Monetary Update

The Fed is widely expected to increase the FFR% tomorrow.
The cyclical fundamentals support an increase, with
the economy, capacity utilization, short term credit demand
and sensitive commodities prices all trending up. The Fed
remains about 75 basis points behind the curve suggested
by the underlying trend of the CPI (5.0% FFR implicit).

In the wake of the hurricanes and the resulting surge of
fuel prices, the Fed moved aggressively to liquify the system
through the holidays. Fed system credit surged by $43 bil.
or a sizable 5.4% over the final four months of '05 through
the new year.

As discussed in prior posts, such injections of liquidity can
be bullish for gold and bearish for the US dollar. Such was
the case this time as well. Note though, that the Fed has been
draining liquidity rapidly so far in 2006, already shrinking its
portfolio of Govs. and RPs by over $20 bil. This development
puts dollar fundamentals back on a firm positive footing and
leaves the gold bugs having to search around for another reason
to add to their piles.

All players will read the Fed's comments tomorrow with great interest.
Buttressed by knowledge of Fed liquidity injections, analysts and
pundits elected to put a very positive spin on the commentary
attending the 12/05 FFR% hike. With liquidity now being drained,
the appraisals of tomorrow's linguistic tealeaves may be more
sober.

Stock Market -- What Am I Smoking?

SP 500: 1267

Well, here I sit. Feeling like an old Wall Street tout.
The fundamental work I do implies 2006 will be an ok year
for the stock market, with the SP 500 closing out the
year around 1385 - 1405 for a gain in the range of 11 to
13%. I have also been fiddling around with business cycles
in terms of confidence, and this bit of experimental thinking
suggests 2006 will see the US at least with a sunnier
disposition.

The keys to what I suspect is an utterly mundane consensus
view are as follows: Moderate 7% topline sales growth, further
expansion of profit margins, increased share buybacks and an
inflation picture, which, while volatile, will wind up the year
at around 3.5% (CPI).

I am well aware of the of the four year cycle of important
bottoms in the market, and by my calculations -- based upon
SP 500 data going back through 1872 -- a typical or average
significant price low could come in the Jun / Jul interval
of this year. A number of well regarded chartists and
technicians are factoring in a substantial sell-off this
year with the Mar / Oct period common. May be, but my
reads of the fundamentals do not now support this view.

However, when I look at 2007, I see a rather negative picture
developing, with inflation pressure intensifying as the
economy closes in on effective capacity. In fact, I now
see 2007 as a down year for the market which could only be
rescued by a strong surge of capacity expansion to balance
off the growth of demand.

I also use a couple of models based on Federal Reserve Credit
and the Adjusted Monetary base. These models correctly forecast a
dull and minor advance in 2005, but have recently turned a little
rosier.

I use this little exercise as the basis for a game plan for the
year and then track the market and the key fundamentals against
it. I play close attention to the deviations in actual from
expected, because they are often the kernels of opportunity.

Katrina On The Installment Plan

Systems here have been down since the last post on Jan. 18. Following nearly 18
inches of rain in October in this area, we've had one 11" snow and several major rain storms, including a doozy this Wednesday with winds topping 70 mph. The 'net
cable connection went down with the power, McAfee slipped a disc and took out
operating system directives. So, we had to rebuild and reboot in the bargain.

This was the week I had expected the S&P500 to top out at 1310. It made 1296 just a short while back, but with Iran carefully kiting the oil price, the jitters set in.
That combined with tech earnings shortfalls certainly ended the March over 1300. The
more conservative guidance from the tech sector was also largely unanticipated.

It was a good run up from late October, with nice trades for all heads up players.
I plan to reconnoiter for a week or so since the short term play to the upside over
the last three months is certainly suspect as of today.

Stock Market -- Short Term Technical

SP 500: 1273

As discussed in a brief technical note on 12/12/05, I have been looking
for this market to pop further to the upside, with the SP 500 projected
to move up to 1310 by mid to latter January.

