Liquidity Cycle -- Looking Ahead #1

The liquidity cycle is currently the strongest it has been during the economic recovery which
began in 2009. Normally when financial liquidity in the economic system accelerates, the
real economy and business profits will follow in positive fashion. With a short time lag,
stronger economic demand brings along faster inflation.

Presently, my broadest measure of financial liquidity to include Federal Reserve Bank credit
is growing a rapid 11% yr/yr. Now, looking back over the past nearly 50 years, the 11%
growth number is right up there with past periods of accelerating liquidity growth. However,
with the Fed's balance sheet at a high base, the growth rate of liquidity is set to slow
markedly over the next year even if the present QE program is maintained.

Since there are questions about how rapidly Fed only liquidity may be absorbed into the
real economy, I suspect the velocity of the liquidity will continue to decline because
confidence in the economy by consumers, banks and businesses still remains well below
normal. Looking conservatively, it is reasonable to expect that business sales in the months ahead have the potential to move up from the 3 - 4% area yr/yr  to about 6.0 -6.5%. This development would lead to faster profits growth and ultimately to a pick up of inflation from the recent
1.5 - 2.0% level to 3.0 - 3.5%. If the banks turn more aggressive and dip into excess reserves,
output and inflation could be stronger. So far, however, the banks have been very passive.

Believe me, the Fed's current $85 bil. per month securities purchase program has increased
its balance sheet to levels that are above what the Fed, including likely Bernanke, is
comfortable with. In fact, the pace of QE is now running faster than the expansion of the
monetary base did over the long 1932 - 46 stretch. Policy is thus moving the Fed into
unchartered waters, even compared to the long pull from the economic bottom of 1932. Thus
the pushback from some Fed board members and economists.

Prior to the latest cat fight over fiscal policy and the debt ceiling in DC, the leading economic
indicators I follow were flashing stronger as was new order data from purchasing managers'
surveys. The battle in DC may have rattled confidence in the very near term, but the liquidity
cycle still points to moderately faster economic growth ahead.

The Fed would dearly like to rein in the growth of its balance sheet and it also dearly wants
to avoid a 1937 scenario when a sudden extended period of "cold turkey" flattening of the
monetary base led to debacles for the economy and the stock market (The latter went down
about 45%).  Hence the "taper caper" -- the idea of slowly weaning the economy and the
markets off the big QE push. The idea of curtailing the QE program likely will present no
substantive economic growth issue if, and this is the big "if", private sector credit demand
finally responds more vigorously. Since banking system data show that the banks have
basically taken 2013 as a long holiday at the loan window, there are no assurances going
forward.

I'll use the little framework above up until the time is at hand for the Fed to put its QE
taper plan into effect.

The secret to successful use of an economic outlook framework is to look for data and
info that tends to disconfirm the base view and not just collect items that confirm it.

I plan to put up a few more posts shortly on the topic with focus on the capital and
commodities markets as well as factors that can undercut the view such as real household
incomes and the magnitude of excess physical capacity in the global system (There's a fair
amount).

Stock Market -- Short Term

The market has rewarded the dip buyers once again this year with a 4% SPX rally over the
past week or so as it has moved up toward the recent all-time closing high. The 10 and 25
day m/a's have turned up and the SPX shows only a modest 1.8% premium to its 25 day m/a.
Traders like the idea of the Janet Yellen selection to head the Fed and think they will have a
new friend in a very high place. Concerns about damage to confidence from the Gov't.
shutdown and nasty debate about the debt limit have been shelved and worries about a
Fed decision to curtail its QE program were set on a back burner. Players rightly concluded
the political fight in DC would not end with the worst outcome and are even speculating that
with new shutdown and debt ceiling deadlines in place for early in 2014, the Fed may have no
choice but to hold off the taper even longer.

It would be strange if the guys did not press the SPX up to a new high to celebrate the reprieve
on the present shutdown, debt ceiling worry but take care to remember the old phenomenon
of "buy the rumor, sell the fact".

One item of interest on the attached chart: Note the downtrend in the MACD. No break here
would suggest limited upside, indeed.

SPX Daily

GOP Right Wing Lands On Its Feet

The intransigence of the GOP righties pushed Obama to accept an increase in the debt
ceiling that runs only into Feb. 2014, and a re-opening of the Gov. for but a limited time.
This partial cave-in by Obama will be a drawback for him going forward with fiscal policy
and will be duly noted by foreign powers the US is currently engaging. For the GOP, they
retain their nasty options for possible use after both houses go to conference and set spending
bill appropriations.

It reminds me of GOP 1964 presidential candidate Goldwater's comment that "Extremism
in defense of virtue is no vice". The Goldwaterites got creamed back then because the
economy was growing fast, inflation and unemployment were low and liberalism was in its
hey day. Political conservatives make up about 25% of voters now, and are increasingly reaction-
ary in the classic French sense of the term -- hold back the future and bring back the past era.
As pundit Andrew Sullivan (The Dish) recently said "They (conservatives) want their president
white and the budget balanced now". The newer righties are both more militant and sharp at
building a power base.

The weak economic recovery in the wake of a deep recession has stolen US household
confidence, increased impatience with the status quo and is fertile ground for the growth of
both righty reactionary and lefty radical movements. The righties are way ahead now, but
continued subpar economic performance will bring on more interest in the left as well.

The bottom line now is the GOP's rightwing obsession with austerity to slam down gov't.
spending and reduce the budget deficit. Policies of this sort may well backfire in a slow
moving and still well leveraged economy and certainly could punish capital at risk.
That's why capital market players need to be very mindful of the power of the right.

Show Me The Deal

The economic stakes are high concerning both the spending bill and a raising of the US
debt ceiling. But the political stakes are also very high, both in terms of the Obama
presidency vs. the GOP right wing and the clear intent of the US Constitution. Rebuffed
at the end of last week, the GOP right has slipped into demagoguery and rabble rousing to
increase the political pressure and is in near breach of the Constitution regarding the
directive that the proper servicing of US sovereign debt be held sacrosanct.

It is now difficult to envision the House meekly voting out even semi - clean bills on
spending and the debt ceiling. So, I am anticipating more drama in the next couple of
days from the GOP right wing of the House to try and break the president's resolve and
I have to wonder for example whether the stock market is now too sanguine in the near
term relative to the very ugly storm which could still billow up as righties and tea partiers
are faced with having to come away virtually empty if Obama holds his ground.

And, Obama must hold his ground because he is being threatened with extortion.

So, show me the deal that will resolve the serious political dangers the US faces.

SPX Vs. 200 Day M/A Oscillator

Most of time, when the SP 500 gets more than 10% above its 200 day moving average,
it gets tougher to make good money on the long side in the months out ahead. That is
because history shows that 10% or higher premiums represent big time overboughts .The
last time the SPX exceeded the 10% m/a premium was in May of this year, and here we are
with the market no higher than back in May when the 200 day m/a oscillator hit its most
recent peak. SPX vs  200 Osc.

Most of the time, when the SPX does get to a big premium to its 200 day m/a, it subsequently
loses all of the premium and, when the corrective process is sharp, can go to a discount.

The SPX has so far worked off most of the recent major overbought situation without a
substantial price correction. The chart I linked to shows a downtrend in the oscillator which
has yet to make a clear bottom, so even though the large overbought has mostly disappeared,
there is still some vulnerability evident.

There are market pundits who are calling for a washout to scare the folks in Washington to
end the circus and produce a compromise that will end the gov. shutdown and resolve the
debt ceiling debate in a way favorable to the economy. Since the "drop dead" date to raise
the debt ceiling is still more than a week away there is clearly time for more brinksmanship
before the denouement or before the cans get kicked down the road for a few weeks. The
GOP is doing one of its scorch the earth routines and is also previewing its campaign for 2014
off-year elections. Obama has a more serious issue -- the very credibility of his presidency.
He needs to stand as firm as he can. Few market players want to sell way down only to have
to reverse the strategy if a "positive" deal is struck. There can be more volatility ahead.

Gov. Shut Down / Debt Ceiling Issues Seen Differently

I have no trades on the books now and am 100% in cash. Partly it is just laziness. Partly
it is that there are no trades that suit my interests. Shorting oil and going long the T-bond
are prospects but have yet to show the volatility I would like to see.

I am in the black for the year but it has been a quiet one, especially since late spring when
the SPX became strongly overbought.

So, it would be nice to see some good opportunities open up between now and the holidays.

My view on politics is that the GOP right wing continues at war with Obama personally and
is using the shutdown and debt ceiling issues to scorch the earth for as long as it can. For now,
I am assuming  that speaker Boehner will simply not vote out a clean bill on the debt ceiling
regardless of whether the votes are there or not. Since Obama can hardly compromise on a
fully extra - legal move by Boehner without damaging the spirit if not the rules of the US
Constitution and further, since giving into clearly extortionate demands would destroy the
credibility of his presidency, he has little choice but to stand back from the Boehner group.
Obama can explore raising the debt ceiling by executive fiat, but any method he might choose
could be challenged in court and would for sure get the House Of Reps. to commence
impeachment proceedings.

