Stock Market -- Fundamentals

Well, the SP500, a laggard during this cyclical bull run,
closed at a record 1532 today. The Market Tracker has the
SP500 fairly valued at 1540 - 1550 through July. It appears
investors are still comfortable with a 17 p/e based on
rolling twelve month earnings and an inflation assumption
of roughly 3%. Measured yr/yr, the CPI has been running a
little below 3%, but the market has yet to show an appetite
to factor in a lower inflation rate.

SP500 consensus earnings are projected to rise 7.3% in 2007
and then crack the century mark in 2008, with a 12.6% rise
to nearly 106.00. Earnings acceleration is projected to
begin late in 2007 and carry over into next year, with
expectations for telecom and tech earnings leading the way.
Implicit here is a moderate acceleration of US economic
growth and decent global growth.

My inflation indicator has picked up some so far in 2007,
primarily because of a surge in US gasoline prices.
However, the indicator is still relatively quiet. Given
how commodities have driven inflation in this current
expansion, it is understandable that investors have a
conservative bent regarding inflation expectations.

The market's earnings / price yield has dropped to 5.9%.
The premium to the 91 day T-Bill is slightly over 100 basis
points, and the e/p yield premium to prime commercial
paper is a scant 65 basis points. The narrowing of these
spreads points to increasing market vulnerability to a
rise in short rates.

The SP500 price premium to the SP500 price level implied
by my monetary base model is rising significantly and
reveals growing market dependence on credit driven liquidity.
No problem so far, but risk from this measure is rising.
Keep in mind also that an acceleration of economic growth
coupled with even a mild pick up of inflation pressure can
rapidly use up the excess liquidity now being generated
through the credit window.

Stock Market -- Psychology & Technical

No momentum this week, so a day of profit taking was
in the offing. But there was also a frisson of concern
as well. What if the economy is close to re-accelerating
and perhaps doing so in a less than benign inflation
environment? That could freeze the Fed. Worse, the Fed
could tighten down the road...This little thought is
supported by data showing strength in orders and home
sales as well as a weakening bond market and a slight
tilt up in the dollar. Even the gold bugs are showing
hesitation. Well, it is worth keeping in the back of your
mind.

Most know the market got itself overbought and extended and
that a key indicator -- MACD -- has turned down. Watch the
market against the first two lines of trend defense -- the
10 and 25 day moving averages. Here is the SP500 chart.

If a correction is about to unfold, the 10 day M/A will turn
down, break below the 25 and lead both down behind the market.

Gasoline Price

The price of gasoline has been an important inflation
driver in the US this year. Ostensibly, supply has been
constrained by a series of spot refinery outages. The
futures contract price for gasoline is juicily volatile
and, interestingly, is looking overbought, with an MACD
near the top of the scale and with yr/yr price momentum
high but past a recent peak. Check $GASO.

Stock Market -- Longer Term Perspective

With 1995 as base year, the SP500 is tracking an 8.8% positive
trendline, right in line with earnings. Coupled with a 1.8%
yield, the implicit return is 10.6% per year. I have assumed a
3.0% inflation rate to compute the multiple. So, the market is doing
fine, based on trendline growth of 8.8% and a moderate inflation level.
Now, it is critical to notice that 8.8% growth is well above the very
long term norm of 6.0 - 6.5%. Over the past 10-15 years, ROE% has
risen strongly up to over 17%. The dividend payout rate on earnings
has dropped below 40%. With a high plowback of earnings, the SP500
has implied eanings growth potential in excess of 10%. Most companies
generate more cash than they can profitably re-invest, so they buy
back shares and generate acquisitions. Balance sheets are stronger
now but are still aggressively managed. Many companies could pay out
more in dividends without harming growth, but since senior management
bonuses are so often tied to maxxing out eps, they keep more cash.
Companies have also been skimping on capital expenditures, but there
is still excess capacity in the system.