My view has been that the price momentum and breadth compression witnessed
from 6/05 through early October was rather unusual and that a breakout - be
it up or down - should be powerful and time compressed into a three month
frame. The market did break out of the tight period to the upside, with the
SP 500 moving quickly from 1178 0n 10/20 up to 1265 on 12/2. It then meandered
up to 1273 on 12/14, and then entered a well deserved back and fill period
until yesterday. In the two trading days of '06, we have seen a move from 1248
up to 1273.

For the coiled spring to pop fully, the SP 500, which has been bumping up
against well observed trend resistance in place since 3/04 on every technician's
chart, really needs to get a move on. Players seem to be involved in a game of
"Alphonse and Gaston" -- You go first; No, you go first, with many waiting
patiently for the other guys to run the market up decisively through resistance.

The clock is running on my gambit and if the market does not pop up strongly
over the next week or two, I will have to head back to the drawing board.

Santa Stopped For Oil Instead

The rally in oil off recent support just above $56 bl. to a tad over
$61 sets the stage for an important January for both the economy and
the markets. $61 bl. is no threat, but if this yearend upmove in oil
is the precursor to a strong seasonal rally, it will force some rethinking.
It has been my view for several months that the behavoir of fuels in
this first month of the new year will be important in casting Fed policy
and in setting confidence levels for a decent portion of 2006.

HAPPY NEW YEAR TO ALL.

Economy in 2006 -- Short Version

As we roll toward '06, the inflation indicator for the short term is signalling
a continuing though less dramatic moderation than the Oct./Nov. period. This is
critical because with wage growth now up to 3.0% yr/yr, the real wage can recover a little. This sets the direction for consumer spending. I also believe housing activity
was shocked by the turmoil of the hurricanes and the spikes in fuels cost. Much
higher heating bills need to be taken into account. Even so, housing should recover
but progress will be modest. There is clear evidence of lost business sales, production
and employment in the wake of the storms. The hits were smaller than I thought they would
be, but bounceback potential is there for early in the year and release of nearly $70
billion hurricane damage relief will be a plus too. Overall the safest bet is to look for growth to accelerate off a flattish final quarter of 2005 and move nicely ahead into mid-year. There may be a slow quarter then, but I look for the year to finish out very strongly
because companies are going to have to begin to add some bricks/mortar capacity by then.
I am more concerned about 2007. Demand is outstripping capacity growth in the US, and
unless capacity grows markedly, the economy will begin to overheat. Profit growth in '06 should stay near 10%, although oil industry profit contributions could slip some as the year rolls on.

My biggest concern is with the continuing profound inflation in fuels costs. We are in a
seasonally quiet period now. Nat. gas is nearly $5 per mcf off its post Katrina/Rita peak
and oil is down $10. to $60 per bl. These are disappointing declines and leave me concerned
as we move into heating season. There is a decent consensus oil will average $54-55 a bl
next year. Devoutly to be wished for at this point. One also has to carefully monitor basic
grain and food commodities. These remain depressed and appear woefully overdue for some
positive price action.

My short rate cyclical indicators point to continued firming by the Fed ahead. Certain key
ones, such as the ISM manufacturing diffusion index have been far too strong to prompt a
let up. Moreover, with 3.0% inflation readings at several points this year, the Fed has no
business keeping short rates so low if they wish to see people begin to rebuild liquid savings.

As I have discussed in several prior posts, banks have been switching to offering jumbo
no or low reserve deposits to counteract Fed pressure on regular reserves. M-3 growth
has accelerated substantially to over 8% yr/yr. Not only will M-3 fund economic expansion,
it is well more than the real economy needs and will flow either into price or asset inflation. Uncle Al has the bubble machine on again, the old fool.

I plan to talk about the stock market in the next post or two. Many market prognosticators, mindful of the four year cycle low (year two of the presidential cycle) are jumping through hoops to find a basis for a hefty sell-off in 2006. As of now, I do not see it, but I have reserved one for 2007.

In all, if commodities do not run roughshod to the upside, it could be a decent year for
the economy/

Interest Rate Scorecard

The comparisons discussed below are based on super long term rgression
models built around the 12 mo. moving average of the CPI.

