buttress their revenue take.

Dragon Has Hoarded Materials
With official China now signalling that a touch of moderation of its
aggressive monetary policy may be in order, inventory speculation
by China companies may be easing . Check out copper.

Stock Market

I covered the cautious technical picture in the 2/1 post (below).
Today, I focus on fundamentals and a bit on psychology. The SP 500
closed today at 1063 after a sharp fall. But the market has really
spent most of its time closer to the 1100 level for a good several
months. At 1100, the market is discounting 12 mos. earns. of $67.
That's about where the consensus forecast is for 12 mos. earns.
through mid-2010. So, I view the market as having stalled out
after it discounted earnings recovery out to the middle of this year.
For my part that represents reasonable behavoir, as it gives time
for the underlying trend of earnings to catch up and "verify" the
advance.

As I discussed in the 2/1 post, I think the first leg of this cyclical
bull market was completed in recent weeks, with the sharp
ascent reflecting rapidly recovering profitabilty from a first
ever small operating loss for the "500" in Q 4 '08, to a quarterly
net per share earning power of around $17 currently. The
recovery move was accomplished by the very aggressive cost
cutting of the component companies, advancing sales volumes
off a low base, and of course, the elimination of the bankrupt from
the index.

As we go forward, we will see the development of modest yr/yr
sales growth spread over reduced cost structures, which will
support further earnings recovery over the second half of the
year. the cost cutting is a done deal, so now the focus for investors
is on the sales recovery. At this point, the leading economic
indicators suggest that sales will continue to recover through
the year on a yr/yr basis, but do not as yet provide signals on
the momentum of sales growth after mid-year. Again, it is
understandable to me why the market would pause as it has.

From a psychology standpoint, I think it is also reasonable for
investors to get a case of the shivers in the wake of a severe combo
recession / financial crisis. It was a harrowing time and
subsequent concerns about growth or credit viability can work to
re-generate some fears as mentioned back in the 9/18 piece
when I first suggested some caution on the market. The classic
example was the 1932 - 33 period when the market rallied
furiously off its low in the summer of '32, was then engulfed again
by fears that hung around for more than six months, and with this
to be followed by a double to the upside in short order.

I think the economy is going to do ok and that the market advance
will resume. But I do not know whether the current sabbatical will
last until tomorrow morning or whether it will persist for a number
of weeks. The current round of "hot" shorter term cycles (13-15
wks) suggest a bottom this month. We'll see.

Stock Market -- Technical

I gave the charts a thorough review over the weekend. Back on Sep.
18, '09 when I started turning cautious on the market, the SP 500
went out at 1068. It closed at 1074 this past Friday. So, despite a
measure of intervening strength, the market staged a round trip
over the said time frame. Over this interval, the market changed
complexion. A lengthy period of winnowing volatility ended in mid-
Jan. when a "fake" upside breakout ended and a correction began.
That change in volatility plus the existence of three distinct uplegs
in price off the 3/09 low strongly suggests to me that the first
major leg of this cyclical bull market has ended.

The recent price correction has eliminated overbought conditions
ranging out to 40 weeks and did leave the market with a tradable
oversold for short term players. However, to count on the
development of a significant new upleg off the 1/29 low appears to
me to be an against-the-house bet. History suggests that when the
stock market comes off the kind of massive overbought condition
we saw develop in latter 2009, it tends to have a relatively sterile
period until the bulls can once again regain command. Unfortunately,
there is no ready time measure to suggest when another upleg might
get started, but it rarely takes less than a good several months. I
have also observed that when the market does come off a giant
overbought, it more often than not corrects / consolidates until it
tests its 40 wk m/a (The SP 500 weekly chart linked to below shows
that the large gulf between the index and its 40 wk m/a is closing
fairly quickly).

It does need to be said that when the stock market corrects after a
period of consolidation as we have recently seen, one has to concede
that stocks could be transitioning to a more vulnerable period. That
test may come over the next two weeks.

Weekly chart.

Thanks Go Out....

Back in the 1980s, when I sported my pinstripe suits, paisley and
rep stripe ties along with the tassel top loafers, I gave a lot of talks
and speeches to professional investment groups, clients and did
many an interview on TV and with the print media in my travels as
a chief investment officer. Along the way, I built an impressive
rolodex to go along with a strong track record.

I retired from the corporate world in 1990 but did stay active for
years as a consultant and investment advisor. I had the talent for
the work, but a personality more suited to being a forest ranger.
I happily left that fast moving world and all I have left of its
trappings is a fondness for kiltie tassel tops -- a trademark.

I enjoy staying under the radar and have done a touch more than
zippo to publicize the blog. I do not use a counter other than the
"profile visits" provided by Blogger, so I do not know how many
folks actually read the blog.

So I was delighted to receive a link from a reader directing me to a
professional organization which reads the blog and thinks well of my
efforts. Link here. Scroll down to #7. That is good company to be in,
and the Katz organization is quite interesting if you nose around
their site. HT to David on this one.

The investment business was very good to me over the years, and it
is my turn to give a little back. Thanks again.

President Obama After A Year

The Obama 2008 campaign platform featured an intriguing mix of
spending and investment programs (energy, education) coupled with
tax initiatives on Social Security and the upscale earner designed to
maintain a semblance of fiscal balance and to thwart an egregious
mal-distribution of income. There was also an expectation of a peace
dividend from the winding down of military action abroad (Iraq).