US only earnings growth has decelerated with an economic slowdown, and
this has recently lead to greater interest in the big multinationals
which have large foreign bases of revenue and have been benefiting
from a moderately weaker US$ and faster offshore growth.

This longer term view of the market helps drive home the point of
the need to recognize how the market has been led by a historically
rapid rate of earnings growth backed by high growth corporate financial
internals. Fretting bears have consistently missed the importance of
a powerful earnings trend, and longer term bulls risk taking this
performance for granted.

When I look at companies, I am more interested in return on total
assets (ROA%) than ROE%, since companies can pump the latter through
borrowing and share reduction. In looking at ROA%, I am interested
not just in a company's ability to maintain profit margins but asset
turnover -- sales divided by assets. You would be surprised how many
companies can cover over declining asset turn with increased leverage.

Liquidity Check

The Fed reversed the big infusion of two weeks ago, so the
growth of monetary liquidity remains modest. The temporary
liquidity injection may have added modestly to the basic
money supply, which needed a transfusion.

The broader, credit driven liquidity measure I utilize did
accelerate markedly in April as banks returned to the
real estate market and C&I loans moved up. Yr/yr, my M-3 proxy
is now up 10.2%, high, but in line with the growth of short term
credit demand. Seasonally, we are moving in to a stronger period
for home sales, but I was still a little surprised by the
size of the move up in the real estate book.

The financial system is generating more liquidity than is required
for current dollar economic output, leaving excess liquidity in the
system to fuel financial and commodities markets in favor. since
the volume and diversity of derivatives also continues to grow there
is rich leverage behind the markets. On top of this, the US trade
deficit widened in March, sending more $ abroad. To this hefty brew
we can add the new rule change in China which allows its commercial
banks to diversify IM accounts away from Chinese securities (It will
be interesting to see whether the "big" money in China starts to
exit Shanghai and Shenzen to leave the smaller retail accounts holding
the bag.)

There is a small but growing chorus of markets observers who are
starting to warn of the risks of markets inflated by credit driven
liquidity. I have mentioned a number of times that markets powered
by credit driven liquidity are riskier than when markets are supported
by monetary liquidity growth. In the latter case, you have central
banks on your side.

One economic possibility that all need to watch concerns the US. If the
domestic economy re-accelerates and there is a little bounce in inflation
pressure as well, the excess liquidity will fizzle quickly, gobbled up
by the real economy. I have been cautious on stocks this year because I
am interested in seeing how well the balance of economic supply and
demand may shape up once the economy shakes off its torpor. So far, that
concern has proven premature given a sluggish environment. Perhaps worse
for me, I may well wait until autumn to see whether the cautious approach
pans out or not.

Shanghai Express -- #2

There is a link to the Shanghai Stock Composite at the end of
the post. As all but the dead know, this market has been in a
very sharp parabolic upmove since early 2006, as China's retail
investors rediscovered their market following a long drought.
There is a mania underway. To qualify as a bubble under my
tough parameters, the SSEC, now just over 4000, will need to top
6700 by late 2008. That is a tall order after the run-up so far,
but a true bubble is far more spectacular than most realize.

There is long term trend resistance by some measures in a range
of 4000 - 4200. A tightly drawn parabolic curve had the market
topping out at prior trend resistance of 3350 in March, but
the market has taken that all out in a nearly vertical assent.
There is a broader, looser parabolic loop that has a top up
around 4500. Suffice it to say, this is a doozy of a mania.
Moreover, despite mentions of mania and bubble in the Chinese press,
the folks are still flocking in to open accounts and buy.

It is worth watching, not only because it is exciting, but because
the Chinese authorities could, at some point, try to stop it. And
this could involve policies that might reverberate in other markets.

I warned several times over the years that when mercantilism turns
greedy as it has in China, temendous mania activity and eventual
financial and economic dislocation can occur. And here we have a
case where rampant real estate speculation has shifted to the
local equities market.