With a CPI of 3.3%, the Fed Funds rate should be between 5.0 - 5.25%. The
Fed is bringing the FFR%, now at 4.25%, steadily higher, but it still
remains well short of where it should be. That short rates have been too
low for some time is well attested by a continued zero savings rate for
the consumer sector and the increased use of real estate based leveraging
techniques by same. To preserve domestic purchasing power, dollars saved
need to earn returns which greatly offset inflation and the income tax bite.
Homeowners have come to regard unrealized appreciation in home value as a
prime source of savings. This has been nice to have, but it is an unwise
practice since the great Baby Boomer housing boom is winding up to a close
now, and appreciation in home prices above the inflation rate will be ending.

By my models, the 30 yr Treasury should be trading around 6.375%. The market
is currently at 4.65%. The model value is a little high since Fed tightening
should lead toward a flattening of the yield curve, but, that said, The Bond
is still to dear in my view. There is insufficient premium for key long
term risk factors such as market volatility and a prospective rising supply
of new issues. I love trading the bond market but I have stayed away since
March, 2005 because I would prefer to trade bond volatility around fair value.

Bond Market

10 yr Treas: 4.46%
30 yr Treas: 4.66%

As we near 2006, cyclical conditions for the bond market are
both negative and volatile. In addition there remains a good sized
coterie of bond players trying to handicap an economic slowdown
and presumed deceleration of inflation pressure. I conclude the
market is in a mild cyclical upturn in yields which may also feature
more occasional spikes both up and down in yield levels.

That conclusion above was brief enough, but one could easily write
on and on about the many "ifs" and nuances and shadings that could
be added to fully flesh out an intriguing picture. I will content
myself with just a few brief remarks.

The markets are neither overbought nor oversold.

Bullish sentiment, as measured by Market Vane, is still positive
at around 60%, but is hardly excessive. the best buying opportunities
come along when this gauge is down around 30%.

There is much speculation that the yield curve could invert. An inversion
would carry substantial forecasting weight if it reflected tightening
credit conditions. But credit conditions are still easy -- there is no
liquidity squeeze.

There is also intense speculation about when the Fed will end its firming
up of the FFR%. If that happens to be, say 4.75%, it could well turn out
that the Fed may maintain that rate for quite some time, in which case
players will gradually realize they may as well shorten maturities.

Looking longer term, the great bull market in bonds is technically still
intact as yield remains in a downtrend. There is an extensive base building
under the downtrend which could be signaling that the bull is coming to
and end, but it is still too early to conclude same. For example, the
case for an end to the bull would be more compelling if the long Treasury
yield takes out 5.00% and then 5.25% this year. We've a ways to go before
we come to those bridges.

Monetary Policy

FF Rate: 4.25%

Cyclical factors that normally govern Federal Reserve policy actions
remain in firm uptrends and it is not difficult to posit another 25
basis point add on to the FF rate at the close of 01/06.

At this point, key factors such as manufacturing order rates and breadth
of same, factory operating rates and the balance between the supply of
loanable funds and short term loan demand all look positive going into
'06, but the momentum of these indicators may well slacken enough next
year to allow the Fed to call a temporary halt to pushing up the FF
rate after it reaches 4.75% or so. At this point, I do not see production
and loan demand growth as strong enough to warrant the Fed to move from
a newly minted "neutral" position to a squeeze.

The action of commodities prices in the seasonally strong winter months
will continue to rank high on the Fed's watchlist. The momentum of the
CRB commodities index has waned in recent months, but not by nearly enough
to give the Fed any comfort. Oil and natural gas prices in particular
remain sticky, and industrial commodities composites are moving higher
as well. The action in the trading pits over the next six weeks could
establish the FOMC meeting for late Jan. next year as pivotal.

I have been very confident about monetary policy and right on in my
thinking concerning same for nearly two years now. But, looking forward,
I find myself much more tentative and less assured about my projections
for rates and basic liquidity.

Stock Market -- Technical

S&P 500: 1260

I am impressed enough with the upwave in the market since October
to look for it to move higher, with the S&P 500 now expected to
rise to the 1310 area at some point well into January.

The move in the S&P from 1248 to 1268 over the week of 11/18 - 11/25
was a pleasant surprise but the sideways to down action since then
was not a surprise, as the market had become short term overbought as
indicated in the last technical comment on 11/19.