Between the wind-up of the campaign in the summer and his first
day in office, there was a tectonic shift in the environment. A huge
financial crisis emerged and the economy went into free fall. TARP
and related programs took up more than $700 bil. Then, there was
an emergency stimulus program of nearly $800 bil. designed to
offset the disappearance of at least $1 tril. in US sales. At their
leisure, historians will debate the merits of these programs, but
prudence suggested taking major action to keep an economic
free fall from becoming uncontrolled.

So, Obama, no economic seer, was "future shocked." He knew in
early 2009 that the recession was cutting so deep that even with
correctice actions, he stood to lose the super majority in the senate
come the 2010 mid-term election when the incumbent party
would normally lose seats anyway.

He elected a slow roll out of the stimulus program to buttress
chances in 2010, and went forward with a big ticket health reform
program to use his first year goodwill and the super majority in the
senate. But he miscalculated on the tremendous negative response
of voters to the bailout of the financial system and the additional
large run-up in the budget deficit from the stimulus program. To
make matters worse, he let his own party dawdle along with the
plan and wasted time trying to snag GOP votes.

The financial underpinnings of his campaign are shot to hell. The
voters are tossing out incumbents across the board and with relish
in the off-year and special elections. so he has gone from bright
young fellow who could do some good to prospective fall guy.

A sensible plan B is easy in outline -- when you have nothing in
front of you but crates of lemons, make lemonade. Measure up and
confront the voters in a straightforward manner and cut yourself
plenty of slack as you try to do your bit to guide the country out of
the morass of steep hits to the economy, the budget and the
wellsprings of voter anger, low confidence and mistrust. Do not
use the SOTU tonight to tell folks you have it wired. Tell them
you are going to make the best lemonade you can.

Monetary Policy, The Banks & Bernanke

Monetary Policy
While economists and markets savants worry over the inflation
potential they see as inherent in the dramatic growth of aggregate
Federal Reaserve Bank credit, the Fed continues to battle a
decline in the broad based measure of credit driven liquidity as
adjusted for inflation. To counterract the continued unwinding of
private sector credit, the Fed has had to expand Fed credit and the
monetary base to provide sufficient monetary liquidity to support
economic recovery.

The basics I look at to determine rate setting are now running about
70% in favor of leaving the 0.0 - 0.25% Fed Funds rate unchanged.
Over most of 2009, these measures were 100% in favor of not
changing the ZIRP. The breadth of the recovery in manufacturing
has improved substantially and is strong now. However, the system
operating rate remains very low. Moreover, short term business
credit demand continues to run off. My short term business credit
supply /demand pressure gauge is weak. With a reading of less than
-10 heralding a large imbalance in favor of supply, the gauge is just
shy of -12. It can be risky, disruptive and difficult to shrink reserves
when credit demand is falling, and I think the Fed would prefer to
see short term business loan demand turn up before tightening.

With over $1 tril. in excess reserves on hand, the Fed is apparently
considering targeting the rate it pays on such reserves (now 0.25%).
It is also considering a term structure for these reserves to
manage them better as the economy recovers further and as credit
demand revives.

The Banks
The system continues to contract, with total footings off 3.6% yr/yr.
With an expected ongoing run off of business C&I loans, bank
system liquidity has improved markedly. This had to happen to
put the banks in better shape to lend going forward, and there is
no sign yet that liquidity improvement has peaked. Higher fees,
trading profits and a slowing in the growth of the loan loss reserve
account is allowing some improvement in capital position.

How About Benny?
Whoever or whatever you are in the world, you can be replaced.
With one third of the senate set to stand for re-election in 2010,
and with an angry electorate in evidence, some senators will feel
compelled to denounce Bernanke and not vote to re-confirm him.
All well and good. He deserves to get his nose rubbed in it for
lax regulation. But, Sens. Reid and McConnell best get their counts
right, because not re-confirming Benny would create a bad vibe
concerning the independence and integrity of the Fed.

Shanghai Express -- In The Roundhouse

Last summer's post on the Shanghai Composite happened to nearly
catch the top for the market. I thought the market was fairly valued
but way overbought. The overbought has been worked off slowly,
but I'll return to that.

During the even darker days of late 2008, China was the first of the
major economies to step up to counter economic free fall with a
massive dose of fiscal stimulus ($584 bil. -- well over 10% of GDP)
and a round of very easy money by directing the banks to lend
aggressively. Reported data indicate the program did arrest China's
nosedive. But with rapid recovery has come a cyclical re-acceleration
of inflation. A substantial but undisclosed amount of the lending went
into speculative asset acquisition schemes ranging from inventory
speculation to real estate. Now, China is looking to regain control
over bank lending to curb speculation and to remove some of the
inflation stimulus. The investment side of the economy was the main
beneficiary of the stimulus. Factory operating rates are on the rise
but some careful observers are concerned about new plant to come
on stream in the wake of the investment surge.

The market stalled out last summer partly because 2Q and 3Q
earnings trailed recovery expectations but mainly because the
"action" moved from the equities market to the real estate market
as players leveraged stock gains to move into both residential and
commercial properties.

There is pundit talk out there that China is devloping a bubble
economy. I do not have the data base to confim that kind of view,
but common sense tells you that bank loan losses are going to rise,
that reserves held at the PBoC will need to increase and that the
banks may eventually have to add more capital in the wake of
the lending spree.