I suppose Boehner could have an epiphany, whip his charges into submission, and vote out
clean bills. Devoutly to be wished for...

I must add that the GOP righties do not hold Mrs. Clinton in warm regard either and see a
knock down drag fight ahead for years if necessary. It is the worst hostility coming from the
right that I have seen since the last couple of years of the Truman administration (1950 - 52),
and the Democrats very much need to start breathing fire and really go after these dangerous
people.

Stock Market -- Short Term

The market is threatening to roll over into correction mode for the third time since May.
As the daily chart shows, key short run indicators are trending down and the $SPX has
broken below both its 10 and 25 day m/a's. SPX Daily

You will note from the chart that breaks below the 25 day m/a over the past year have
engendered further weakness, and note too that the 10 m/a has rolled while the 25 day is
flattening and perhaps preparing to turn lower.

The increased volatility in the market since Jun. would allow the SPX to drop down to
the 1660 area before there is a threat of a shorter run trend reversal.

The SPX drew up to a major intermediate term overbought against its 200 day m/a when
the premium rose to a high +10% this spring. Since mid - May, the market has gone on
to new all - time highs, but it has been difficult to hold the gains as the SPX has moved
off a zippy tight speed line up into a lazier and more volatile pattern.

Traditional liquidity, inflation, short rate and economic indicator fundamentals remain
positive. However, the market grew fully valued over the Apr. -Sep. period and has been
vulnerable to bouts of profit taking. First, it has been the developing ambivalence by the
Fed over continuing the big QE program and now, we have the fiscal policy / debt ceiling
bullshit from official Washington to work through. Although the turkeys that comprise
the far - right in the House might ultimately relent on the debt ceiling, the group remains
nasty, destructive and cynical enough to damage the economy for as much as they can get
away with. This ensemble remains apoplectic that a man of color continues as president.

The price dips in recent months have rewarded aggressive buyers who trade. In this
emotionally charged environment, I am inclined to let the current dip play out more.

Gold Price

The gold price has been traveling with some old pals in recent months, namely the oil
price and the $USD (gold behaves inversely to the buck). The yellow metal did latch on to
the  seasonal rise in the price of oil this summer, and it derived benefit from the Syrian crisis
and labor unrest at the shipping point in Libya. Now, however, the US and Russia are
teaming up to remove Syria's chemical weapons and Iran's new president, Mr. Rouhani ,
is talking nice to the US in an effort to get out from underneath tough sanctions which have
hurt Iran's economy. Moreover, oil is poised for a period of seasonal weakness and with the
Syrian and Iranian threats off the table in the short run, we'll soon see if oil supply / demand
fundamentals are in tight enough alignment to mitigate a seasonal run down in the oil price
to the $85 - 90 bl. area by late Jan. of 2014. Thus the gold bulls may have to shift more
focus on to the $USD and the US debt limit fight which is just starting to roll out. Gold Chart

Gold did fail to break the downtrend in price running from Sep. 2012's $1800 level when it
recently rolled over at around the $1400 point after a strong rally in summer's months. That is
a bad sign, but since the oil price has yet to break sharply lower, gold may get to test the
downtrend line again in coming weeks. Even so, gold is drawing price action impetus from
other markets and has yet to show a supportive fundamental base in what must still be
counted as a bear market. To hold technically, gold does need to take out and rally above
the $1360 level in the weeks just ahead.

SPX -- Monthly Chart

Today closes out Sep. 2013, so I thought I would take a look at the monthly chart.

Technical
This is a cyclical bull market which has carried the SPX to a new all time high recently. The
market is extended on a cyclical basis off the 3/09 low and is also very extended within a
long term band that carries back to the end of WW 2. It can definitely go higher but once the
SPX rises above the 1700 - 1750 into hyper - extended territory, history strongly suggests the
market could be bought considerably more cheaply within the next five years. SPX Monthly

Note also how extended the monthly readings for MACD, RSI and Williams %R are getting.
Note as well how far above these indicators are from excellent possible buy points. From a
technical perspective, this is a well advanced bull market, which if it continues to move
higher without a substantial breather, is going to force participating investors to accept sharply
higher long run risk.

Fundamentals
Now we get to the fascinating part. Tops in the market coincide with economic expansions
with elevated cycle pressure measures and high rates of resource utilization. At these points,
broad money / credit growth is normally at +10% yr/yr or higher and short term interest rates
are at least 5% and in uptrend mode to counter a credit supply / demand pressure gauge that
is running at strong positive levels in favor of demand. Finally, inflation is in cyclical
acceleration mode. The current US economy still has ample resources to grow, moderate
cycle pressure gauge readings, only 6% funding growth, a low credit supply / demand
pressure gauge of a mere +1.4, a ZIRP on short term interest rates and very low inflation.

So, the stock market is rather fully extended, but the economy is not. There is slack to
support economic expansion for a good several more years.

What we do not know is whether the economy can realize its expansion potential without
continued substantial quantitative easing from the Fed. This epoch is not like any time
since WW 2. Stocks wise, it matches up with 1932 - 36. The market crashed in 1937 when
the Fed removed QE and allowed a slight rise of interest rates. the analogy has 2014 match-
ing up with 1937 and there could be trouble if the Fed tapers down QE to zero next year
and consumers, businesses and bankers lack the confidence to transition the economy to
self - sustaining expansion.

Stock Market -- Daily Chart

The latest leg of the bull advance has been underway since latter Nov. 2012. SPX Daily
The market could not hold the 11/12 - 6/13 speed line and a fairly tight up channel has
given way to a milder and more volatile advance, but the broad trend is intact. The
current, still minor corrective action of the SPX is from a short term overbought position
and if the more volatile price action remains in force, the SPX could drop further into the
low 1650s area without wrecking the new up leg underway since later in Jun.

The moderation in basic trend and the step up in volatility plainly reflect the introduction
of sterner talk from the Fed about eventually curtailing the large QE3 program. The FOMC
did extend the QE thrust at its Sep. meeting, but some Board members continue the rounds
of harping about its eventual curtailment before many moons have passed.

The US fiscal policy / debt ceiling circus is well underway and there is an obvious stronger
level of mutual contempt between Obama and his allies in the Congress and the GOP right
wing. The ugliness on display is welling up fast and it now seems like there may be a
stunning crescendo of invective yet to come. I do not think investors have taken the show at all
seriously so far, as more zigs and zags in debate and tactics likely remain ahead. If there is
a battle over the debt ceiling which seems headed straight for the eleventh hour, there could
be nasty reactions in the bond and stock markets that come suddenly and late in the game.

Junk Bonds

The junk market has been struggling since earlier in the year as yields have been buffeted
by rising Treasury rates. Junk price indices have rallied recently on signs of a stronger
economy and hoped for better fixed charge coverage and could get some further play if
traders grow more confident that the Fed will resist curtailing its large QE program for
a while longer. However,the Bloomberg high yield index is sitting down around 6.50%
and is carrying a small premium to an array of investment grade bonds which can be had
to yield between 5 - 6%. That now smaller quality differential spread does not present junk
players with a favorable comparable risk / return profile for now. Bloomberg High Yield

US Stock Market

Fundamentals
The more critical directional fundamentals -- growth of monetary liquidity, near zero short
rates and confidence -- remain positive for the market (Confidence is reflected in the trends
of narrowing credit quality spreads and a rising p/e ratio). My broad measure of money +
credit funding growth has exceeded the demands of the real economy, thus leaving excess
system liquidity to flow into the current favorites of equities and housing. A substantial loss
of earnings growth momentum has yet to significantly inhibit the market's advance and a
rising oil price has so far been well accommodated.

My weekly cyclical fundamental indicator has regained positive traction in both forward
looking and coincident categories, but a degree of caution is still advisable given the scant
growth of consumer and business incomes.

The Fed is keeping its large QE 3 program in place for now, but It is harassing the market
with threats of curtailing and eventually zeroing out this effort if the economy can show
sustainably faster growth. The specter of winding down QE does seem aimed at inhibiting
speculation in stocks.

Below par cyclical inflation does provide theoretical support to the market's p/e ratio of
16x+, but the market is tending toward full value as earnings progress remains subdued.

The President and the Congress have another circus planned for just ahead with the
rebellious right wing of the GOP so far unwilling to vote out clean budget and debt ceiling
bills and with Obama prepared to veto what is on the table now. Because the major players
are more coldly angry now, it would not be a surprise to see stocks become more volatile
in the weeks coming up. However, since the players may put more cards on the table by
the end of the forthcoming week, it is still early for strong pessimism. This is ugly stuff
with a heavy undercurrent of race coming from the right.

Technical
The strong advance in the stock market throughout 2013 to date has so far been a winning
hand in an against-the-house bet on technical grounds and the heavily overbought nature
of the market since May has yet to produce the odds-on deeper correction that big time
overboughts generally set up. SPX Weekly Chart

Monetary Policy -- Going The Fed One Better

I have argued over the course of most of this year that there was no economic case to end
or curtail the Fed's major QE program. I also discussed earlier in the year how pressure
to reduce the QE program would rise by mid - 2013 as the Fed's balance sheet rose to the
top of the range for QE programs dating back to late 2008. There is no doubt in my mind
that a number of Fed staffers got very nervous about that, leading to "hall talk", babbling
over lunch, and leaks to The Street and the media which in turn precipitated the "taper talk".
The "taper" stuff was a dumb and costly idea and it is a shame that key board members such
as Bernanke, Bullard, Dudley, Evans and Yellen put up with it. Dumber still that so many
Wall Streeters ran with it and spun it.