The impulse up during October and November was clearly strong enough
to warrant an extended consolidation, which could easily last another
week or two before we begin to run out of time in looking for a resumption
of the rally. I am also uncomfortable with the high degree of bullish
sentiment I see in the popular gauges such as Marketvane and Consensus,
so a brief continuation of the sideways/down bias might be in order
to reduce the head on this glass of beer.

If I have a more substantive bother, it would be in the intermarket
area where the charts for oil and the bond yield are no longer
so hospitable to stocks as during most of November. The tenacity of
oil around $60 has been a surprise as this is a seasonally weak period
for oil.

I plan to discuss the stock market more fully as we get a little bit
closer to 2006.

Gold Bugs Frothing At The Mouth

Boy, higher inflation this year and then Uncle Al says the Fed will
no longer publish M-3 after 3/26/06! Sacre Bleu! The Gold bugs see
a plot hatched to hide the inflationary ways of the central bank!
Get the women and children off the streets! Buy gold in a hurry they
declaim.

The best time to buy gold is late in the first quarter or in the second
quarter of the year when commercial demand is in a lull. Commercial demand
gets rolling later in the year to provide the metal for holiday gifts
in the West, and the wedding seasons in South Asia (India, Thailand etc.).
Gold can spike up late in the year on last minute commercial needs and
speculation of a sharp seasonal move up in the commodities markets.

I put Gold's commercial value at $440 per oz. under normal commercial
supply/demand conditions. At $493 an oz. now, it is well over what I would
want to pay for it as an inflation hedge speculation. Maybe I'll wait until
spring of 2006 and hope to pick up some below $450.

Stock Market -- Technical

The "Day of Atonement" rally half-facetiously anticipated in the
10/12 technical note came to pass right on time, putting an
exquisite but understandable squeeze on the bears just after the
market seemed to have broken down clearly. The Street simply
spent part of September accumulating stock to distribute it out
on the turn.

The market is clearly overbought short term and is slightly above
the top of the lengthy compression range in effect since June.
However, it did bounce convincingly up from long term support
(70 week M/A) and my internal supply/demand indicator shows an
overbought but sturdy advance.

The longer term price momentum indicators remain very anemic and
directionless and raise the question of whether the advance is but
a seasonal one that could meander into early January following a
correction at some point in the next week or two.

Key intermarket factors have been positive for stocks, notably a
rally in Treasuries and a weaker oil price. Reversals in these
sectors would probably undercut the enthusiasm for stocks.

For me, stronger readings on long term price momentum measures
are needed to warrant more than light exposure.

Stock Market -- More On The Profile

S&P 500: 1233

I wanted to discuss further some of the risk factors in the
stock market environment.

Liquidity leading indictors such as Federal Reserve Credit and
the adjusted monetary base (St. Louis Fed) remain very anemic in
growth. Not surprisingly, real money growth -- M-1 and M-2 -- are
now down yr/yr on a % basis. Normally this is threatening to
prospects for continued economic expansion. However, as often
previously discussed, banks have switched funding to low and no
reserve deposits not counted in to M's 1 and 2. Even so, the
expansion is less well anchored because with no customary growing
base of liquidity, the economy is running on a mix of incomes and
increasing leverage only.

I also look at the earnings / price yield on the S&P 500 compared to
the "risk free rate" -- the 3 mo. T-Bill. The S&P e/p yield is 6.0%
based on 12 mo. earnings while the Bill is near 4%. This indicates
a still rather moderate risk level, but the gap has been closing as
the Fed raises short rates.

Important as well is inflation risk. The market has lost most of
its positive momentum over the past eighteen months because of a
sharp acceleration of inflation, which in turn, has reduced the
p/e multiple or earnings capitalization rate. In short, investors
have been raising the ROI% hurdle rate. Now the CPI yr/yr % change
may ease a bit for a couple of months, but the inflation rate trend
is still up.

To date, the gathering of incremental risk has acted only as a drag
on the market's progress and not as a negative trigger. But you have
to keep track.

Fed To Stop Publishing M-3 Money Aggregate

Or, Uncle Al's Revenge....