For now, China is trying to put trim in the sails to avoid a more
awkward battle with inflation and asset speculation down the road.
Cannot blame them for that. The ripple effect has been to
stifle the commodities markets in the short run as players wonder
about the effects of a possibly more muted China economy on global
demand.

My view has been that the $SSEC is fairly valued in a range of 3200-
3500. The market closed today at 3128 and is coming close to a test
of the 40 wk. m/a. The RSI is around 51 and is thus still well above
a ripe oversold reading under 30, but the RSI trend is down. All in
all, we are at the point where we see how real China concerns
actually are. Folks will be watching since China is in the lead among
the majors in grappling with whether and how to exit its big
stimulative programs.

A fall in the Shanghai index RSI to under 30 would in my view set
up a nice rally opportunity via the various etfs available $SSEC
Chart.

China is planning a bullet train connection twixt Beijing
and Shanghai...Construction to begin shortly...Seems
now that I should retire the "Shanghai Express"
phrase for a new one...

Stock Market -- Technical

Since the latter part of 9/09, I have been suggesting using a degree
of caution regarding the stock market. Some reasons are technical
and some have been fundamental. I have not forseen anything fatal
ahead, just the need to realize the market has come very far very
quickly and that there has been some slippage in the fundamental
narrative.

Today, the SP 500 cracked the uptrend line under this mild rally
which has been underway since late October and which has barely
earned the term "rally". We now have a slight oversold condition
with no confirmation that the shorter term trend has actually
turned down. Just a caution light for the break below the 10 and 25
day m/a's. Now, the SP 500 closed at 1116 today, and a break under
1100 would give a stronger signal that further weakness is likely.

I have also mentioned that shorter term cycles ranging out to 15
weeks suggest a bottom in early February. Never bet the farm on
cycles, but keep them firmly in view. The pattern since late 10/09
has been to jump on even the slightest hint of an oversold. The
current one, as mild as it is, is the deepest since late October, so if
the boyz do not come piling back in on the long side pronto, we may
have picked up a pointer.

By my discipline, the "500" would get interesting below 1095.
So, I plan to keep an eye on the action over the next week or so.

SP 500 chart.

Stock Market Fundamentals -- Caution Signal

With a mildly positive retail environment over the past year plus
a powerful recovery of export sales, the $ value of industrial
production is recovering rapidly. Through 12/09, $ production is
up 0.6% following several months of deep negative readings. On
the other hand, the broad measure of credit driven liquidity is
down 1.8% yr/yr reflecting a contraction in private sector credit
demand. As a consequence, the US is now running a liquidity
deficit instead of the large measures of excess liquidity seen earlier
in the year. So a major tailwind for the stock market has now turned
into a mild headwind. That development coupled with a rapid rise
in the price of oil above $75 signals caution based on my indicators.
The liquidity and oil price measures are secondary indicators and
would be far more fearsome were the US in an advanced state of
expansion with monetary tightening and with short term interest
rates in sharp ascent. Even so, for the stock market to maintain
buoyancy in a period of economic liquidity deficit, investors must
find it has special relative appeal and be willing to sell off other
assets to divert funds into equities. With cash / near cash holdings
low, a likely candidate would be bonds. And, such might happen, but
that is a very tricky call.

When I look at the stock market over the longer run compared to
the aggregate growth of credit driven liquidity over the comparable
period, that ratio remains well below levels seen at major market
tops. So, I am talking caution rather than bear. Moreover, as the
recovery proceeds and private sector credit demand rises, the stress
on liquidity may ease nicely and return the stock market to a much
more favorable position.

Since few analysts do this kind of work anymore, my concerns
might prove to be but a quaint artifact. But, think it over
nonetheless.

Retail Sales -- True Test Of Strength Comes in 2010

As fate would have it, the initial report for US monthly retail sales
for 12/09 hit my projection of $353 bil. exactly. Yr/yr, the gain in
monthly sales was 5.4%.

The monthly peak was $380 bil. set in 11/07. After that sales
weakened gradually in 2008, until there was a precipitous fall
over the final four months of the year. In an economic recovery,
retail sales can start off gradually, which is what happened this
past year. However, I am now looking for sales to rise 7-8% in
2010 as employment improves and consumer confidence with it.
This is the kind of sales acceleration we should see based on the
strength of the leading indicators and pent up demand built
over 2008 - 2009. A rise in retail in line with my projection would
bring sales back up to the prior 11/07 peak. I am looking for
progressive strength in retail as 2010 wears on and I would
regard a significant shortfall, like perhaps a 5% gain, as a major
disappointment. My guess is that I fall at the high end of the range
among retail sales forecasts.

US Trade & Oil

The global leading economic indicators have been signaling a "V"
shaped recovery since early 2009. Still, it is a mild surprise to
observe how strongly US trade accounts have responded and in so
timely a manner. Since both imports and exports substantially
overshot the weakening of the US economy in early 2008, It has
been tempting to think trade would undershoot in the early days
of recovery. Not so.

Owing perhaps to cumulative dollar weakness plus the more nearly
synchronous nature of this cycle, US exports have increased at a
26% annual rate since last spring and clearly represents the
strongest of major US output sectors.

