Earnings In Longer Term Perspective

Since the end of WW2, cyclical expansions in corporate profits have
averaged 4.2 years. The band around the average is wide and there
have been observable "double dips" in profits even during ongoing
economic expansions and stock bull markets.

If the current cyclical recovery / expansion of profits meets the
average for the postwar years, then profits could well expand into
2013. The stock market tends to make cyclical tops around the time
profits are cresting. Thus, if the current uptrend in profits is an
average one, it would be fair to say that the stock market would also
make a cycle top in early 2013.

If the cyclical rise of profits is decently normal, then SP 500 profits
could peak around $115 - 120 in 2013, and the stock index could
rise another 60+% from current levels.

The object of this post is not to make earnings or stock market
projections, but to get you the reader to maintain an open mind and
to do your homework as an investor. Look, earnings might grow only
through 2011 before cresting, or profits could expand to early 2016.
Neither development would be a "black swan." In a similar vein,
earnings could experience an average expansion but the p/e ratio
could be sharply crimped by accelerating inflation or, we could
see a little bubble up in p/e on development of a goldilocks mentality.

My own view is that the economy has the potential to expand out to
2016, but that the ride will be bumpy as there is likely to be a
cyclical acceleration of inflation and higher interest rates to contend
with.

But, it is important for you to have a reasonable plan and to be set
to change strategy as your risk tolerance allows when events start
to deviate from plan as they often do. (Risk tolerance is an objective
measure, but it is best defined in terms of each investor's particular
circumstances, both financial and emotional.)

For now, with the economy in the early stage of recovery you should
open up your thinking to include the possibility of much higher profits
over the next few years, even if such a thought seems to be almost
impossibly close in time to the economic free-fall of 2008.

Financial System Liquidity

The Fed wound up its quantitative easing program at the end of Q 1
2010, so we are now seeing a leveling off in its balance sheet, as well
as a flattening out of the monetary base and the basic money supply.
Liquidity in the system is being further constrained by the continuing
run-off of financial co. commercial paper and a drawdown of low and
no reserve jumbo deposits.

Some areas of the banking system's loan book are picking up after
months of decline, including consumer loans, credit card balances
and even C&I loans to business. To fund an expansion on the asset
side of the balance sheet, banks are doing more open market
borrowing for now.

In the short run then, the Fed has left target interest rates unchanged
but it may have just started tightening up on the provision of liquid
balances to the system. From a long term perspective, I would much
prefer to see the Fed be moderately more liberal with the provision
of monetary liquidity, but its foot is off the accelerator for now.
Should the Fed continue with the current liquidity tightening regimen,
My stock market support and long term economic growth indicators
will start to lose positive traction as it would suggest the economy
will grow more dependent on private sector credit creation. These
would be normal non-fatal developments as the economy recovers,
but I regard loss of growth momentum of monetary liquidity as
signalling an upturn in fundamental risk.

It is still a little early to proclaim that short term business credit
demand has turned the corner and is headed up, but a turn does
seem to be getting closer. A turn in business loan demand strong
enough to reverse the downtrend of my credit supply / demand
gauge would be another factor in favor of the Fed raising target
short rates.

Profits Indicators

The corporate profits indicators have been on the right side of a
strong "V" pattern for months. Viewed yr/yr, the indicators are
consistent with both sales growth and profit margin expansion.
This all on top of massive cost cutting done in late 2008 and
through 2009. Estimates for earnings are on the rise as normally
happens in the early phase of an economic upswing. The stock
market is discounting a rapid recovery of earnings out about six
months in time. Projections for SP 500 earnings range from $75 -
80 per share for this year and from $90 - 98 for 2011 (The prior
record high was a restated $91.47 for the 12 months ending in
mid-2007).

If you've been reading the blog for a good while, you know I have
long regarded a big bounce in 2010 SP500 net per share to be an
easy mark to hit. The indicators currently suggest a strong run
for profits well into Q 3 '10 and probably the final Q as well. But,
my indicators are mute on 2011. When it comes to next year, we
are looking at assumptions. To hit the high end of the range for
2011 of $98 per, sales are going to need to grow by 7-8%, and this
in turn would involve the return of broader pricing power for
companies. So, we would need to see a normal full second year of
economic recovery, and we would also have to witness the onset of
fiscal stimulus withdrawal and a turn to a more restrictive
monetary policy with both developments having minimal effect. In
short, the analytical work that has brought us this far constitutes
the easy part of the job when it comes to earnings. Looking well
into 2011 is going to be more tricky.