Readers of this blog know that way back in 1992, Uncle Al
and the gang eliminated or greatly reduced reserve requirements
on a variety of large and jumbo time deposits ostensibly to
provide extra liquidity as the commercial banks stepped in
to the mortgage market in place of the S&Ls which had failed
or were being merged out. This was a legitimate response by
the Fed at the time.

As the economic expansion progressed and the Fed started to
raise rates, the banks quickly learned to reduce the cost of
funding by switching to the reserve-exempt deposits to fund
lending operations. By 1995, the Fed should have reversed
course and re-imposed the reserve requirements on the big
deposits. It did not and the banks used this loophole for
years to feed the economic and stock market booms. The banks
also began to use the RP market more aggressively to fund
FX traders, hedge fund managers and the mutual fund industry.
They also started using RPs to fund lending out of the pot,
a cheaper way to raise money than Fed Funds where other banks
will charge 20% or more in a tight Funds market.

Rather than re-claim the control that is rightly theirs, Uncle
Al has decided to stop reporting the data and to leave analysts
to scramble to find appropriate proxies.

There will be a vigorous and vocal protest from a number of
economists. The Fed might spin an explanation, but many will
be unhappy and only time will tell whether the Fed will relent.

There are proxies that can be used in place of M-3, although
I will dearly miss the Repo data (now a $550 billion item).

Uncle Al has whipped a digit on his detractors in his final hours.

M-3 is slated to dropped starting 3/23/06.

Stock Market Profile

S&P 500: 1220

I continue to employ a "pocket change only" exposure to
the US stock market. We are well past the low risk / high
return phase of this still extant cyclical bull market.

Risk to the market continues to rise, but in fairness to the
bullish, the risk is coming up from extremely low levels seen
in Q4 2002. Moreover, confidence in the economy remains fairly
high as well. But it is not the type of "easy money" period I
favor.

My S&P 500 market tracker stands at 1150. It declined sharply
with the surge of the CPI in September to 4.7% yr/yr. I have
given some thought to smoothing out this unexpectedly large
lurch in the CPI to give the market a somewhat higher multiple,
but decided not to so as to avoid fiddling each month with
the inflation input. I doubt we will see yr/yr inflation stay
at this high level for too long, so the value of the market
may be understated at 1150 or 15.3x current operating earnings.

My earnings model has been holding up well, but there has been
some internal slippage, as the continuation of reasonable top
line or sales growth is increasingly more dependent on pricing
rather than volume growth. Cost inputs remain under control
reflecting good productivity growth and mild wage/benefit
pressures. So, many companies should still be experiencing
profit margin expansion.

To qualify as a "normal" cyclical bull market, the S&P would have
to reach 1360 by year's end or early Jan. 2006. Statistically, that
is a tall order at this point. The earnings underneath the market
have held up very well, but the market p/e ratio has been clipped
by the acceleration of inflation starting in mid-2004.

I have not given up on this market yet. With the overall operating
rate for the economy below 80%, we are far below effective capacity
and not in imminent danger of over heating. Secondly, the progress
of the market relative to a broad liquidity measure such as M-3
has not been so strong to date as to leave one concerned.

So, there is plenty of upside, but to realize it, the surge in
commodities inflation which has been driving inflation higher needs
to at least level off so that the Fed does not have to put the
economic expansion at ever greater risk to choke inflation pressures.
For now, the drivers in the commodity sector are fuels -- oil and
natural gas. We are in a seasonally weak period for fuels right now,
so a better test of the power of fuels pricing trends likely awaits
the closing days of 2005 and early next year.

I have been looking for weakness in oil and gas prices, but the
declines to date off the Katrina induced highs have fallen short
of expectation. Recovery of US production has been slow, and OPEC's
solemn promise to boost its output appears to have been a bluff.

I am guessing now that late January, 2006 will be a critical time for
the market and for the Fed as that will be an important window to
measure continuing inflation pressure, economic progress without some
of the recent distortions, and the arrival of new Chair Bernanke.

More on the stock market in upcoming days.