I think the truth is that not only does the economy have to perform a lot better to warrant the
reduction of monetary stimulus but that a decision to curb stimulus will prove a risky bet
until well after the economy is functioning normally with income and credit flows that are
well recognized as adequate to sustain the economy in the absence of highly accommodative
monetary policy.

The risk to the stock market and the economy of a premature curtailment of QE remains
very large in my view. QE has been there to keep confidence up and the deflationary
wolf away from the door.

I am sure Bernanke would like to eat out in Wash. DC on others' tabs but, as he completes
his valedictory lap, it would be nice if he called out the Congress again for their recklessness
in mishandling fiscal policy and, nice as well, if Obama got behind him.

Corporate Profits Indicators

Sales
Over the past few months, my sales growth indicator has moved up to around 4% yr/yr
from 3%. The very long term average for yr/yr  sales growth is about 6.5% and the current
measure is running lower both in terms of volume growth and pricing. My expectation for
the current year, set at the outset of 2013, was for a 6% yr/yr gain through Dec. So far,
both volume and pricing have fallen below the estimate. Historically, it has been hard
to maintain profit margins when 12 month growth comes in below the 5% level. On the
plus side, the leading indicator sets I follow suggest at least a mild acceleration of volume
growth ahead.

Profit Margin
The work continues to suggest mild pressure on the operating profit margin through Aug.
Facilities operating rates have been down ever so slightly over much of 2013 and this has
worked as a modest drag on profit margins. My sales vs. cost ratio has been running about
-0.4% which means that pricing has not been recouping operating cost. My productivity
measure has been flat this year, too. Productivity growth has naturally slowed appreciably
over the past two years following the dramatic improvement seen over 2009 - 10. If sales
do pick up in the final quarter of the year as now suggested, companies can recover some
of the modest pressure on margins seen so far in 2013.

S&P 500 Net Per Share
I have been hoping that SP500 eps would rise 6.5% to about $103 per share this year. Net
per share could actually do a little better owing to factors such as lower cost of capital and
share buybacks, but $103 of pure operating profits would be fine given drags on sales
growth and operating margins seen over most of 2013.

The stock market often heads for trouble when SP 500 net per share rises above the top of
the very long term range of trend earnings such as happened in 2000 and 2007. The top of
the long range trend channel is now running about $120. The economic recovery is now
over four years in duration, but profits are running well below the top of the long term
range owing to how deeply depressed eps was at the bottom of the recession and the fact
sales growth has moderated markedly since mid - 2012.

30 Yr. Treasury Bond -- Deep Oversold

My weekly fundamental indicator for the Treasury bond suggests mild price weakness
for the year to date. The bond has been swept lower in price since late last year with the
heftiest part of the decline coming since the late spring when the Fed began to talk about
curtailing the growth of the large QE program. Market players fear the loss of a large
bid the under the market if the Fed tapers, and have been buying into the idea that the
economy should accelerate ahead. The 91 day Bill has stayed near zero and inflation
pressure has been mild, but the yield curve has steepened sharply as investors prepare
for the return to a faster growth environment.

From a technical perspective the bond is deeply oversold relative to its 40 wk. m/a and
bond advisory bullish sentiment has been evaporating rapidly  $USB Chart With the next
Fed policy meeting due up in but a few days, and bearish bond sentiment as high as its been
since early 2011, there could be a quick long side trade here if the Fed skips the taper and
focuses on an economy which has yet to exhibit the sort of balanced growth envisioned in
their forecast. Moreover, if the Fed, under political pressure, decides to curb the QE program
and investors  review the Fed's comments and decide the action is premature, the bond price
could benefit anyway. Keep an eye out.

Oil Price

The oil price has had a very fine  run from a seasonal low point in mid - 2012. As with stocks
and home prices, the oil price has benefited substantially from the significant excess liquidity
generated via the Fed's QE program. With global economic growth having been slow over
most of the past 15 months, the ongoing supply / demand situation has simply not been
strong enough to support the nearly 40% increase in the oil price we have seen since mid -
2012. This is currently a seasonally strong period for the price of oil, but this interval is
only likely to run for another two to three weeks before the industry moves into a period
of seasonally weaker demand.

The global economy has started to firm up very recently, but this is well discounted by the
current price of around $107 bl. Oil traders will be looking carefully at the status of the
Fed QE program particularly since the price is currently quite elevated seasonally. I do not
think the economic case is there to support curtailing the QE program, but all the "taper talk"
from the Fed suggests this program may become tainted politically because of the wrong-
headed pushback it has received. The next FOMC policy meeting is a week away.

How about the situation with Syria? To get a sizable spike up in the oil price out of the
Syria situation would ultimately likely require not just the start of a US attack on Syrian
military targets but retaliation from Syria and / or its partners that would in some way
imperil a significant quantity of oil production. Consult with your local geopolitical
expert for more.

The COT reports from the futures market shows continuing very large long positions by
the major  speculative traders who tend to be wrong more often than not when they have
outsized positions on the books. This action has been mostly a play on support from QE
rather than Syria worries.

There could be a big payoff for long side oil players if an attack on Syria heralds a more
dangerous supply situation, but recognize the crude price is extended on the eve a period
of seasonally weak demand. WTIC Oil Price

Stock Market -- Daily Chart

Back on 8/19, I posted that the SPX had trend support down in the 1630 - 1640 area.
The market closed at 1646 on the 19th but it was not until the final week of Aug. that
the SPX dropped to the trend test area. As fate would have it, the PMI data for US mfg.
and that of other nations was published right after Labor Day. The numbers were strong
and were followed by good services PMI's as well. Players liked these strong readings and
have rallied the stock market since 9/3. Other cares and woes have been set aside in the
process as the SPX has moved up from a mild short term oversold. SPX Daily

The rally has taken the SPX up through the important 10 and 25 day ma's. The 10 day
has turned up and there will be stronger trending support for this rally if the 25 day turns
up and if a rising 10 day can also move above the 25.

The bull run from Nov. 2012 remains in place as the market has been registering higher
highs and higher lows throughout the year. But note that as the rally has matured, the
advance of the SPX has lost considerable momentum since May reflecting much stronger
Fed talk about QE tapering and, perhaps an accelerated rise in long term bond yields.

The market is trading at a 7.2% premium to the 200 day m/a, so some of the hefty
intermediate overbought in place since the spring has been worked off. The guys have
been in there to buy the dips and the SPX has not experienced the stronger negative
action which far more often than not follows a heavy duty intermediate term overbought.
If you have been long over the course of the year to date, you have beaten well established
odds.

My thought over the past month or two has been that the SPX up at the 1700 level should
prove a formidable challenge for the bulls on both technical and fundamental grounds, but
the price action even recently has yet to support this conjecture.

Purchasing Managers Surveys -- Unconfirmed Bright Spot

US purchasing manager survey data for new orders and general activity have picked up
strongly over the past two months. That news should qualify as a significant  plus for
the US economy. However, the data does not square well with weekly forward looking
indicators and weekly coincident indicator activity which suggest a slow pace of growth
going forward. The discrepancy here represents a very unusual development. I have
teased the weekly data at great length and I can reduce the discrepancy only somewhat.
Because I have respect for all the data series involved, and further, because each of the
series can be volatile in the short run, I am not going to blanket judge the play out ahead.
New industrial production data will be available next week from the Fed, and it should
show a good increase for Aug. if the PMI surveys have it right.

One additional matter though, and that is the continuing grim news about employment and
the real wage. Couple that with a progressive loss of internal cash flow growth momentum
from business and you have a picture where the PMI survey data, if on the mark, could
provide genuine re-invigoration to a sluggish economy. 

Basic Materials Stocks

This group is driven by expectations regarding global economic momentum and the pace
of industrial commodities prices. Performance relative to the broader market has really
suffered over the past two years reflecting subpar global growth momentum and a
weakening of sensitive materials prices which reflects the slow growth and falling
capacity utilization. With evidence in hand that the global economy has recently been
firming up, the group has began to do better against the stock market. Basics Vs. SPY

The improving relative strength of the smokestack companies reflects investor bets that
the economy is set to do better. But note that the supply / demand balance for the industry
does not favor dramatic output pricing leverage as it did over the 2003 - 2008 period
when rapid industrial expansion paced by China gobbled up excess capacity. Investment
in basic materials such as copper has been catching up. Over the past year, popular
industrial commodities indices are up about 8%. That is pretty mild, but is still better
than the inflation rate.

Trading wise, sensitive materials prices have been getting a favorable play as the year
closes out and winter sets in (Companies set manufacturing schedules for the year ahead).
The relative strength of this group has been in a pronounced downtrend since mid - 2011
but is closing in on a possible positive reversal. Keep an eye on it.