Technical, Sentiment, Psychology Summary

I thought I had it nailed when the SP 500 dropped sharply over
latter Jan. into early Feb. '10. That break came on time and so did
the rally, but the rally, contrary to historical market behavoir,
developed into a much stronger one than expected coming after
a classic three upleg run from the 3/09 low. I figured we would
see a rally of substance after a good several months had transpired.
I made some money in it, but to compound my frustration, we
are now seeing the upmove extend despite the fact that plenty of
capable analysts / traders have known it was overbought for
at least a couple of weeks. Well, I'll stay with my trading discipline,
but this has been a frustrating several weeks.

This morning at 9:33 am on CNBC, floor commentator Bob Pisani
says, "Folks, there's a wall of money coming into the market...That's
what traders are telling me." So we know sentiment is bullish and
is at extreme levels on a couple of measures. And we also know
that the trading/research/strategy side of The Street has its
swagger back, and that there are a raft of money managers on TV
to tell us the market is cheap on 2011 eps estimates. You know,
guys who were hiding under their desks a year ago.

My ex-post reading on psychology is that with the downward break
in the market into early Feb. there had to be a large number of
money managers who saw a chance to jump on board after the
Greek debt crisis subsided and the economic indicators improved.
These were the guys who were low on equities exposure.

So, all told, this cyclical bull went into fast forward mode timewise,
and even if stocks get dumped for a week or two straight ahead
(it's overdue), I plan to hunker down and trend follow for a good
several weeks before I try to be the first kid on the block to make a
fresh call on direction.

Stock Market & Financial Liquidity

Comparisons between stock market trends and money market
fund holdings did not prove very rewarding for a long while. During
the great bull market from 1982 - 2000, money market funds
experienced dramatic growth as well. There was sizable growth
in total financial system liquidity in the early part of the past
decade, but the stock market languished for a fair part of that
period. That is the main reason I demoted system liquidity
measures as a market tool after 2003.

But, interestingly enough, money market funds -- retail + instit'l --
did reach such a mass size in the past decade, that a positive
correlation between fund flows and and stock market trends has
developed. Money fund outflows were a far better guide to the bull
market that started in late 2002 / early 2003 than were much
broader measures of liquidity.

During the recent bear market, mm-funds increased from $2.3
tril. to $3.5 tril. over the 5/07 - 3/09 interval. That jump rated
out at +52%. Since 3/09, when a new cyclical bull market got
underway, combined mm-funds fell from $3.5 tril. back down to
$2.8 tril. currently. So, about 58% of the cash cushion that was
established over the mid-2007 - early 2009 period has been
drawn down.

Now, it is the stock market that calls the tune here and not the
mm-funds flows. Moreover, the mm-fund data is reported with a
lag, so using this data to time the market will not prove helpful.
We can say that mm-fund outflows are supporting the market
and we can speculate that the well is not yet dry.

I plan to play around with the data in the months ahead, as there
may be some interesting relationships here nonetheless. Here
is a link to the Fed's mm-fund database.

Stock Market -- On Thin Ice Short Term

My rather simplistic view here is the length of time that has gone
by since this rally started in early Feb. is simply sufficient to warrant
a pullback of substance either this week or next. So, I am looking
at the prospect of a small short position.

I am mindful of the many commentators, myself included, who have
pointed out for the past few weeks that the stock market is over-
bought. And, it is. But the progress of the rally has thwarted the
attempts to topspot the market with OB / OS formulas.

So the tactic I plan to follow involves waiting for a clean break of
trend to the downside starting with watching for the market to
crack down and through the 10 and 25 day ma's with enough force
to invite both of the latter to roll over as well. If there is no break
of substance, I'll just keep the powder dry.

Check out the SP500 chart and see what you think. Chart.

Rules Of Road Are Up The Road

The leading economic indicators have pointed to a "V" recovery
from deeply down levels for over a year now. And so we are
seeing stronger retail sales, businesss orders and production.
Next will come inventory restocking, stronger payrolls growth and
more positive income levels. There is substantial pent up demand
and more fuel to support it than many realize. Besides the rapid
and dramatic recovery of profits, there are gains for consumers
from a sizable level of home refinancings and liquid assets held over
in the wake of crashes in auto and home sales. Large sums of down-
payment money were never put into play.

But it is important not to confuse the bounce phase of recovery
from the longer term priorities of economic expansion. So it is
that the initial phase of recovery has oftened concealed the
demand priorities of consumers and business as the economy
progresses particularly as regards the deployment of capital for
longer term purposes.