Imports have also accelerated off the spring '09 low and have been
especially strong in recent months reflecting higher oil and fuels
prices.

Surely, part of the strength in each category reflects inventory
pipeline refilling, but the joint progress has been dandy enough to
allay fears of broad based protectionism which can dog a deep
global downturn. So far, so good.

There may well be an issue going forward concerning the
composition of US imports. The US is early in recovery, but the oil
price is already running at a high level. If the oil price trend
continues, it may divert consumer spending away from non-fuel
goods and services, which could negatively affect non-fuel
exporters. In the same vein, you have to remember that sharply
higher oil prices will pressure profit margins of oil-dependent
exporters such as China and India.

So, one issue regarding the recovery of global trade and broader
recovery for that matter will be how well OPEC and the non-OPEC
national companies manage oil prices. Looking back to 1970, the
record has been dismal, with intermittent booms and busts in
price. Since the supply picture has improved significantly in
recent years, OPEC / NOCs have the capability to provide better
supply / demand balance over the next few years if they are
smart about it. Since the track record of oil price management
has been disastrous since control passed from the "seven sisters"
to the present cartel, experience indicates oil and gas price
management going forward should remain an area of concern for
both advanced and emerging economies.

Economic Indicators

Leading Indicators
The pace of recovery of the weekly leading indicators for the US
has re-accelerated following a flat period (late Sep. - early Nov.)
The weeklies are now running a little stronger than I expected.
The monthly indicators are also running stronger mainly reflecting
a recent surge in % of mfrs. reporting higher order rates. The
commercial side of the economy is running positive, but the
momentum of new orders has tailed off over the past two months.
On balance, the new order picture is stronger now but less even.

Looking globally, the world economy is growing, but the pace of
improvement in new orders has leveled off since Aug. following
a positive burst earlier in 2009. The US and China are showing
the broadest improvement in recovery, especially in manufacturing.

Profits Indicators continue on a sharp recovery path save for
finance where lower loan volumes and higher loan loss reserves
are penalizing results. Still, the financial sector may be modestly in
the black currently compared to enormous losses posted a year
ago.

Inflation Indicators
Gauges of future inflation are rising strongly and are signalling
that economic recovery will bring a cyclical acceleration of
inflation pressure. A stronger commodites market now leads
the way, but global capacity utilization has also turned up.

Economic Power Index
This index has weakened further. The yr/yr % growth of wages
has moderated in a weak labor market and the real wage has
turned down on a yr/yr basis, having been eclipsed by the 12
month inflation rate. The rate of decline of civilian employment
has started to moderate yr/yr, but remains formidable. On a
month to month basis, job losses are moderating and may be
entering a bottoming period.

From a political perspective, the Obama administration has 10
months to do its part to husband the economy along toward
jobs growth and a lower unemployment rate. It will likely
release the bulk of the stimulative program spending and target
additional measures to promote jobs growth this year. Pure
politics suggests that the economic recovery best be far
enough along by May to show a positive turn in employment
followed by subsequent declines of the unemployment rate to ward
off the GOP. Chief economic advisor Larry Summers is good
at this kind of statistical fire drill.

Sector Portrait -- Materials ($XLB)

Above all, investment managers like to buy relative strength in
earnings. With China and most of the other industrial economies
in recovery mode after deep recession, analysts look for basic
materials or "smokestack" companies to post gains in profits
for 2010 that far outstrip the earnings potential for the broad
market.

The keys here are recovering volumes and prices which give the
basic producers sizable earnings leverage over a large base of fixed
cost. True to form, industrial commodities prices are trending up
and are well above prior year levels.

For large players, the $XLB is a momentum game which feeds on
volume recovery and pricing, with pricing getting the edge in
emphasis. The group tends to do well early in each year when
re-order rates and pricing are seasonally strong.

With China now a large player in heavy industry, investors have
a greater interest in this group than at any time since the 1970s,
and it is favored as a pricing power play.

I have linked to a relative price strength chart for the $XLB as
compared to the SP 500. Notice the recent seasonal breakout in
RS but notice too that this trade is getting overbought short - term.
Remember as well that historically at least, this group often loses
its advantage as the big earnings gains are being posted. Players
still regard them as "rotgut" cyclical plays.

CHART.

Commodities Market

Commodities prices are clearly cyclical, but do not match up with
business cycles fundametals with precision. However, with signs of
global economic recovery abundant and with accomodative monetary
policy in place, an advance in commodities prices is a typical enough
development. Observers have pointed out that commodites prices
follow 3 and 6 year cycles as well as a 40 wk. cycle. These tracking
methods are also imprecise. Historically, it has been important to
track commodities prices against the CPI over longer term periods
such as 10 year intervals because such measures reveal where the
pricing power is in an economy. As a last introductory comment,
major inflations most often start with a powerful, sustained surge
in commodites prices, especially energy.

Over the past 10 years, broad commodities composites have held
their own with the CPI, and have surged ahead over the past 12
months. Commodities consumption has declined relatively in
modern broadly diversified economies, and periodic supply /
demand tightness in the materials area must be contrasted with
a pool of surplus labor that has developed via globalization. In
short, it is tougher to generate commodities-led inflation when
labor costs lag so substantially even if monetary policy is more
expansive than its longer run measure.