Here is the 15 year track record for the XLB spdr against the SPY. XLB Long Term  

Syria Risks

So far, the debate in the US about whether we should launch a missile attack on Syrian
military and related installations has been more calm, intelligent and enlightening than I
expected it would. The public, weary of war and increasingly skeptical that any US military
action in Islamic dominated countries is worth a dime or a drop of our blood, remains
largely unmoved. The majority here do not want such an attack.

A 60 day time limited attack on Syria focused on the military would do tremendous damage
to the place even if it primarily involves cruise missiles. Do not be fooled into thinking that
concentrated bombing is but a "drive by".

So it remains good that the public seems demanding and that critics are probing the
administration's case forcefully. It is also good that Obama and his crew are going to have
to work harder to make their case and for them to realize the political risks involved.

Maybe no attack will occur then, but if one does proceed as currently outlined, there could
be substantial retaliation and blowback to come from Syria and its allies. Even Russia is
reported to be inserting a few warships into the waters off Syria. Cruise missiles soaring
above or around Mother Russia's gunboats is not a recipe for carefree days on the Med.

I push the risk issue a little because these are troubled times with leaders in many countries
under pressure to have their economies perform better. And, with largely subpar global
economic performance for the past five years, patience and temperament are getting a little
frayed among the folks and their leaders. This is a tough time, a very tough time, to risk
widening a war based on deep hatreds that go beyond Syria's immediate borders.

Stock Market -- Weekly

Technical
Back on Aug. 4, with the SPX trading above 1700 at an all time high, I mentioned that
the market was again in an extended position and that it was significantly overbought
on an intermediate term basis. The downtrend underway since then has partially relieved
both the extended and overbought readings, but it leaves the SPX with negative indicator
readings for the intermediate term. SPX Weekly

What is striking about the chart is the very high levels of MACD seen this summer. MACD
readings of 50.0 or above are not routine, pedestrian events but reflect top levels only seen on
the weekly chart during powerful momentum runs in bull markets. Not surprisingly, such
excesses often foreshadow sharp, temporary corrective phases which lie not too far ahead in
time. The recent positive whipsaw in the MACD reading was a rather unusual occurrence
and showed how anxious players were to capitalize on the Fed's large QE program. Risky
business from a technical point of view.

Fundamental
The more recent instances of Fedspeak suggests They will cut down on QE if the economy
firms and perhaps leave well enough alone if the economy remains sluggish. A continuation
of sluggish sales growth by the corporate sector implies low or no earnings growth. That the
market is no higher than in May suggests investors may now be feeling a little boxed in and
anxious that there is no clear game plan for them to follow to take the market higher.

When the latest QE was first initially put into the sketch stage in mid - 2012, the market
rallied a good five months before it was actually implemented. So, with liquidity
tightening now hanging over our heads and with no clarity yet as to when and by how
much liquidity will be parsed (let alone if it will be anytime soon), players could take some
additional time out to try and handicap just where the Fed may be headed and whether
positions should be trimmed with the upcoming pathway less manifestly bullish. Call it
an adjustment to the appearance of clouds in the crystal ball.

Syria And Beyond...

The US dropped atom bombs on Japan. It used Napalm and highly toxic Agent Orange
defoliant in Vietnam. It used white phosphorous --"Shake & Bake"-- in Iraq. So why
worry about Assad using sarin gas and inflammable chemical agents in Syria especially
since the US has been unwinding war exposure? Well, chemical warfare, although
very risky, is underestimated as a weapon and stands as a terrific instrument of terror.
Now that Assad, in a fight to the death with Sunni rebels, has opened and deployed
from his chemical warfare goodies box, the seals have been broken and the security and
further use of the weapons have no taboos.

Big dogs can take out Assad's air force, missiles and heavy weapons or at the least fully
neutralize them. Securing the chemical stuff is a very different matter, particularly if the
US or others want to neutralize it. Putin, acting grandly as the champion of Assad, should
be saying : "Holy shit, the Chechens could get this stuff and use it on us." Ditto Iran,
which will have to fear another Sunni led chemical weapons attack if  this stuff gets out.
Then there are the obvious dangers to the US, Europe's capitals, Israel and Syria's other
neighbors.

So far, the big dogs seem willing to let this civil war, based on some of the deepest hatreds
known to man, play out and perhaps end with a ghastly conflagration. Obama has been
stumbling along with the chemical warfare issue and has invited the Congress to debate
whether the US should strike Assad and his men via cruise missile attacks. Of course
a debate will be an ugly affair and mostly beside the point when the world's focus should
be on those horrendous weapons. We can only hope this debate will further enlighten people
to the dangers involved as the war grinds on and how big a challenge we will face if
those weapons are not neutralized and fall into the wrong hands. If control is lost as it
may well be, we can look forward to having Amazon eventually put up pages of sharp
fashion, anti-toxic chemical suits with matching masks and sneakers.

Bank Credit & System Liquidity

Bank Credit
Excluding the Fed, banking system interest earning assets (loans, investments) have
shrunk slightly over the past several months reflecting low economic growth and still
relatively stringent lending standards. The Fed is now the lone provider of incremental bank
credit to the system. Earnings wise, the banks in the aggregate are getting by on fees and trading
profits. The banks are also slowly losing market share to other consumer credit facilities.

In their own way, the banks do mirror the economy and collectively they are starting to
offer a bleak picture once more. Moreover, since the Fed is now the primary lender, it
is curious that the Fed seems keen to begin to curtail this service. System data on credit
suggests strongly the Fed is simply bluffing here in the short run with all the talk about
tapering.

Here's a graphic look at another important component of private sector funding:
Commercial Paper Outstandings

Financial Liquidity
With banks operating a flat asset book, they are not out there chasing deposits. So, my broad
 measure of credit driven liquidity has slowed down to a meager 2.8% annual rate based on
six month data. This compares to a 9.2% annualized rate of growth for the six months ended
Jan., 2013 and shows just how slow the system is now running. The liquidity side of the
economy is now functioning just ever so slightly faster than stall speed and points to how badly
a significant pick up in US economic demand is needed.

The Fed should be pressuring bank CEOs to get their asses out into the community to
find and assist the many good business and household credits out there. The banks, having
sinned as profligate lenders, are now sinning almost as seriously by playing scrooge to
the public.

The Gold Rally

The gold price made a fast double bottom down at $1200 oz. just as the seasonally strong
period for gold demand got underway in early July. Gold started to rally in a favorable
pro-inflation context. There has been a moderate acceleration of the US CPI from very
depressed levels, the oil price is in a favorable seasonal mode, the US dollar has been
under sudden pressure and commodities prices generally have been faring better since the
beginning of July Gold Price With Panels For $USD, Oil and $CRB

The timing for a turn in the seriously distressed gold price could not have been better. There
has also been help from a mild positive turn in sensitive materials prices and the accelerated
weakening of several emerging economy currencies such as India and Indonesia.

Gold is rapidly getting overbought in the short run but this is not so on a more extended
six month basis. Moreover, oil and gold can run strong seasonally into the autumn.

Now the rally has been a very fast one and it is difficult to project whether all the afore-
mentioned factors will remain in supportive roles. If you are riding this rise in the gold
price, you need to watch the constellation of supporting players and you should also note
that you are competing with very fast, large money coming over from bonds and just
recently, from stocks.

As readers know, I inadvertently called the recent bottom in gold at near $1200 when I
shelved the shorting of gold because it had fallen down to levels near or at production costs
(6/27). I am not at all ready to proclaim a new bull market for gold. I would note that when
a financial asset , commodity or precious metal comes off a perfect, long term parabolic
pattern such as gold recently has, the odds favor an extended period of price weakness
along with occasional, sharp rallies. Gold Price - Long Term History lays the burden of
proof at the hooves of the bulls.

Global Economic Supply & Demand

Global economic demand has remained positive yr/yr for the duration of the economic
recovery, but momentum has decelerated rather steadily over the past three years and
for the past year has been running at a decidedly subpar 2%. Global capacity growth has
exceeded that of demand for well more than a year, leading to declining operating rates,
falling commodities prices, decelerating rates of inflation and very importantly as well,
a sharp decline in the momentum of world trade. With banks globally still in repair
mode, credit to support trade finance and cross border investment has become more
limited, so that even prior rapid growth emerging economies are suffering a deterioration
of internal fundamentals as exports have slowed to a crawl and aspiring middle class
consumers  have drawn in more imports. To add insult to injury, an apparent commitment
by the Fed to curtail its very large QE program, has worked to force long term interest
rates up around the world.

Interesting then global PMI manufacturing data for Jul. and Aug. to date show an upturn in
output and new order rates. This is very good news even after acknowledging that PMI data
can be volatile. A re-acceleration in production and trade growth from the recent dreary
and socially risky 2% would be very welcome globally and for the US as well, since our
exports were a strong driver of recovery in the initial stage and have been quite subdued
since the spring of 2012.

Naturally, faster global output growth would eventually lead to higher inflation. However,
an acceleration of global capital flows needed to underwrite the kind of speculative
expansion witnessed over 2003 - 08 now seems remote as banks have more leverage
restrictions and are still unwinding remaining excesses from the last boom. As well,
business will take its time to gear up after experiencing the dramatic loss of sales
momentum seen over the past three years.