Thinking Ahead

A surge in the growth of monetary liquidity by the Fed as 2008
wound down set the stage for economic and stock market recovery.
The Fed sat on monetary liquidity for over 10 years prior to the
Great Depression. This time, it sat on monetary liquidity for 4 years
(2004 - 2008) and that ushered in the Great Recession or near
depression. But, now we are in a new and large liquidity expansion
cycle.

Historically, one of the early and major beneficiaries of a sharp,
positive turn in liquidity growth is corporate profits. As we now
see, profits and cash flows for business are surging, so much so,
that private sector credit demand has been slack as financing
needs are met internally.

Now, eventually, as the economy recovers, private credit demand
will grow again and, as tax receipts rise, public sector credit demand
will subside. But, the pressure to contain public sector spending will
not subside and public debt issuance will be further crimped.

However, even as credit needs come into better balance, there will
emerge another consequence of strong liquidity growth, and that
final element in the liquidity cycle is inflation.

There is "action" in the commodities pits, but it would be unusual
to see an acceleration of inflation beyond the volatile fuels and
other commodities components until 2011, when the economy is
further along and more resources are at work. Then, I think, we
could see pricing pressures exert more influence upon interest rates
and the market's p/e ratio, thus leaving the capital markets with
the next major challenges.

So, as you go forward with your investing and/or trading programs,
you will need to monitor not only how well the economy is holding
a recovery path, but emerging inflation potential as well.

Inflation almost invariably begins in the commodites pits with fuels
a primary culprit. In fact, like profits and the stock market, the
broad commodities composites are also often early beneficiaries of
a positive turn to the liquidity cycle. As rising commodities prices are
absorbed into the economy as costs, the groundwork for a broader
spread of rising prices is set.

Economic Indicator Issues

with the economic recovery moving along, I am skipping the usual
detailed commentary to focus on a couple items of strategic interest
to the capital markets.

First, the group of weekly and monthly leading indicator sets I
follow are progressing, but we'll have to watch over the next
several weeks to see whether the indicators are at momentum
inflection points and whether further advances will be more
moderate. More moderate progress for the indicators would be
the normal development. What's interesting is that it is not clear
that we are there yet. This applies to global as well as US measures.

Secondly, with the pace of shrinkage in the banking system's short
term business loan book moderating and with non-financial top class
commercial paper demand rising, total business lending may be
nearing a positive turnaround. In fact, with the stronger market for
industrial commercial paper, my indicators behind whether the Fed
should raise rates have moved up from 30% to 50% in favor. This
development raises the "buzz" level on The Street re: Fed policy
as does today's news of an increase in payroll employment. The
weakness seen in the Treasury market in recent sessions reflects
sector swap rotation to pick up yield, but it could also reflect
"handicapping" on an eventual reversal in Fed policy.

Finally, the inflation pressure guides I use did level off early in
the first quarter of 2010, but with the strong action in industrial
commodities and petrol, these gauges may be firming up again.

Stock Market -- Short Term Technical

This post is an exercise in due diligence. Short term consolidation in
the stock market has taken it off the uptrend line in place since the
2/5/10 interim low and left it just a smidge above the 10 day m/a.
So far, what we are seeing is a work off of a sizable short term
overbought condition which can be rescued easily enough. Even so,
I pay homage to the break of trend and the market's proximity to
the short term m/a's. I also note that the 9 month cycle rolls around
in mid-April and that a shorter cycle also has a low around the same
time. As always, remember that cycles shift and fail, but deserve
respect nonetheless.

There's a three day weekend ahead for the market, and with
employment data due out on this Fri., there may be position
squaring underway currently, as only the SP 500 mini will be open
and that only until 9 am. As well, with tomorrow being April 1,
the quarterly window dressing is done. Thus, I would be looking
toward next week to see if the rally may be rescued or not.

SP 500 CHART.

Gold Price

I last discussed the gold price back on 11/20/09. I claimed it was
very overbought but could have a blow-off spike up into the
high 1200s before settling back to $950 in the spring of this year.
Gold did get up toward $1240 oz. in late '09 and did settle back to
$1050 in early Feb., but it has moved up some from there in recent
weeks.

Gold is now struggling to hold its uptrend rolling back to late 2008.
It has broken the trend twice this year, but the breaks have been
modest and you have to give a volatile medium like gold some "over
and back" chances around a trendline before you can say with
authority that a downside break has occured.