Keep a weather eye on this baby. The SSEC

FOMC & Monetary Policy

Most observers expect the FOMC to leave the Fed Funds rate
(FFR) unchanged at 5.25% at tomorrow's regular meeting. The
key data I track for monetary policy trended down over the
second half of 2006, but have stabilized recently, particularly
capacity utilization and manufacturing activity. It should be
said that the Bernanke Fed may have diverged from the Greenspan
Fed in electing to hold the FFR% at 5.25% despite evidence of
a weakening economy over Half 2 '06. I guess the Fed can coast
on this data for a while if it wants to.

The leading economic indicator sets I follow show a sharp firming
up for the month of April. As Aristotle liked to say -- one swallow
does not a summer make -- so the upturn needs to be carefully noted
but not raptured over. If the Fed does elect to mention that the
economy could be regaining strength in the FOMC meeting statement,
it could give the markets a shiver, since some players would
immediately conclude prospects for an eventual FFR% cut are out
while potential for a FFR% increase later in the year is in. So,
the FOMC wordsmithing tomorrow might be of special interest.

I also note that FOMC added substantially to its portfolio last week
both via outright Treasuries purchases and RPs. It is not clear
why they did this, although cash in the system is very low, and they
have been stingy in recent weeks. The Fed Bank Credit portfolio will
be worth watching carefully over the next week or two as well.

SP 500 At Fair Value (1500+)

The SP 500 closed above 1500 today, so I have it as fairly valued,
having caught up with the higher price level dictated by lower
inflation and a still positive earnings progression.

To stay in a bull market in the US, here is what is needed:

1) The US economy must gradually resume growth of about 2.75%.
SP 500 profits need to resume yr/yr growth of at least 8-10% well
before the year is out. This implies moderate pricing power at
the top line coupled with 1.5% productivity growth and continued
moderate wage growth. Look for continued share buyback programs
as too many companies have implied internal growth rates that
cannot be satisfied by internal investment (Book ROE% is high and
earnings plowback is high, yet the global economic pie is not
growing fast enough to accomodate internal redeployment of all that
capital).

2) Inflation must stay contained at 3% or lower when viewed on an
intermediate term basis. US economic growth of 2.75% will put upward
pressure on domestic operating rates. Thus capital investment must
expand rapidly enough to keep operating rates rising only slightly.
Capacity growth has been too slow to date in this current economic
expansion.

3) Further increases in the Fed Funds rate -- now 5.25% -- would be
an unwelcome development as it would reduce the relative attractiveness
of SP 500 ROE% at market value.

3) There are obviously a host of exogenous factors that could make things
better or worse, but factors 1-3 are the time honored critical ones.

Economic Quickie

The Inst. For Supply Mgmt. report on manufacturing turned
up sharply in April, signaling faster growth in this sector.
Most interesting was the very large increase in the breadth
of companies experiencing higher new order flow. This ISM
report can be volatile, so the very positive turn in the data
could be a fluke. However, since I use the ISM new orders indices
as leading indicators, I'll take it as a heads up on a possible
turn in manufacturing. The jump in new order breadth for April
breaks a downtrend underway for some time.

The ISM site is worth a tour. www.ism.ws

Stock Market -- Technical

On the basis of trends, the market is obviously positive.
It is also short term overbought and extended. Moreover,
the longer term momentum work I do suggests an extended
market in the sense that investors and traders have been
unwilling to keep pushing shares up with the market at its
recent premium to the 40 week M/A during the upcycle underway since
late 2002. There have been periods in the past, especially
during the raucous 1990s, when no such discipline was observed
and the market went to very large premiums to the underlying
trend. But this cycle has shown far more constraint and
discipline.

It is also interesting to note that May is becoming an "iffy"
month seasonally. Longer term, May exhibits seasonal strength
that builds on April, but in recent years, May has triggered
some aggressive selling as some players like to exit the market
in the spring with an eye to re-entry in the autumn.