Note the recent improvement in the commodities market: CRB Weekly

Stock Market -- Shorter Term

As discussed in the 8/4 post on the weekly chart, the SPX at 1710 was once again fully
extended on a price basis just as it was in May. Since then, the market has fallen into a
short term downtrend that was recently confirmed by negative rollovers in the 10 and 25
day m/a's. Viewed strictly short term, the SPX has moved from a mild overbought up at
1710 down to a mild but deepening oversold. SPX Daily There is short term trend support
for the SPX down in the 1630 - 1640 area.

From a purely technical perspective, I do not have a strong point of view regarding the
direction of the stock market in the weeks just ahead.

I am surely not the best guy to listen to this year on the stock market as I have thought
that SPX 1550 represented a decent top for the year on both fundamental and technical
grounds. I have been concerned however, that the guys would use the QE elixir to drive
the market higher even though the underlying business sales and earnings fundamentals
did not warrant the drive. They have done so.

Presently there are concerns in the market about the future of QE and the widely discussed
eventual cut back in the growth of this program. And this is now coupled with questions and
debate about the current strength of the economy. So, players see more risk in equities for
the time being and we are witnessing profit taking and some effort to replenish cash kitties.
For my part, the weekly leading economic indicators have turned more positive but are not
showing anywhere near the zip needed yet to support rosy earnings estimates for the final
quarter of this year and especially for 2014. Moreover, I flat do not think there is a case
for curtailing the Fed's QE program in the months ahead without a switchover to a sizable
fiscal stimulus program to backstop a sluggish economy, and for what it is worth, I doubt
Bernanke does either.

Right now there is a swirl of competing forecasts, predictions and expectations about the
likely courses for the economy that is too rife with varied assumptions to capture my interest.
Ditto the bond market where there has been a case for a very gentle upturn in yields but
nothing in support for the strong reaction well underway.

August on the sidelines has been very pleasant for me.

Economic Indicators, Company Comments Whipsaw

Purchasing manager data released in early August suggested a firming US economy
with clear suggestions of further strength ahead. The weekly leading economic data
sets I follow also suggested a better pace for the economy, especially with initial jobless
claims dropping down. This info strengthened the hand of those folks who have been
claiming the Fed is set to cut the pace of QE soon. Thence comes the whipsaw. Cisco
Systems is battling a soft patch and is adding to layoffs. Macy's sees softness in sales
and today, Walmart -- the largest US retailer -- reports lighter traffic as a combination of
higher payroll taxes and mildly accelerating inflation cuts into consumer spending
power. Today, the Fed reported flat industrial production for July, and retail sales,
although up 5.4% yr/yr, barely budged forward in July. The past month was sluggish
indeed for the economy and company and Fed regional data suggest the opening weeks
of August were slow as well.

Should the economy pick up going forward, then there will be no discrepancy between
the leading indicator data and recent reports on sales and output. We will just have to
wait several weeks to see if the recent upturn in the leading data, including strong new
order numbers from the PMI reports, were one shot wonders or not.

My coincident economic indicator, which measures the very basic economy on a yr/yr
basis, came in at +1% for July. It shows a continuing sluggish economy with a down-
trend in momentum still very much intact. Hopefully, readings for Aug. and Sep. will
confirm the recent pick up in leading indicator data via a positive turn in the
coincident indicator.

Stock Market -- Daily Chart

On a seasonal basis, the market is behaving perfectly -- flattish, with low volatility and light
volume. SPX Daily Chart It's August in the Hamptons and the living has been easy.

The sharp advance underway since mid - Nov. '12 is still underway, although the SPX is
failing to sustain the momentum or speed line of the original impulse that ran into May.
The market is not overbought in the short run, but it does remain relatively strongly
overbought against its 200 day m/a. So far, investors have waived off this significant
intermediate term caution. Attached short term RSI and MACD are trending down,
but the market does not show breakdowns of the 10 and 25 day m/a's which would signal
a likely, more noteworthy move down. The VIX remains very subdued and indicates a
strongly confident tone to the market. On balance, it has been very hard to scare players
off the market so far this year.

Seasonally, the stock market does tend to give up some ground ahead in Sep. and Oct.
There is already a surfeit of "crash talk" out there on the Web as guys try to make the
big call via capitalization on the 1929 and 1987 Oct. crashes. There are also folks who
have moved into crash debunk mode. Some of it on both sides makes for interesting
idle time beach reading on vacation.

There is a serious element here, however. Historically market panics such as the US
experienced in 2008 - 2009  can beget an add -  on panic / recession a few years out
provided that the steep loss of confidence the initial panic caused hasn't been broadly rebuilt
and providing that near concerns develop regarding liquidity in the system. Post 2008,
the Fed's QE programs and ZIRP policy have been in place to keep the wolf away from
the door, and system liquidity levels are probably adequate to keep the wolf at bay so
long as the Fed does not behave foolishly and cavalierly in the months ahead regarding
any prospective firming up of monetary policy. In a like manner, the administration
and the Congress will be squaring off on the budget and the debt ceiling later in the
year and we can hope but not genuinely expect that no further damage to this modest
economic recovery will be done via foolish fiscal policy choices.

Stock Market -- Take A Deep Breath

It is August. More folks are on holiday. Volume is light. The stock market has quieted
down. However, more Fed governors are speaking up in favor of curtailing the growth
of the large QE program which has been the major driver of the market's strong advance
since late 2012. Normally when the Fed wishes to curb the growth of Fed Bank Credit,
it simply freezes it in inflation adjusted terms and uses tighter liquidity conditions to raise
short term interest rates.The stock market can shudder briefly but usually bounces back
so long as credit growth is brisk enough to fund continued economic progress.

Both the monetary base and M-1 monetary liquidity are very sensitive to changes in Fed
Bank Credit. In fact, I use real M-1 as a sort of ultimate longer term leading economic
indicator. Presently, the growth of real M-1 is running about 10% yr/yr . It has been
decelerating, but has been way too fast to create concern about the economy. A gradual
tapering in the growth of Fed Credit would push the issue whether real M-1 might be
slowing too fast well out into 2014. Even then, there might not be a problem for the
economy if credit growth is fast enough to fund both real output and cyclical inflation.
Moreover, if the Fed can trim its credit account without raising short rates, there would
even be less pressure for the economy. Finally, and if necessary, a new QE program
could be put in place to backstop a faltering economy.

Market players have loved the QE programs even as earnings improvement momentum
has slowed to a crawl. The QE programs, in underwriting a strong bull market, have
worked to allow confidence in the economy to recover from the depths. Straight line
reasoning implies that a reduction in and subsequent elimination of QE would damage
the stock market, undermine confidence and, in the end, punish the economy.

The history of this economic recovery suggests the Fed, if it goes through with its heavily
leaked new program could top the market for quite some time unless investors and
traders see enough in the progress of the economy to waive off QE as a concern. My
reading of the evidence since 2009 says that if this transition is to occur, it may not do so
quickly unless the economy surprises to the upside for a good several months as QE
subsides.

I would dearly like to see the economy recover a faster stride and failing that, I would
prefer the Fed, if it concludes it must curtail the QE, go ahead in a very cautious manner.

QE curtailment, tapering etc. could well introduce a sizable element of perceived risk
into the market "equation" even though from a strictly monetary economics point of view,
no such worry should surface for another year or so.

Take a deep breath and think through carefully what I have outlined. I happen to like the
idea that the market could be close to where it is now a year further out in time before
the QE reduction issues are resolved and a new bull leg can begin. It is not a prediction,
just a thought. In the meantime, I will stick with my indicator disciplines.

SPX Daily Chart

Eurozone Status Check

Here in the US, there is stronger interest in the Eurozone stock market than that seen
for a good several years. The view gaining in popularity is that the EZ will very soon
be coming out of recession and that EZ stocks may offer more appeal than US stocks
in view of a possible strong leg up in EZ stocks as an early-in-the-recovery play. Since
EZ policies have many critics here, this perspective is far from unanimous.

I have followed a very simplistic approach with the EZ over the past couple of years
with my focus on Euro monetary liquidity. The growth of such liquidity has been
strong enough over the past year to have entered an area of sufficient magnitude to support
a mild economic recovery. I would like to see Euro M-1 up 10% or more yr/yr, but that
is well within reach this year. Euro M-3 is growing very slowly as EZ credit is still
shrinking, but it is monetary liquidity that usually leads the way in re-inflation start ups.

The EZ PMI has been in a base mode of a downturn-indicated  level of just above 45 for
most of the past 18 mos. and has just risen above the 50 level into expansion mode.
This sharp turnaround may well signal an end to recession conditions for the EZ in the
aggregate. Yes. it could be a fluke, but it is a hopeful sign after such an extended basing
period. 8/5 EZ PMI

Euro land  stocks have been trending higher over the past two years as players have mostly
blown off attention to the recession for the EZ as a whole. Plenty of investors here in the
US have ignored the market because it has seriously underperformed  the SP 500 and have
taken little notice of the strong recovery of the Euro currency. Europe 600 Stocks

The charm for US players despite already rising Euro share prices is the economic recovery
may finally just be starting with Euro stock composites 25 - 30% below the prior 2008 all
time high. The "600" index chart above shows its relative strength against the SP 500 ETF.
Traders are eyeing the recent basing of this RS measure against a longer term downtrend
and may well like the idea of a stronger Euro which is coming out of an extended down-
trend against the dollar.