Commodities composites are interesting now because prices have
surged through long term resistance levels. These surges can last
from 12 - 30 months and can be rewarding to speculators who now
have a large cadre of fellow players who can engage in the markets
through a variety of ETFs and ETNs.

Below is link to the CRB commodity composite chart with a 6 month
or intermediate term perspective. It is a postive view. If you are
intrigued by the idea of the 40 week or 10 month cycle, watch now
because a downdraft is due. If such was to unfold, it would shift
the trend trajectory to a less elevated level. CHART.

Stock Market -- Technical

As fate would have it, market behavoir over the latter part of Q 4
'09 exquisitely concealed its likely direction as we start 2010.
Naturally, a nice long weekend has probably served only to make
traders more fidgety.

Short Term
The SP 500 entered a mild uptrend in late Oct. It closed out the
year right on the trend line, spent most of the time over Nov. -
Dec. in extreme price compression and did it all on light volume.
Mid and smaller cap. measures did far better, as players used
Dec. to anticipate the positive "January effect."

The market is "neutral" in the short term -- neither overbought
or oversold.

My price oscillator off the 25 day m/a has become increasingly
compressed since the spring of '09, with players buying on ever
more shallow dips and taking profits on ever more humble blips.
This exceptional nine month long pennant formation closes out
the week of Jan. 11 - 15 and could herald more price volatility.

Over the past three odd years, the market has exhibited a
pattern of lows set every 15 - 17 weeks. The next low point is
due in early Feb. '10.

Intermediate Term (6 - 26 weeks)
The market remains in a sharp uptrend on the weekly charts
dating back to the Mar. '09 lows. As with the shorter term
daily chart, the uptrend will be tested right at the outset of
the new year.

The market is significantly overbought on all intermediate
measures and is showing discomfitting flatness of momentum
on my weekly price oscillator which is run off the 40 wk m/a.
I generally skip the long side of the market when this smoothed
measure levels out as it has often signified a topping process.

Long Term
The monthly charts show a powerful advance in progress, but
one which is now rapidly becoming overbought. The internal
momentum measure is strongly positive and leaves room for a
moderate price correction that would not turn the charts bearish.

Looking ahead, we continue to have the same issue to contend
with that beset thinking over the final quarter of '09. The
trajectory of this advance has been so strong off the 3/09 low
that we could witness a churning, consolidating market for a
good 4-5 months before you would have historical warrant to
to begin to question its pedigree as a cyclical advance.
Something to keep in mind.

$SPX weekly chart.

Stock Market Fundamentals -- Indicators

Looking at 2010, most projections I have seen fall in a range of 1150
to 1350 for year's end. My SP 500 Market Tracker has the "500"
winding up next year somewhere between 1235 - 1300, depending
upon how strong recovering earnings may be. I do not a have major
issue with the Tracker projection as of now.

Core indicators -- monetary liquidity measures, market short rates,
confidence measures and the trend of lower quality investment
bond yields remain positive. So, I am still on a fundamental buy
signal. As the economy recovers, I doubt all the measures will
remain positive over the course of the year, so I look for a time
when the market will transition from an "easy money" buy signal
to a market more suitable for traders with time horizons that may
run out to a year.

My earnings indicators remain strongly positive as we move into
2010. The market tends to do well when earnings are accelerating
on a 12 month basis relative to the long run trend. Companies have
taken out enormous sums of cost, so earnings operating leverage
should remain strong, even if top line growth is moderate.

I am less confident about two key secondary indicators. One is
the oil price. The real oil price rose sharply over 2009, and petrol
prices rose accordingly. The impact of such on inflation was clearly
muted by a large decline in natural gas cost for heating, processing
and cooking. Pricing in the energy complex represents a key area
of uncertainty for the stock market in 2010. The other measure is
the degree of excess liquidity in the system. The economy is
expanding now and the broad measure of credit driven liquidity is
still in decline. Excess liquidity is winding down and could disappear
by spring 2010 unless private sector credit begins growing again.
The stock market rarely progresses strongly for long without a
liquidity tailwind, as the real economy normally outbids the market
for liquidity. We saw a situation like this in 2004 when real growth
outpaced liquidity in the early phase of expansion. Situations of this
sort are far more common in the latter stages of economic expansion
when inflation pressures arise and the Fed starts trimming credit.

Stock Market Fundamentals -- Valuation

S&P 500 Market Tracker
This method of valuing the market rests on very long term ties
between earnings, inflation and the market's p/e ratio. The Tracker
has the SP 500 valued at 950 - 960 to wind up 2009 and at 1235 -
1300 to wind up 2010. With the SP at 1126, it is clear the market
is looking well into 2010 and is discounting continuing sharp eps
recovery. As I will discuss in the next post, the earnings indicators
do support handsome recovery next year. Readers should know that
the market will often trade at a premium to the Tracker in the
early stages of earnings recovery / expansion and that intervals of
this sort with the market at a premium can last two or so years.
The current premium over the Tracker value is nearly 18%. That
represents a sizable spread and points to significant price risk if
there is a conservative turn in investor psychology. For the record,
the Tracker did hit a cycle low of 655 for the "500" last spring
as earnings were bottoming. It matched the lows.

Valuation -- Digging Deeper
The market is discounting a return of earnings back from extremely
low levels to the very long term trend.

Investors are pricing in a sharp improvement in $ dividend payout
and expect solid earnings and dividend growth over the next 5 - 7
years.