Commodities Inflation

As discussed in prior posts, I have pointed out that the
current surge in commodities price aggregates, although
not so broadly based, has been the most powerful we have
witnessed in over thirty years.

The historical record shows that grand commodities inflations
begin in sudden and dramatic fashion, almost "out of the blue"
as it were. They tend to follow upon long periods of price
stability and, on occasion, deflation.Thus, prior to a
sudden breakout of upward price pressure, there is usually a
long interval of underinvestment in the capacity to supply
the market which results in a jump in pricing when demand
does finally accelerate.

Grand commodities inflations can last for periods of up to
15 - 20 years. Commodities composites at wholesale can
easily triple and quadruple over such periods. Interestingly,
oil per barrel is now trading about six time above its 1999
low. In short, these are very powerful events, and when one
is underway, it will in a cumulative fashion have a pronounced
effect on the general price level, as measured say by the CPI.

I bring this up for a couple of reasons. first, the power of
the recent run in the CRB and wholesale commodities composites,
following a long dormant period, strongly suggests to me that
another grand bout of commodities inflation is underway.
Secondly, although run-ups in commodities prices can be
squelched for a while by rising interest rates and a tightening
of liquidity, the upward pressure on prices tends to resume
in a strong fashion when the rate / liquidity pressures are
relaxed. This occurs because of the long lead time necessary
to bring large incremental capacity on stream (Developing
small increments to capacity generally proves uneconomic.)

Thus, for the third time in the past one hundred years, we
may well have another major upleg of inflation to contend
with. I lay this out as a prima facie case, but one which
I think has some merit.

I did play the big 1968 - 1983 commodities cycle. I bought
some gold but enjoyed excellent fortune in the grain markets,
which as irony would have it, have yet to participate in this
round.

Surprisingly, it is possible to make good money in stocks and
even a little money in bonds during commodities booms. But
to be successful, you have to re - equilibrate risk and return
assumptions and not use the more favorable profile that likely
obtained during the lengthy preceding period of commodity
price stability.

Monetary Policy Update

We have now baby stepped up to a FF rate of 4.0%. Fed/FOMC
liqudity measures -- Fed Credit and the adjusted monetary base
remain constrained, although the money base did pop up for a
week or two past Katrina.

M-3 growth has accelerated sharply this year as bankers switch
funding from regular reserve deposits to the larger no or low
reserve deposits. The banks have the window open to lend and
loan growth continues brisk. Ironically, the system liquidity
embodied in M-3 has no doubt helped the energy pit traders and
hedgies keep rolling.

Uncle Al continues to push up rates gently, hoping to coax a break
in the energy driven commodities market. Tricky business. Just so
you know, recent experience (1995-2000) shows that the CRB commodities
index did not buckle until after market short rates exceeded 5.0%.

The Bernanke Appointment

As was widely expected, GWB selected Ben Bernanke to replace
Uncle Al come the end of 1/06. This was a wise choice. The
Bernanke facial countenance reminds me of a rotogravure of a
nineteenth century British scientist, someone like the great
empiricist John Stuart Mill. Unlike Greenspan, who, when all is
said and done, was a laissez-faire theorist on the economy
and the markets, Bernanke is much more sharply focused on
the-matter-fact and how economic developments cumulate to
produce the future path of an economy. In contrast to Uncle
Al, he is at once more of a pragmatist and far more plain
spoken as well.

His primary interest from a policy point of view is to have the
Federal Reserve provide a monetary environment of stability and
to avoid policies which are so one sided as to increase economic
volatility and produce economic trends which may be extreme.
His concern is that once extremes are met within the economy,
reactive processes may be needed which in turn will produce
their own excesses and deficiencies, thus taking positive,
directional initiative away from the Fed. Thus, he is at once
an anti-Greenspan and an anti-Volcker who sees the past twenty
five years of policy as having been needlessly tumultuous and
risky.

He has also expressed a strong interest in inflation targeting,
suggesting a longer term low inflation rate consistent with
assuring a stable, growing economic environment. This will not
be an easy sell at the Fed, since many on staff will be tempted
to say that they have been endeavoring to do that. Bernanke
wishes to de-mystify this process and to foster much clearer
communication with all constituencies. However, what most
interests me about the concept is that it may well free up the Fed
to use its tools -- rate setting, liquidity provisioning and
reserve regulation -- in more flexible and pragmatic ways.