There is risk in the trade since a scale down of US Fed QE could bother some foreign
markets even more than it may jostle US equities.

Trading Russia -- Better Lucky Than Smart

I have done alright trading the Russian stock market via the ETF route and as a higher
beta proxy for the oil price. There was a nice long side trade in early Dec. 2012 on a
stronger oil price and with better late autumn industrial output (See 12/5/12 post in
archive if you're interested).

I have stayed away form Russia this year because of the sharp divergence between the
price action of oil and the RTSI and passed up the recent opportunity to go long with
the exchange's value having dropped down to important support. RTSI Weekly Chart

Russia's industrial economy held up reasonably well in 2012, but the domestic side has
clearly weakened in recent months. The poor price action of the stock market after Jan.
of this year tells me the smarter money surely had the edge as it has been discounting
slippage of the industrial sector into negative territory. Russia Mfg. PMI

Moscow has been having good fun with the Snowden affair, but it is time for Putin and
his boys to tackle a deteriorating domestic economic situation which has damaged the
market after a solid 2012 economic performance in the face of the Eurozone recession.

Relative to the oil price, the RTSI should probably be trading up around the 1600 - 1700
area. But, being half a world away, I plan to stay on the sidelines for now to see how
the domestic economy performs in the shorter run. In the meantime, there is the great
music to enjoy -- No, not Pussy Riot --  but Shostakovich and Prokofiev, two of my
favorites.

Stock Market -- Weekly

Fundamental
The key driver for the continuing advance is the Fed's ongoing large QE program. It has
fostered broad liquidity growth in excess of the needs of a muted real economy, and with
slight progress in corporate earnings, provides a strong tailwind for investor confidence.
Some investors believe the economy is set to accelerate and some are very happy with
very slow economic growth and low inflation and interest rates. Weekly cyclical data
I follow show some recent firming for the economy, but this index has been flat since Feb.
and must strengthen considerably to support the economic growth acceleration case.

The SPX is up about 54% from the 3Q 2011 when this latest extended up leg began.
Over the same period, SPX quarterly net per share earning power has expanded but 7%.
The p/e ratio has risen by nearly 50% leaving the SPX fully valued for now. Few wish to
fight the Fed.

Technical
The SPX remains in a strong uptrend. It is again getting extended in price as it was just
back in May. The RSI and MACD show rising trends from the 2011 low with the MACD
now very overbought on the weekly chart. Notice the recent and not often seen whipsaw
in the MACD, signaling strong player desire to add to positions on dips. The market
remains at a hefty premium to its 40 wk. m/a as well. SPX Weekly

The VIX volatility index -- a barometer of fear vs. confidence -- has dropped down to a
level just a hair above the 10 line which demarcates strong confidence and supreme
complacency (bottom panel).

---------------------------------------------------------------------------------------------------------------
The continuing expansion of the p/e ratio marks the passage of the SPX from value driven
to price momentum speculation. Keep your quote device nearby as the fast action guys are
arriving in trucks.

Market Breadth Has Yet To Confirm Recent Advance

Recent strong equities performance to new highs has yet to be confirmed by a run to
a new all time high for market breadth. Hardly fatal, but this non-confirmation is worth
your continued attention anyway as it could signal a more narrowly focused advance
for the market even if it does not necessarily presage a topping stage. Obviously, the
non-confirmation from the adv / dec line is small enough now that it could overcome it
easily enough during further positive price action. Breadth Vs. Price

Monetary Policy -- Setting The Clock For Confrontation

As expected, pushback on the QE program is on the rise: It is inflationary; it will create
asset bubbles; it is not proving effective . The economy has shown some signs of improve-
ment in Jul., but Bernanke chose first half 2013 performance -- 1.4% annualized GDP
growth and below target inflation -- to press the case for continuing the program.

My weekly leading economic indicator sets are turning up and that is welcome. But, we
probably need 4 -6 months of stronger indicator performance to make the case that the
economy is entering acceleration mode sufficient enough to have a worthwhile discussion
of sustainability. Outward appearances suggest strongly Bernanke will give up his
chairman role by 1/31/14 if not sooner and there could be substantial pressure on the new
chair to begin to wind down the QE program even if it is far from clear that it is ok
from an economic perspective to do so. Moreover, if the economy is set to do better as
many now think, QE liquidity could continue to funnel into the oil price, thereby setting
off higher inflation which, over time, could pressure real incomes. Put up more points
for the anti - QE hawks.

I figure the fight over curtailing QE is likely to be settled within the next 6 months. The
issue is a big deal because broad measures of financial liquidity are barely adequate to
sustain decent growth. I realize that a still very depressed construction market is holding
down private sector credit growth and that bank lending and funding would likely improve
sharply on stronger construction demand. Yes, there is idle developed real estate, but this is
also symptomatic of the business and banking caution the Fed has had to confront and
could well be indicative of a more general and shallow confidence at work in the system
which could be undermined by a premature reduction of the QE program.

Inflation Potential -- Long Term

To come up with longer term potential, I use a "back of the envelope" model that has
worked very well for a number of years. In brief, I subtract a real economic growth
assumption from the 10 year annual rate of gain for money M-2, the most stable of
the aggregates. Over the past decade, M-2 has gained by 5.8% per year. My growth
factor combines reasonable projections for annual increases in both productivity and
for the labor force. This assumption works out to about 2.8%. Thus, I peg longer run
inflation potential at 3.0% per year. M-2 has been decelerating in the long run as has
real growth potential for the US based on a downturn in the growth of the labor force
(Productivity has been improving as a partial offset to lower labor force growth).

The yr/yr CPI has averaged 2.1% over the past six years on a 60 month smoothed basis.
The period encompasses 6 / 2007 through 6 / 2013 and includes a very deep recession
and below average economic recovery. The excess output capacity and weak labor
market over this interval primarily accounts for the shortfall of inflation compared to
the 3% projection and extremely sparse credit growth has played a roll as well.

Supported heavily by the Fed's QE programs, M-2 has begun to accelerate since 2010
and has been growing about 7.5%. This progress has been undercut by weakness in
other important measures of bank funding such as "jumbo deposits" ($100K+) and
financial sector commercial paper. The inflation rate since 2010 has averaged 2.2%
when measured on a smoothed yr/yr basis.

In the US, business capacity utilization should average about 80 - 82% in a stable
growth environment and the unemployment rate should run lower than currently. But,
the nation's operating rate has not topped the 80% level since 2008, and the economy
has not run near full or effective capacity for almost 20 years. Moreover, wage growth
over the past 10 years has barely been strong enough to support 3% inflation.

When we look out over time, it will become increasingly difficult to hold inflation
at or below 3% if some mixture of monetary easing plus faster credit growth puts new
upward pressure on that 10 year M-2 growth rate.

looking in the shorter run, inflation has been running 100 basis points below where it
should be and since fails in monetary and / or fiscal policy can punish output in an
economy with still substantial idle resources and relatively high debt levels, you should
realize the latent deflation potential in the outlook until there is a more sustainable
strengthening of real output, wages and pricing power. The US is not out of the woods
yet and I would happily trade a brisker economy with 3% inflation over what we have
been experiencing.

Many people scoff at the CPI and substitute their own measures to suit their convictions.
Do not be a fool. The CPI is a good approximation of inflation in the US system.

Stock Market -- Daily Chart

The SPX has come off a spike QE re-affirmation rally as the market awaits the next
chapter on monetary policy this week and seeks to glean if there may be new hints
about the continuation of this program. Of particular interest would be whether the
Fed believes the economic outlook is solid enough to commence a program of curtailed
QE wherein the Fed say only buys between  $60 - 70 bil. per month of securities instead
of the current $85 bil. program and, if so, when the curtailment might begin. There is an
apparent consensus that a moderate "taper" program could begin this autumn. The weekly
leading economic indicator sets I follow have started to show some slight improvement
but do not at all yet suggest that such speculation about monetary policy is appropriate.

Regardless, the run up in the SPX off the 6/24 closing low was fast enough that that no
one can blame traders for wanting to take "a breather". The SPX just broke below its 10
day m/a and the short term indicators are showing some deterioration. So, despite the
idea that some consolidation is reasonable, more damage in the indicators in the days
ahead would signal a pullback. SPX Daily Chart

Viewed long term, the SPX horizontal line of 1700 on the daily chart would confirm
a turn to a more speculative market on technical grounds if the SPX takes it out soon
and would fall in line with my fundamental work that puts a new speculative era in play
above 1650.

The Pro Inflation Trades

The fairly standard block of trades to capitalize on an acceleration of inflation are: short
the US dollar and go long commodities, oil and a PM of your choice such as gold. This
type of trade was magic starting early in the past decade and running through mid - 2008,
and then again from early 2009  into 2011 on a hefty global re-inflation to bring the
world's principal economies out of the Great Recession.