It has been my view that the market entered a topping process a
short while back. So far, that view has proved incorrect as the
market has pushed to new cyclical highs without breaking a sweat.
I have hesitated to make a 2007 forecast of the market based on
fundamentals, and perhaps I should have buttoned my lip on the
technicals as well. From my perspective, the suggestion will have
proven a big disappointment without a solid 5-6% sell-off in the
next couple of months.

Stock Market -- Fundamentals

In Monday's post, it was pointed out that the SP500 (1488)
was closing in on fair value of 1500. That works out to a
p/e of 17.0 x twelve months of operating earnings for the
index through 3/31/07. The big change in the environment
since mid-2006 was the sharp drop of the inflation rate.
Thus, from my perspective, the run-up in the market since
mid-2006 does not represent a blow-off but a move up to
reasonable levels based on an advancing economy and a return
to a more moderate inflation level. If you were to push the
envelope a little to incorporate a 2.5% inflation rate, you
could argue for 1550 on the SP500 (2.5% represents the yr/yr
change in the "core" CPI through 3/07).

The persistent upward momentum in the market over the past
nine months also obviously reflects positive investor assumptions
about the future. The market is in the process of discounting an
eventual re-acceleration of US economic and earnings growth and
the continuation of a moderate inflation rate.

Top line growth for both industry and finance has slowed
appreciably since mid-2006. The growth of wages has accelerated
modestly, but there has been just enough productivity growth to
avoid a broad reduction of profit margins. So, yr/yr, corporate
profits could be up 4-6% through the March quarter. It is not at all
likely that the market could hold a 17 p/e if investors did not
expect earnings comparisons to improve markedly later in the year.
Analysts expect earnings to rise serially in Qs 2 & 3 of this year,
but no major breakout to new highs in quarterly earnings is projected
until the final quarter of 2007, when the SP500 index earnings are
projected to top 25.00 for a 100.00 annual rate. To get there, it
sure would appear that the US economy will have to accelerate.

On top of this assumption, comes the idea that a re-acceleration of
US economic growth will not lead to a cyclical acceleration of
inflation. This latter assumption has looked dubious for some
months now, as US productive capacity has not kept pace with
production growth potential in a faster growing environment. I have
stayed cautious on the market until I see how well companies respond to
a resumption of faster order growth rates.

Another factor to keep in mind is that the average small and mid-cap
stock is trading between 19.0 and 19.5 x earnings. In fact my unweighted
universe of 1750 stocks is trading at an average of 18.5 x earnings. This
underscores the high expectations for future growth and benign inflation built
in to the market.

More on the fundamentals later in the week.

Stock Market -- Fundamental

By my Market Tracker, the SP 500 -- now around 1480 -- has
been fairly valued in a range of 1500 - 1550 since the latter
part of 2006. This is a broad range for the Tracker and it
reflects above average swings in analyst sentiment concerning
earnings prospects as well as continuing high volatility in
the inflation readings. At present, the Tracker is at the bottom
of its recent range for the SP 500 -- 1500.

The rally so far this year has carried the market closer to the
estimate of fair value. The strong surge in stock prices since
mid-2006 primarily reflects an upward adjustment in the earnings
capitalization rate reflecting the sharp drop of inflation pressure
since the middle of last year. SP 500 earnings are still seen as
rising this year, but the estimate is about 3% below the consensus
forecast for 2007 as of late 2006.

I am going to leave it here for the day, but will return to the subject
a few more times over the next several days as I figure out how best
to strategize with a foggy crystal ball.

Inflation Notes

The sharp uptrend in the broad CRB Commodities Index underway
since early in the year is starting to break down as a reflection
of developing weakness in fuel feedstocks. This index can be
volatile over the short run, so one does not want to make a big
deal out of a break in the short term trend. Even so, it is
worth noting.

US productive capacity growth continues to lumber along at a
modest 2.3%. This continuing low rate of growth is below US economic
demand growth potential and remains a sore spot in the US outlook.