My gold macro-directional indicator has been rising pretty steadily
and strongly since the latter part of 2008. The monetary
component rose sharply over the past 15 months, but is very likely
to settle in to a much more modest trend as major central banks
rein in quantitative easing and special lending programs . Thus,
for its strength, the gauge will be more reliant on the pricing of oil
and a basket of industrial commodities as we move forward through
2010.

Updated fundamental research on gold mining now pegs the all in
cost of extraction at $700 oz. for new mines. I have used the new
data to reset my micro indicator for the value of gold up to $650 oz.
and may adjust it higher if the global economy continues to expand.

I continue to regard gold as very expensive and will likely only
play it on the short side from time to time. CHART.

Stock Market -- Valuation Benchmarks

Last of a three part post on market fundamentals.

The SP 500 Market Tracker based on 12 months eps through

3/10 sits at 1060. The market is currently trading at a 10%

premium to the Tracker. The spread is not onerous.

With rebounding earnings and rising estimates, the market is

discounting continuing strong net per share performance into the

third Q of 2010. Again, not unusual.

The Tracker, based on a full year consensus estimate of a touch

over $78 per share, would fetch a value 1290 for the SP 500 by

late in 2010. Since advance indicators point to sharply rising

recovery eps into Q 3, this is probably a reasonable enough

projection.

So far, investors are showing no concern about the issues of

exiting accomodative monetary policy and strong fiscal stimulus.

Both issues could arise as concerns later in the year.

The Market Tracker based on super long term trend earnings

gives a "500"value of 1155 for 2010 and 1230 for 2011. So, for

investors with a longer term time horizon, the market is now

fairly valued. This means that the chances for sizable excess

returns depends entirely on continued strong earnings gains and

a moderate level of inflation (not in excess of 3.5% per).

I also use a simple dividend discount valuation model and a

kindred p/e assessment model based earnings plowback. The

dividend discount model reveals that investors are expecting a

cyclical recovery of the dividend and that players are also

factoring in earnings / dividend growth of between 7.5 -8.0%

long term. From an economic perspective, this would imply

top line growth of 6.0 - 6.5% plus further profit margin

improvement. That would represent a tall order if the USA was

the exclusive focus. So, implicit in investor's minds are continued

aggressive balance sheet management such as share buy-backs,

and the benefits of increasing SP 500 exposure to faster growing

emerging and developing economies with lower cost structures.

Clearly, investors do not have humble expectations.

Over the past 20 years, companies have allowed dividend

payout ratios to decline and have increased the ratio of earnings

plowed back into the business. Return on Equity % x earns.

plowback rate = implied internal growth. Excluding the recent

recession years the formula would run as follows: 15% x 65% =

9.75%. That would imply a p/e ratio over 20x trend eps.

Investors, seeing that few companies can grow by over 10%

a year, have not bought into the corporate strategy since the

bubble days of 1996 - 2000. And, they have been correct to be

more conservative. In fact, I suspect that earnings and market

performance for the SP 500 would have been more stable had

companies payed out more in dividends than they have.

Stk Market Fundamentals -- Indicators

Second of a three part post on market fundamentals.

Core market directional fundamentals have been positive since
late Dec. 2008. This group includes measures of monetary
liquidity, market short and long term interest rates and
confidence indicators. These are my "easy money" measures,
both in terms of betting with an accomodative Fed at your back
and the opportunity for a high return / low risk long side play.

Core indicators turn decisively negative when restrictive Fed
policy chases up short rates and corporate yields, curtails
basic monetary liquidity growth and starts to bite into my
favorite confidence measures. That process has yet to start.

When the "easy money" period ends and a more restrictive
policy is adopted by the Fed, the market may sell off some, but
can recover and go right on up. But this type of situation offers
moderate return for steadily increasing risk. It is a time to play
with a substantial and rising liquid reserve kept aside. I am
developing a couple of indicators for increasing business cycle
risk keyed on the 91 day T-bill and measures I use to determine
when corporate earnings are nearing a peak. More on this at
another time.

True to form, the 3/09 - 9/09 period was an "easy money" run.
I played it full out, but have been in on the long side more
sparingly since, simply because the advance was so strong and
I was concerned players would be far more nervous than they
have been.

Secondary indicators remain negative. the real price of oil has
found a less ominous upward trajectory, but a continuing
advance forms a headwind for economic growth. Also, with
the broad economy advancing and the broad measure of credit
driven money growth declining, liquidity available for the
stock market is shrinking.

The market has done somewhat better over the past 6 months
than I thought it would. The trajectory of the advance has been
unimposing, but it has been strong enough so far to raise a
doubt whether the negative secondary indicator readings have
created much of a headwind.

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.