I bring this up at this glum, slow time for the global economy because my inflation pressure
gauge may be set to rise and because there are preliminary signs of economic demand
improvement in big economies -- The US, Euroland, and Japan (China, the most voracious
user commodities and fuels, is still decelerating in growth). I also know there are lots of
players out there who favor this trade and would like to see it run strong again. For now,
this trade is working on a thin reed, awaiting more robust economic performance.

The chart I link to has panels for the US$, commodities, oil and gold. Inflation Trade Chart

US $
Graceful uptrend in place since latter 2011...Failure to take out 2012 - 13 resistance in 84 - 85
area and failure to take out 88 level resistance seen over 2008 -2010 keeps it suspect and the
hopes of inflationistas alive... The dollar's natural appeal in the wake of the deep global
recession of 2008 -09 has been undercut by the QE programs despite the very slow growth of
money + credit...Stronger US inflation pressure needed here to hurt $ in still risky global
economy.

Commodities
Strong downtrend from 2011 reflects unwinding of China's mercantilist engine, slower
global growth and larger spare capacity...Note downtrend is now being challenged...
I still see the CRB as undervalued on production cost basis and see 325 easily achievable
on stronger growth...CRB responding cautiously now.

Oil
Oil has been benefiting from spillover of QE into selected risk assets (see 7/19 post below)
...Took profits above $108 bl. on overbought...Note the $80 -110 approx. range of recent
years and that $110 should be broken to deliver the pro inflation trade.

Gold
The bounce here looks mostly like a response to stronger oil and commodities which have
put players of this oversold metal  in mind that there has been a small pick up of inflation
 pressure born by the fuels sector.

Stock Market -- Weekly

Fundamentals
The forward looking economic indicators remain both sluggish and range bound and do not
signal an acceleration of sales and profits growth. Such has been the case since early in
the year. The QE program from the Fed has been surging along and this has been the prime
underwriter of the strong advance for US stocks this year. The p/e ratio on 12 months net
per share is approaching 17X, thus just lifting stocks up from value to the start of a more
speculative phase. The current bull  now represents the third liquidity driven speculative
advance since the mid - 1990s. The excess liquidity which is fueling this advance is not
credit driven as have been most prior heavily momentum driven runs which have been
eventually negated by rising short term rates and credit tightening. The current run has
been fired up by a combination of exceptionally strong money liquidity growth coupled
with both low output growth and inflation thus allowing surplus liquidity to flow into
stocks. The 1935 - 36 period when stocks soared on QE is the closest analog.

Like the 1930s, the curbing and / or shut down of QE would represent a powerful
tightening of monetary policy and leave both the economy and the market vulnerable
unless we see private sector credit demand return to more normal levels.

Technical
The weekly chart is now showing a positive whipsaw which has lifted my intermediate
term indicators from negative up to neutral. The sell signal generated a short time back has
been swept away by easy money policies continuation reassurances from none other than
BB of the Fed himself. The market remains overbought for the six month window and is
now getting overbought on a very long term basis as well as the SPX is once again at the top
of its post WW 2 channel. It can blow through the channel top and money can still be made,
but the risk of eventual large losses heads progressively skyward. (The SPX has only gone
above its channel top twice since 1945 -- It happened 1995 - 2002 and 2003 - 07).

SPX Weekly Chart

Gold -- Keep The Down Staircase In Mind

My e-mail inbox is filling up with recommendations to buy gold or securitized gold in
the wake of gold's thrilling downturn since last Autumn. Since I receive precious few
missives from the Bugz, this is interesting.

I do have a caution and draw your attention to the stair case down for gold which started
last Oct. with gold at $1800 oz. Each step down since then has followed when a step was
put in following a rally which ended in resistance that could not be successfully breached.
As the chart shows, the latest step is set at $1300 resistance. The chart cries out for heavy
diligence here. Gold Price Chart

Oil Price

Trade / Invest
The oil price has advanced nicely this year so far. Longer term players have had the easier
time of it. The leg up in price in Jan. was a tough one for traders because it came at a time
when oil was supposed to be seriously seasonally weak. The positive jog up since Apr. has
been easier what with a flare up in Egypt and concerns over transport safety around Suez
and the Sinai. WTI has stayed within my projected $85 - 115 bl. range for 2013 and has
stayed within a subtle uptrend in place following the initial spike up off the 2009 recession
low.

The fundamental supply / demand picture for oil does not warrant the kind of advance seen
so far this year and, to be realistic, neither does Middle East / North Africa (MENA) tensions.
There is no short run bull case from the usual suspects, but as fate would have it, it appears
oil traders are enamored with the Fed's QE programs and have welcomed the arrival of Japan's punchbowl as well. The oil price, like the stock market, is front - running the fundamentals.
As of now then, oil players are also stuck with the machinations of the QE programs and very
much need to watch along carefully with equities players.

Perhaps $110 per bl. is in view for WTI, but oil is overbought in the short run, and for less
greedy traders like me, there are profits to be booked. $WTIC Daily Chart

The way I read the long term chart circa 1999 to the present is that oil is still in a bull
market, the $148 bubble top in 2008 notwithstanding. The bull remains in effect because
as supply has risen with demand, excess capacity at the wellhead has remained in a down-
trend, making supply security a more prominent feature in the environment. There are
rivals to oil coming, but the oil market still has the scale dominance. Longer term players
might well look at oil in a continuing $20 per bl. central range which is now set at $90 -
110 WTI. At this point, a sharp break below $90 bl. should trigger a careful review.

Macro Implications
There is a tough issue with petroleum products in the US. As oil has advanced in price,
folks have been conserving. However, with wage growth on average of only 1.5 - 2.0%
in a still weak labor market, sudden advances in gasoline and heating oil  prices can
wreak havoc with real household incomes and confidence. At this point, an oil price
above $110 bl. which sustains would be a source of concern.

Inflation Potential -- Cyclical

The inflation rate experienced a more or less normal cyclical acceleration coming out of
the Great Recession in 2009. The 12 month CPI swung from a mildly deflationary reading
on up to a cyclical peak of 3.9% for Sep. 2011. Then things changed both in the US and
globally. Output growth lost substantial momentum over 2011 - early 2013 and US
and global operating rates declined mildly. The starch went right out of inflation, with the
US 12 month CPI declining to an extraordinary 1.1% by Apr. this year.

The yr/yr CPI has accelerated since then and is at a point where there could be a positive
reversal to the trend. Capacity utilization has ticked up slightly and commodities and fuel
prices have starting moving up. $CRB Composite & Wholesale Gasoline Price Chart
Fuels pricing, including long quiescent natural gas billings, have been the main culprits.

My inflation pressure gauge made a yr/yr % change bottom in mid - 2012, and the index
from which I derive it has put in a recent double bottom. The US, at least, is at a cyclical
inflection point, but it is too early to say the index itself has reversed. I do use a couple of
other economic measures that are considerably less attuned to the commodities markets.
Here the suggestion is that inflation should begin to accelerate on a cyclical basis starting
in the second half of this year and run higher through 2014 (These measures are based off
leading economic indicator trends and are not that sensitive to short term developments).

Since my work is more indicator driven than reliant on forecasts, I am posting this warning
on inflation even though I do not yet have evidence the economy is about to break positive
from the dreary, low growth mode it has been in.

There is a way to look at long term inflation potential based particularly on monetary and
productivity trends. Sometime over the next week or so I will post on this view. For now,
suffice it to say that longer term inflation potential is mild and that a period of deflation
cannot be ruled out.

US Economic & Profits Indicators

The monthly coincident economic indicator is measured on a yr/yr % basis. It came in
at +1.3% for June for a slight improvement over May ( A CEI reading of +3.0% represents
solid, moderate growth). The sales and production side of the indicator was pretty fair,
but the income side -- real take home pay and 12 month % change in civilian jobs --
was negative reflecting higher taxes on wages plus the effect of somewhat faster inflation.
My weekly CEI, a conservative measure, was up by about 1% yr/yr. To maintain a moderate
level of consumer spending, householders are having to borrow more and dip into savings
because wage rates remain rather low. Retail sales have held up reasonably well despite
the income pressures on households.

Consumer discretionary spending stocks are now overbought relative to the broader
market, but continue in a leadership role. XLY Relative Strength

My primary top line or sales growth indicator for business improved in Jun., but averaged
only 3.3% for the second quarter. With sluggish growth overseas and a stronger US $, it
would be fortunate if corporate sales growth came in at 3.0% overall for the quarter. My
price / cost ratio has been improving in recent months, but there is still mild pressure on
profit margins. Business sector output growth and pricing power remain subpar in this
challenging economic environment.

Financial System Liqudity

Broad financial system liquidity growth has continued to decelerate over the first half
of 2013 despite the Fed's large QE program as the banking system's loan book growth
has slowed leaving banks less interested in bidding for deposits. Ditto the growth of
the system's key liquidity asset -- Treasuries. The activity mirrors a sluggish domestic
economy and modest progress in the need for trade financing. Mortgage run off and
defaults top new originations despite a decent pick up in housing and broader building
activity. It is worth noting that part of the slowdown evident in credit and the broad
measures of liquidity is a reflection of a loss of inflation momentum since last autumn
on lower capacity utilization not just in the US but globally as well. The world has yet
to shake the deflationary bias introduced by the "Great Recession."