It is good to see Def. Sec. Bob Gates spreading balm around in
discussing the middle east, particularly Iran. The Cheney Show,
which involves threatening talk in Iran's direction, is not smart
as such talk helps kite the oil price, suppress US consumer real
incomes and puts more dough in Iran's coffers.

The headline CPI advanced at a 4.7% annual rate in Q1 '07. Looking
short term, this has pushed the inflation adjusted, after tax
return on 90 day paper into negative territory and has led to
weakness in the US dollar. The dollar now needs the attention of
US officials since it is trading down near long term support. It
will be interesting to see if moderation in the broad commodities
composites might give the dollar a lift and stave off the issue of
whether the US is willing to allow the dollar to fall below support.

Stock Market -- Technical

The stock market is overbought on all measures for
the ten day short term. It is also on the verge of making
my intermediate term view the wrong view. I have argued in
recent weeks that 6-13 week breadth and momentum indicators
portrayed a developing topping process. But, at this juncture
I would have to say that unless there is a sharp sell-off
starting at some point over the next week or two, the idea
of a topping process may have to be shelved.

The last technically strong entry point I had was in June/July
2006. The rally that began then was a terrific one to trade or
ride. The rally that kicked off in the first half of March, 2007
did not have the deep oversold pedigree I prefer and I have passed
on it. The tough thing for me is that viewed short term, this is
a respectable run-up, nonetheless.

So, from a technical perspective, I am on the beach for the next
two weeks, left to hope we get a sharp correction to a stiff
overbought. Now the existentialists out there will chuckle at
this, remembering as they will that Albert Camus was fond of
saying that "to hope is to despair"....

Liquidity Factors

This is an update post which builds on the original "Liquidity
Factors" memo posted on 2/14/07.

Monetary Liquidity
The Fed continues to maintain basic monetary liquidity growth
at low levels. M-1, the basic money supply, has shown barely
any growth for some time now. Monetary policy remains firm.

Credit-Driven Liquidity
This wide measure of money remains in a strong growth pattern,
although yr/yr growth has leveled off at about 9.0%. The growth
of bank lending to key sectors -- mortgage and real estate
development, home equity and C&I loans has moderated in recent
months, although the real estate and C&I books are still up
smartly yr/yr. The real estate loan book did dip in March reflecting
the turmoil in the mortgage market. Bank funding remained aggressive
and sales of asset backed paper resumed growth. Funding tends to
follow loan growth, so there could be some moderation of broad money
growth ahead. The slowing of the economy since mid-2006 is beginning
to be reflected in asset generation and funding.

Economic Liquidity
With a more sluggish real economy and still high broad money growth,
there is surplus liquidity in the economic system to support financial
and real asset investment and speculation. There is a liquidity
tailwind for areas that are viewed positively. Unfortunately for the
Fed, commodities speculation has picked up some, which reduces the
efficiency of monetary policy management. The loss of Fed control
traces directly back to the Greenspan Fed liberalization of reserve
policy implemented in late 1992 and never reversed.

Trade-Driven Liquidity
The outflow of dollars through the trade window remains high but
relatively static. The leveling off of dollar outflow will negatively
impact offshore growth with a lag.

Crude Oil Quickie

After a bizarre meet with Pres. Ahmgonnabebad, the 15
Brit mariners were sent home with pink goody bags late
last week. Today, Iran started hyping its ability to
produce larger amounts of enriched uranium. The market
ignored this latest price kite job, and continued to
sell off crude in the wake of the capturees' release, with
oil down over $5.25 bl. to $61.50.

April is a strong seasonal month for crude and I am hoping
the geopolitical bunkum will stay quiet long enough to get a
good fix on supply / demand fundamentals. Tame fuel prices
would take pressure off the global economy, so let's see if
we can get a clear read on these markets in the weeks ahead.