Investors are aware that the SP 500 has been moving over the
years to a much higher earnings plowback rate as corporate
managers have acted agrressively to accelerate profit growth. But
the p/e ratio implied by a high 65% earnings plowback rate is well
above what investors are willing to pay. Earnings growth has
accelerated since the latter 1980s, but earnings have become far
more volatile. Moreover, CEO interest in maximizing short term
earnings results has greatly fattened executive pay, but has
penalized the incomes of the rank and file and has done nothing
to add to shareholder value for over ten years. Sloppy returns on
assets deployed has led to heavy intermittent cuts in headcount
and wages to boost productivity and profit margins. True, the
development and growth of low wage emerging economies has
hurt US corporate pricing power and return on assets. Even so,
concentration on cost cutting in preference to wiser asset
management has left too many companies writing off too much
asset value and disgourging too much headcount when business
turns down. Finances within the market tell me that wiser business
asset management and higher and more stable dividend payout
would provide a less volatile and more satisfactory earnings and
market performance.

Cost cutting in the area of 25% plus moderate growth next year
could lead to a 15% return on equity for The Sp 500. A high
earnings plowback rate of 65% would imply sustainable growth of
nearly 10% in earnings over the long term. The global economy
will not support such ambition and continued CEO focus on labor
productivity to the exclusion of wise asset management will lead
to further squandering of resources that would best be dividended
out to shareholders.

In summary, investors are pricing in a standard economic recovery,
but are not now willing to pay a premium for aggressive asset
and resource management going forward and for good reason.

Stock Market Quickie

Volume has been light for a good several weeks now, and with the
year end holidays upon us, has dropped off about 50% save for
the recent options expiration. The light move up reflects year's
end window dressing by institutional and funds managers, with the
full panopoly of tricks on display (you own 100k shares of smaller
cap XYZ corp and you play in another 1k shares bid higher so you
get an extra 1/8 on your full position etc.).

I plan to do full profile fundamental and technicals on the market to
benchmark us before year's end and will post shortly.

US Dollar ($USD) -- Technical Note

The recent rally in the dollar continues on. The buck has come
up through its 10 and 25 day m/a's and both averages have turned
up to confirm the trend. MACD is positive and I like the ADX
reading which shows a positive turn and rising momentum. Chart.

However, do note that the dollar is now approaching overbought
levels on the RSI measure. I think that soon we'll see how sincere
this contra-seasonal move up in $USD is.

Financial System Liquidity

The Fed continues to make sure that narrow measures of monetary
liquidity grow. This remains essential to underwrite the early phase
of economic recovery. Since I think the Fed ought to maintain higher
levels of monetary liquidity in the system through time, I remain a
cheerleader here. The broader measure of credit-driven liquidity
(about $13.8 tril.) has yet to sustain growth from month-to-month
and is about 0.7% above year ago levels. This performance reflects
the continued roll-off of private sector credit demand and the
spectacular collapse of the shadow banking system and hence the
commercial paper market.

Flat funding for credit is not a major issue in the early stage of an
economic recovery, because businesses can fund operations via
internal cash flow. Moreover, in the current situation, mortgage
demand in the residential market is only beginning to show a little
improvement. However, as 2010 progresses, it will become
more important for the credit markets to loosen up to provide
more funding of a rising level of economic activity. This will not
be as easy a process as in most past cycles, since there are a
number of banks still posting higher loss reserves from loans
made over 2005 - 08, and this constrains both capital and
confidence.

When bank credit is damaged as badly as it has been, the chief
credit officer at banks has the CEO's ear and can hold the
loan officers at bay and under control. He rules the roost. But,
as an economy expands and inquiries rise from decent credits, the
commercial side of the bank gradually regains power and $ finally
flow. Smart CEOs keep the chief credit person in play as a
consigliere once the commercial guys swing into action.

There has been a sizable amount of excess liquidity in the system
relative to the needs of the real economy. With recovery and
with no discernible growth trend in system liquidity, excess
liquidity is receding and could disappear for a spell by late
winter, 2010. That would remove a substantial support factor
for the stock market and could leave it vulnerable to a price
correction, especially if investment portfolio cash levels are low
(they are). So this is something for stock investors to watch
for early next year.

Monetary Policy & Short Term Rates

It was steady as she goes today from FOMC. No surprise. The
economy is recovering and the deterioration of the job market is
ebbing, but my key benchmark policy indicators do not suggest it
is time to raise rates. In fact, two of the indicators -- capacity use
rate and my short term business credit supply / demand gauge
remain well in the red. The latter, the pressure gauge, can turn on a
dime, but for now it is still showing weakening demand.

My cyclical model for where the 91-day T-bill should be, based
on super long term historical data, puts the rate in a range of 1.0 -
1.5%. As we move into 2010, the model will lift the value to 1.5%.
So, The Fed's ZIRP is behind the curve and points to the Fed's
conviction that inflation poses no problem in the early stage of the
recovery. Just so you know how accomodative the Fed is being,
consider that the long term model for the bill rate with capacity use
"neutral" at 80% is 4.5% (US operating rate now just 71.3%).

You should remember that even though the CPI is 1.7% below its
mid-2008 historic peak (still deflation), we now have the CPI up
1.8% yr/yr, and the inflation thrust indicators remain in a positive
direction.