Thoughts On Bernanke & Selected Markets

Well, as suggested on 7/8 (below), Bernanke did round on the monetary policy hawks
with a defense of his views. By my hard nose standards, it was a wimpy riposte, but the
markets loved it, with stocks jumping to a new high and gold in strengthening rebound
mode. QE remains in place for now, but remains in play politically as the Board is
strongly divided over its future. Gentleman Ben battles the sharks.

The SPX has made a new high. The short term indicators are positive, but the market
is again heftily overbought on a 6+ months basis and is subject to the possibility of
a "secondary" or rebound top as seen back in the Spring of 2011. SPX Daily Chart

The bull leg in place since Half 2'  2011 remains in place and is once again getting
very extended, enough so that more shorts will be invited in if the SPX can move up
closer to the 1700 level.

The fundamental environment is far from ideal. Monetary liquidity is strongly positive,
short term interest rates are negligible, and inflation pressure is low. All to the good. But,
the progress of business sales and operating internal cash flows and earnings remains
scant in a slow growth global economy. With liquidity carrying the day, the SPX is
gliding into overvalued territory, leaving stock price momentum to pull even extra duty.
Some players are comfortable with this and some are not, like me.

By sheer luck, on 6/27 (below) I switched from a negative view of the gold price to a
more balanced view. The future was down around the $1200 oz. level then, and after
a retest, there has been a nice rebound. Assets have powerful occasional bounces in deep
bear markets, and maybe I'll catch the gold train on the long side when the indicators
turn trend positive. Gold Daily Chart

The long Treasury is back on the radar, but like gold, it would be nice to see some repair
in the indicators. $USB Bond Price

Stock Market -- Back To The Daily Chart

The SPX, although rallying in recent weeks, is finding some resistance up around record
ground of 1650. The market has spent nearly two months trying to break and hold above
this level. SPX Daily Chart The new move up has taken the SPX through short term
trend resistance, but has deposited it at the same level seen on 6/18 before a stumble.
This is the fourth impulse up to regain the 5/17 closing high of 1669, and perhaps that
magic moment is at hand. Even so, you need to keep a critical eye out as there has clearly
been overhead resistance which could prove nettlesome.

For my money, SPX 1650 is the very upper border of value in this market currently. A
strong move above this level in the short run will begin to take the market into more
speculative territory and will add more downside price risk.

The Fed: Quantitative Easing Queasiness

With this latest round of QE, Fed Bank Credit has expanded up to the top of the range
in place since the programs started in 2008. FBC Chart (pdf) In turn, the longer term
trend of QE is actually running mildly ahead of the pace that was set over the 1932 - 46
period when the Fed let the monetary base expand very dramatically to counter the Great
Depression and to provide liquidity support for WW 2. So, although the current QE
program is not without precedent, it is still very large compared to the 1932 - 46 program
when the US economy was more deeply depressed. However, unlike the Great Depression
years, total financial leverage in the system, especially longer term debt, is now very much
larger on a relative basis. In short, economic demand is less suppressed, but leverage is
larger and of much longer duration.

If you pull up the FBC chart again, you will see that the Fed curtailed QE both in 2008
and 2011 after large spikes in the credit balance. And, as I have discussed, it is mid -
2013, and there is another spike up in place. there are many critics of the QE program,
and it is especially hard for Fed board members to keep up their nerve when FBC is
rising up to the top of the trend going back to 2008. The heavy pushback to QE has
arrived and it has been difficult for the Fed to be steely about it even though
unemployment is well above target and inflation is well below the Fed's goal.

The Fed's job has been made more difficult by the large back-up in bond yields which
increases the cost of longer term funding both for business operations and for construction,
naturally including housing. Bond investors, now concerned about all the pundit talk
regarding curtailing the QE program, have dumped bond holdings heavily. In fact, by
ingenuously reminding investors that a firm economy will bring an end to the QE effort,
the Fed has undercut its position and is watching matters backfire in the credit markets.

I think the curtailment of QE through much of 2012 damaged the momentum of the
economic recovery. The current "taper talk" is not helping now either. Moreover, the
Fed and the Gov. in DC may again need to be reminded how risky it is to pressure
economic demand in an economy that is still well leveraged and deflation prone.

Most have concluded that the Bernanke era at the Fed is about over. If so, it would be
nice for Ben to stand up soon and say "Nope, the economy is still too sluggish and
the risk of a deflation event is still too high....We need the liquidity and we need to
see our federal government take steps to get people back to work."

 

Stock Market -- Daily Chart

The SPX has rallied above its 10 and 25 day moving averages. The short term indicators
are also turning up. Curious then that the SPX did not breach a modest downtrend line
on Fri. 7/5 when it rallied up nicely. For some trend traders, that failure is an automatic
sell signal. SPX Daily Chart

That failure does leave the market in an interesting technical position, for it is exquisitely
poised to move in either direction in the week ahead. Bernanke will speak on 7/10 and
may have a comment about current monetary policy, but the pause in the rally may also
have much to do with the opening of the earnings reporting season for Q2 '13 and especially
the forward guidance that various companies may provide. My forward indicators suggest
that such guidance may be both reserved and muted as rather slow growth in sales, both
in terms of volume and pricing, seems on the menu. No shocker there, but we still have to
see how investors may tilt their collective interpretation (Do not forget the QE program in
this regard).

However, the technicals suggest not to be prejudicial but to be open minded in the short
run.

Leading Economic Indicators

Weekly
The US weekly indicator sets have been volatile but were basically flat over the first half of
2013. There was substantial improvement so far this year over the second half of 2012,
but the indicators leveled off after Jan. of this year. The stimulative effect of the big QE
program was offset by the effects of the 2% payroll tax increase, fiscal drag from the
sequestration budget trims and more conservative turns by banking and the business
sectors. Many economy watchers highlighted better housing and auto sales data, but total
US production was held nearly flat by the large export sales business which has yet to
progress this year in a marketplace of very sluggish global trade.

Monthly
I like to watch new order rates from the manufacturing and services PMI reports. There
was nice improvement here from 6/12 through 2/13, with Feb. being a very strong month.
Since then, there has been a substantial downturn in new order rates for both the service
and manufacturing sectors on both domestic and exports categories.

Looking Ahead
From an indicator perspective, the evidence does not point to an acceleration of economic
or profits growth for the current third quarter. There are expectations the economy should
gradually improve as the negative effects of the payroll tax increase and fiscal spending
cuts abate over the next 12 - 18 months, and some folks see "trickle down" benefits from
the strong stock market and the recent sharp recovery of home prices. These are reasonable
expectations. However, because the economy responded so positively to the mere
announcement of the QE program after June of last year, it might be wise not to get too
far ahead of the narrative now that the Fed has surfaced the idea of curtailing QE not too
far down the road. This recent discussion of the issue has affected the capital markets and
it could have an impact on business planning as well.

Adding The Long Treasury Back To My Trading List

With the long Treasury now back up around 3.5%, I am returning it to my list of trade
candidates (long or short). Way back in late 1980, when I first started buying bonds I took
on but survived several bouts of career risk as a result. Since 1982, trading the long bond
has been a  cakewalk as we have seen a phenomenal bull market. Many think the low 2.55%
readings seen in 2012 mark the final bottom for yields (and top for prices). Could be, but
viewed long term, the 30 yr. Treas. yield needs to rise above the 4.20%  level and stay there
for a while before such talk would gain some credence.

For years, I have used a long term inflation assumption for the US of 3% per annum. Thus
for now, I am using a 3.5% cut off rule to buy the bond as purchasing the Treasury at or
above 3.5% gives you a shot at earning a minimum premium over inflation for the long
term. There have been many years since the early 1980s when the market has priced in
a much higher premium than 50 basis points over the long range inflation rate and when you
are trading you have to study to see at what premium over inflation the market may derive
comfort.

Take a look at the 30 yr. Treasury on a weekly basis from a yield perspective: Long Treasury
Viewed against the 40 wk. moving average, players have taken the Treas. yield up to a
large premium. So, I see the market as substantially too high on a yield basis and nicely
oversold on a price basis. Note that the technical indicators also suggest that the yield is
presently on the high side. In addition, some trader advisory services are now perhaps a
little too bearish on the market (Consensus Inc. principally).

Surprisingly, trading bonds can be a fairly simple matter often enough. This is not one
of those times despite the bearish sentiment and the deep oversold in the market. I even
think the yield on the long guy is too high relative the mopey, draggy performance of the
economy. But, players have begun to re-price risk in this market to account for the time
when the Fed may curtail or end QE and begin pulling the large bids now under the
range of fixed incomes. The stark response to the "taper talk" serves notice about the
nervousness of investors even though the recent adjustment could turn out premature.

Whatever, there has been enough damage done in the market to move me to consider
getting back into the game to look over possible opportunities.