Jobs And Indicators

For Q1 2007, civilian employment gained an average of only
109K jobs a month, with all of it coming in March. Slow going
for the quarter. Measured yr/yr, employment is up 1.8% and
wages are up 4.0%. That would be fine, except that a bump in
inflation is cutting into the income growth. Fuel prices need
to settle down or else consumer spending in constant $ will be
undercut.

Leading indicators are sluggish. Breadth of commercial and
industrial new orders is still positive, but is at a three year
low and is trending down. Indicators suggest GDP growth of no
more than 2.5%.

Stock Market -- Technical

Gee, how often does the market do what you advise it to
do? Last Tuesday the technical post hinted at immediate
weakness -- the market obliged -- and opined a drop in the
SP500 from the 1428 level down to 1420-1410 could set the
market up for a more reasonable rally. Again the market
obliged. The market now features more stability, is in a
short term uptrend and has solid enough technical credentials
although it could be getting a little overbought short term.

The recent rally does not leave me in that happy a position. The
short term trend deserves respect, but my intermediate term
indicators continue to suggest the market remains in a topping
process that could run for several more weeks. So, for now, I'll
watch along and we'll see whether this rally has some staying
power.

Oil Price

After the big pratfall from the summer '06 high of $78 bl.
oil bottomed near $50 in January and has rallied strongly since.
Yearend through late April - May is a strong seasonal period
for oil as refineries switch over production to gasoline. It
is also clear that the price weakness seen in late '06 and early
'07 likely led to rebuilding already significant coverstocks.
The recent run-up in price to the $65-66bl area has to be very
much a reflection of perceived supply risk owing to the new
presence of two full US battle groups in the Gulf and the
realization that the flag officer, Admiral Fallon, commands the
whole shebang, Iraq included. That plus the Iranian promise to
engage in "illegal acts" in retaliation for further UN sanctions
on its nuclear development program set the stage for a strong
rally when Iranian special forces illegally took 15 Brits into
custody recently.

Now short of some further ugly and draconian actions, the Iranians
have about milked the value of displaying the captives, and the
pit traders would have to be a little dumb to rally off old news.
But it appears this will be a pressure area for awhile, with the
Iranians having to be careful not to overplay their hand. The US
has the Iranians very tightly contained militarily, and further
sanctions may well, in cumulative fashion, put more economic
pressure on Iran, which is now nearly a basket case.

Oil is getting somewhat overbought, and is due for a rest, but
could still finish out its normal spring rally. The trend off
that $50 low when projected out is ominous, so capital markets
players will have to watch the action in the pits carefully to
make sure oil settles down soon.

The Fed's Concerns

Fed chair Bernanke spoke to the Joint Economic Committee
of Congress today. His concerns:

1. The labor market is tight. Capacity Utilization for
primary processing of basic feedstocks and materials is
very high. Growth of capacity utilization in the US is
low across the board. This combo of factors pushes the
Fed to sit tight and say some prayers that cash rich
corporate America starts spending more on development.
(Europe has a similar problem with labor. The available
workforce does not have the skills needed by growing
businesses. The tech sector is on the verge of blowing
orders because they are coming up short in skilled labor.)

2. Inflation excluding food and fuels is high relative to
target and is proving stickier than the Fed thought it would
be. On top, fuel prices are rising again. The inflation
situation pushes the Fed to sit tight as well.

3. The subprime mortgage market fiasco has surprised them. Oh,
the Fed knew full well that the tightening of monetary policy
would prompt a rise in delinquencies and foreclosures, but
they likely did not bargain for the collapse of credit
underwriting standards and outright fraud that is putting so
much additional pressure on the market. The Fed and the FDIC
among other regulators now have no choice but to embrace
regulatory reform. This will add to the problems in junk credit
markets for the forseeable future, because financial organizations
tend to freeze asset generation until the new regs. are spelled
out and understood. The junk asset-backed credit markets will
suffer. The Fed would like to sit tight on this, too, but they
will have to monitor carefully for spillover effects to the general
economy.

This is the first tough stretch for the Bernanke Fed. We'll see how
they handle it.