Bernanke's practical and empirical approach is very congenial to
me and I am happy to give him the benefit of the doubt.

Inflation For Idiots

In its 9/05 CPI report, the Bureau of Labor Statistics again
but still belatedly acknowledged the growing impact of rising
fuel costs on inflation. The whopping 1.2% increase in the
monthly CPI puts the yr/yr rate of inflation at 4.7%. Note
though, that the BLS is still fibbing about the "core" rate of
inflation which it posted as 2.0% yr/yr. ("Core" inflation
excludes the volatile foods and fuels components of the CPI).
Apparently, no one at BLS ever goes shopping, because if they
did, they would know prices are popping up like dandelions in
springtime.

The statistical scam here, I think, is to more fully load the
fuels prices into the CPI first, which they are doing, and then
to start loading the effects of the several year fuels price surge
into the core, with the hope that the worst of the price surge
in the food and fuels component is now behind us. Then, as the
"core" inflation rate rises, the Street can say, "look the
leading edge of inflation is simmering down."

Now, don't get all indignant, Presidents have been cooking the
economic statistics for years now. Johnson and Nixon were
heavy handed chefs. Clinton was by far the most earnest and
attentive fibber, and George W. is just in-your-face cynical.
Fed chairmen from Arthur Burns to Greenspan have been their
willing accomplices.

Some of the idiots out there are going to try to keep the old
scam going. Here's Morgan Stanley chief economist Steve Roach:
"Energy is being driven by a unique set of forces -- supply and
demand -- that are not bearing down on other goods and services."
Guess Steve does not go shopping either.

So, where does all of this leave us? Well, based on 4.7% inflation,
Fed Funds should be at 6.5%. Long Treasuries should be at 7.5%
and the p/e ratio for the S&P 500 should be 15.3X with an index
value of 1146. Interest rates are so low relative to these indicated
levels because rates are being priced off the low "core" rate readings.
Depositors are being ripped off and bondholders are surrendering
wealth after taxes on the income streams are figured in.

I am expecting fuels prices to ease because those markets should be
coming into better balance. I also expect the "core" inflation rate
to go up. For example, US produced auto prices have returned up to
ordinary retail from the employee discount levels. Moreover, the
BLS will have to start showing the effects of higher fuel costs
on all items or the fib will grow too large to correct without major
dislocation.

My best guess now is the CPI, measured yr/yr, will slowly drop back
into a range of 3-4%. From my perspective, that implies that interest
rates remain too low and that the current market p/e of 15.9x estimated
12 mo. operating earns. through 9/30/05 is reasonable.

Realistically, given the hanky panky with the inflation rate,
each player has to decide for himself or herself what a reasonable
inflation estimate is and factor that into his/her return
expectations for the capital markets.

Stock Market -- Technical

S&P 500: 1177

My primary technical indicator gave me a sell signal on 8/16 with
the S&P 500 above 1230. I paid it no mind because I could see the
market in a compression zone. I got a short term buy signal on
9/6 with the "500" at about 1215 and ignored it as well for the
same reason. I then got another sell signal on 10/4 at 1214 on
the index. This one is more worth notice, because it heralded
a break down from the compression zone and raised the question
of whether a more substantial decline might lie ahead,
with the prospect of the "500" falling to about 1075.

For fundamental reasons I have been playing only with pocket
change since March, 2005, so I am not at risk on the long
side. Moreover, we have moved into respectable oversold
territory, so I am not contemplating a short position.

I have not yet given up on the idea we remain in a cyclical
bull market, which makes me doubly loathe to short this baby.
So, I am going to see how resolution of the oversold
develops before taking action, although my sense is the
time to trade has drawn nigh. Frankly, I also remember my
days on Wall St. where we had a amusing rule: Sell on Rosh
Hashanhah (10/4 this year) and buy on Yom Kippur (tomorrow
10/13). It's a fun contrarian rule if you know the holidays
and not a bad one at that. So, I'll wait to see what the
next few days bring.