The Banks & Their Fat Cats

Banks
System capital has improved over the past year, although most
of the increase reflects the net addition of TARP funds to the
system. On a "quick" basis, banking system liquidity is also
improving, as commercial loans roll-off rapidly against Treasury
holdings. This is a normal development after a deep recession
and primarily reflects weaker business loan demand. It is no
exaggeration to say that US based businesses have lost up to
$2 trillion in gross sales globally during the recession, and that
means a large reduction in working capital financing needs.

The banks' loan / lease book expanded in November after months
of decline. There was an uptick in the residential mortgage
portfolio to reflect higher home sales in the US. Still, loan / lease
footings are down 6.5% yr/yr, as C&I loans to business have
dropped by nearly 17.5% yr/yr. Bank loan loss reserving is still
growing, albeit at a more modest pace. The system loss reserve
account has topped $200 bil., or 16.5% of gross capital.

The system is repairing slowly. Bankers are no longer friendly
and it is understandable that credit standards have tightened
further when you consider that loan losses are still rising. With
business sales only beginning to recover, and with excess housing
inventories still being worked off, the economy does not yet
need robust development lending by the banks.

Relative to a sensible long term trend to include 3% inflation,
the loan / lease book of the banks was $1.5 tril. on the high
side in 2008. It is now half that amount.

The Fat Cats
Attacking commercial and investment bank compensation
programs has been a fine, populist sport for nearly two years
now. The programs that were volume or production based were
exquisitely dumb as they gave bankers the green light to put
their firms capital at risk in pursuit of higher comp. Plans will be
subject to regulatory review going forward.

Their are a lot fewer bankers around these days upon which to
lavish bonus money. If you are into attack mode on the comp.
issues, you might keep that in mind.

Even so, when one gazes at the shrinkage of the asset base of the
system, the still rising loan and securities losses books, and the
fact that TARP money has underwritten cash flows for many
banks and IBs, you have to admire the insouciance of a number
of the guys who are still standing. This issue is not going away
soon, and it will be interesting to see just how the Fed and other
regulators will treat bonus plans going forward.

Stock Market -- Be Careful With The Ho-hum

The market has been in a period of substantial price compression
for a month now. It has grown so tight that bull vs bear efforts are
perfectly balanced. Easy to go to sleep on the job. What's worse,
price compression can easily last another month or so, although the
bull vs bear balance may grow more imperfect. But, price com-
pression periods usually lead to major price action when they
break. I think it is very difficult to call the direction of these breaks,
and I know from experience that you can get head faked when the
break comes, because there can be occasions when the first few
days belie the eventual direction. In short, if you are trading, it
can be a frustrating period. But, know that there is action ahead.
SP 500 chart shows the compression.

Inflation Potential

The broad CPI made an historic peak of 220.0 in 7/08. Then,
deflation set in and the CPI made an interim cyclical low of 210.2
in 12/08. Since then, prices have risen. The CPI hit 216.2 in 10/09.
Still, this latest reading is below the all - time high by 1.7%. So,
even though the economy is inflating here in 2009, we are still
in a deflationary period, and will not be out of it until the CPI takes
out the 220.0 all-time high.

Now, the markets closely observe inflation momentum on a trend
basis. Inflation often restarts even after a severe recession period,
and for now, the shorter term trend is for more inflation when
measured yr/yr. My inflation thrust indicator, which fell the
most steeply in many years from mid- 2008 through mid- 2009,
is now rising quickly and suggests the inflation rate is going positive
yr/yr now and that it will reach around 3.0% on a 12-month basis
through 1/10. A broader cyclical measure I follow from the
Economic Cycle Research Institute turned up early in 2009 on the
first signs an economic recovery may develop. It has moved up
rapidly and is also signalling a crossover in the CPI% yr/yr from
0.0% to a plus reading.

Looked at month to month, my pressure gauge is losing positive
momentum, reflecting a slowing in the progress of recovery in
commodities prices (chart). In fact, the CRB composite shown in
the chart is now "stuck" in long term resistance zones of 265 - 280.
Now without a fresh surge in commodities, any advance in the CPI
through mid - 2010 is likely to be tepid, and the old 220 high would
stay safe for a good several months. There is too much slack in
the US economy to expect a more rapid rise of inflation pressure
without another strong surge in fuels and other major commodities
sub-groups. It would be easy to question whether inflation would
be more than very mild except that there are two newer forces
to contend with: The growing importance of China and its satellites
as an industrial power, and the much heavier influence of pure
financial speculation in the commodities markets (viz. the oil price
bubble of 2007 - 08).

So, commodities will remain the key variable in the inflation
outlook. For now, it looks like expectations in these market sectors
have grown more subdued. But, let's not kid ourselves. Speculative
interest in fuels and other commodities loops back into the
economy just as readings of the economic indicators can feed into
speculative interest in commodities. So, you have to watch both
processes carefully in assessing the inflation outlook.

Oil Price

A bump up in the weighted exchange value of the US$ has helped
nudge the oil price into a more normal seasonally weak interval.
AT $80 bl., the price was fabulously overbought. Then it was
trading at a 33% premium to its 40 wk. m/a, when a good rule of
thumb for traders is to be wary of any commodity that trades at
a 20% or more premium.

My view has been that autumn seasonal weakness could take oil
down to $65. Its decline so far has been so tortuously mild that
one is hard pressed to say with confidence that it could slide
another $8-10, especially since the bulk of the big overbought
has been relieved. But I would also note that the 12-26 wk MACD,
which does not whipsaw often, has turned down. Chart.

In my view, it is difficult for the US economy to expand at its
potential when the real price of oil is rising rapidly. Advances in
oil of this sort are short-term inflationary, push the Fed to tighten
credit and punish the real wage, as wages are far less elastic than
the price of oil currently. Unstable oil and petrol prices also
create uncertainty for businesses and households facing capital
investment decisions. Now, it is true that the oil demand to GDP
ratio has come down over the years, but that salient factor can
be outweighed over the shorter run by booms in the oil price.

Interestingly, my longer term log scale chart (weekly) has oil on
a fast track to $150 bl. by the end of 2010. That, or anything
within hailing distance of it, would be disastrous for the broader
economy. At present, basic supply / demand for oil hardly
warrants a $75. price. So I am expecting oil to break down from
the current upsweep and settle into a far more modest path, lest
chances for a continued path of economic recovery are imperiled.

Economic Indicators

Weekly Leading
Both sets of weeklies resumed advancing in Nov. following brief
respites. They remain strong, continue to signal a "V" recovery
and point to growth out through Q1 2010.

Monthly Leading
the momentum of the breadth of new orders for businesses has
leveled off. The indicator did make a slight cyclical high for Nov.
It is solidly positive but is well below boom levels. "V" pattern
is still indicated.

Business Strength Index
This indicator is well off its lows. Now in the 123 - 125 area, it is
still below the 130 - 140 threshold that normally marks a turn
toward tightening by the Fed. The weakness here is in capacity
utilization %.

Economic Power Index
This index declined sharply in Nov. as the yr / yr rate of inflation
cut into a declining rate of salary growth. Real wage growth could
flatten or turn slightly negative through early 2010. The
employment momentum part of the index improved markedly
last month as there was a mild gain in total civilian employment
after months of deep decline. The bottom line here is that basic
consumer purchasing power remains increasingly dependent on
automatic fiscal stabilizers and fiscal policy initiatives. The
favorable change in employment momentum is a good sign that
needs to carry through further in the months ahead. The rise in
oil and petrol prices through 2009 has undercut the recovery.

Economic Slack / Pent-up Demand both remain sizable
and form the base for a lengthy period of recovery.

Other Current
The depth and persistence of inventory liquidation did catch me by
surprise. A normal cyclical swing off current levels could alone add
1.5% to GDP over the next year.

The home purchase tax credit is helping to clear excess inventory
in the housing market. Mortgage purchase applications dropped
recently, so the inventory clearing process could slow in early 2010.

Long lead Indicator --US
This composite hit historically high levels in late 2008. It remains
strongly positive, although there has been some slippage in the
wage vs. inflation component recently.

Global
The global indicators are consistent with modest economic
expansion. The readings are far above the low levels seen back in
the depths of the recession, but are not especially strong. The flow
of new orders in foreign economies has lagged the US and I
would rate it as a little disappointing to date.

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For a look at a real-time measure of economic activity by the
Phila. Fed, (ADS / BCI) go here. Open the PDFs. The index
does not include the positive employment data for early Dec.
We need to see a reading above 1.0 soon here to confirm that
a decent recovery is underway.

Economy -- I'm Out On The End Of The Positive Limb

The US has experienced near depression conditions and severe
demand privation over the past two years. There is more economic
or capital slack in the system than at any time since the 1930's.

My reading of US economic history suggests to me that with
powerful monetary and fiscal tailwinds, the US should experience
a strong and sustained economic recovery that can run out at
least 5 - 6 years. Now, naturally it is not like days of yore when
US growth potential was quite a bit higher. I peg that potential at
2.8% growth per annum, but I do expect at least a couple of years
ahead where production grows at 5 - 6% and where employment
gains are strong. I also expect to see the US move from modest
deflation to inflation that could approach 5% on the CPI. Further,
I expect an eventual sharp climb in short term interest rates, with
the 91 day T-bill yield eventually returning toward 5%, and with
that could come a rise in longer dated Treasury bond yields back
toward 6%. That kind of inflation / interest rate framework will
crimp the stock market p/e ratio, but the offset there will be
likely substantially higher earnings.

I expect a return to more stable monetary policy, and I expect a
combination of higher tax revenues and a more aggressive trade-off
posture toward spending priorities will lead to substantial
improvement in fiscal budget balance. If anything, the risk now
is toward premature tightening and creation of fiscal drag. The
struggle in the years ahead to regain better fiscal and monetary
policy balance will increase economic volatility for short intervals.

I think we will remain in an elevated financial risk mode through
mid - 2011, as not even a stronger than expected US and global
economic recovery may be good enough to save any number of
marginal household, business and sovereign credits. For some,
the negative hit to cash inflows relative to debt service already
sustained may be too much to overcome (like Dubai).

I did not expect I would be doing a longer term overview again.
After all, I am no spring chicken. But, we are looking at extreme
low levels of economic activity, and history says that when such
is addressed, the economy eventually regains substantial verve.

The web is overloaded with points of view that would challenge
my simplistic outlook and I have to say part of the reason I
wanted to establish a stronger position was that it would better
enable me to grasp and profit from deviations to plan as I go along.

There, I said it and I am glad.