Federal Reserve -- Trick & Treat

I would not pretend to know what the Fed will choose to do
with the Fed Funds Rate come Halloween Wednesday. The heavy
betting is on a 25 bp cut then followed by another 25 at the
upcoming 12/11 meeting to stoke holiday shopping. The markets
have all but stampeded the Fed into a cut on Halloween. At
some point, the Fed is going to need to reclaim authority at
the short end of the yield spectrum. Blowing off the speculators
on Halloween would be terrific fun, but it could create a ruckus
not soon forgotten.

So, the bettors are counting on a FFR% cut treat this week. The
"trick" is that the Fed is continuing to run a very tight ship
in terms of monetary liquidity. Federal Reserve Bank Credit and
the adjusted monetary base, cornerstones of policy, are up a
pittance this year, despite the July crisis. However, the Fed
also sees that a third of the funding lost in the lock up of
the commercial paper market has shown up in the banking system's
jumbo deposit category (over $ 200 billion just since July). So,
credit driven liquidity, although barely growing short term, is
repairing nicely.

Things may change, but so far the Fed is holding off on the kind
of fast liqudity infusions we saw in Uncle Al's heyday. We'll see,
but right now, a modest US liquidity situation does not of itself
support all the excitement in the various markets we have seen
since last August.

Gold Price -- A Less Glib And Flippant View

Yesterday, I had some fun with the wilder side of the stories
surrounding the recent price action of oil and gold. Today,
I look at the more normal measures for gold.

The weekly macroeconomic price directional for gold continues
to track the ups and downs of the gold market rather well. The
macro indicator hit a new all-time high this week reflecting
the powerful surge underway in the oil price. For 2007 to date,
better than 90% of the move up in the macro indicator reflects
the combine of oil and industrial commodities prices -- elementary
building blocks of inflation.

Over the long term, a one point move in the indicator has translated
into a $7.50 oz move in the price of gold. However, since the end of
2005, a point move in the macro indicator has translated into roughly a
$25. oz move for gold. That's a dramatic increase in gold's volatility
relative to the indicator and it reflects a greater speculative
interest in the metal coupled with the deployment of more borrowed
or leveraged money moving into the market. Much the same can be said
for the oil price.

Prior to the speculative jump in the gold price in early 2006, it was
tracking a 13.6% annual return trend. That's very good relative to the
inflation that developed over the period. With the price channel
established over 2000 - 2005, gold would close out the year at around
$625. But gold at the current $788 is well above that level and is
rapidly getting extended relative to the speculative leg in place since
early 2006.

I'll keep reporting on gold, but the action is too zippy for me.

The Artist Zu Sheng Yu

I promised some links to interesting artists whose work
deserves a look. Below is a link to the work of Zu Sheng
Yu, whose stuff I first saw only two years ago. China's
loss is our gain. Lovely work.

Note: I have a long position here. A few years back, some
canvases could be had for $800 - 1k. We are talking $26K
now.

If the link does not pick up, go to www.zsyu.com. There
are 20 pages of work to view.

Oil & Gold -- Wild & Wooly

Oil and Gold prices took off in the immediate wake of the
subprime financial crisis circa mid-August. Speculators have
bought the whole nine yards of the "Helicopter Ben" pastiche.
The Fed's decision to cut the FFR% in mid-September only added
fuel to the story. Ben has not complied, except seasonally.
Then there's GWB / Cheney and Iran's Ahmgonnabebad kiting the
oil price with an ongoing pissing match regarding Iran's
nuclear ambitions.

Now, we have both oil and gold in speculative blow-off mode,
with prices for each now in danger zones viewed long term.
Both markets are getting extended and vulnerable. So, I
would say that whatever your upside targets for these entities
may be, recognize that prices are in zones when even slight
dents to the mantras can lead to unsportsmanlike tumbles.

The Fed normally adds to liquidity as the holiday season
approaches, and the FOMC is moving at a remarkably leisurely
pace. GWB and The Shooter want to sound tough vis a vis Iran
and help out their oil buddies as well. Their macho routine
has been ineffective geopolitically and has been a disservice
to the US from an economic perspective. With the troop "surge"
of this year and the large naval build up in the Gulf, I would
have thought that US aircraft would have lit up the border with
Iran already to disrupt supply pipelines to Iran's Iraqi
clientele. And, I doubt we can count on the Turks to hit oil
production in northern Iraq.

So, lots of talk all round, but not any action. Oil and gold
might need some of that wilder action to keep the runs going.

Stock Market Comments

As discussed in several recent posts, the stock market
experienced a strong bullish impulse off its mid- August
low that went too far, too fast. I had a nice run off those
lows, but exited in early October as the action was too zippy
for my taste. The crunch came last week as earnings
disappointed, oil surged and G-7 came out grumpy. My plan is
be thankful for the recent surge and bide my time, allowing
the market to sort itself out short term. These are uncertain
times and the Sep. / Oct. high flyer discounted a rapid return
to sunny prosperity.

The SP500 bounced off classic pivotal support today at 1500.
That may bring in some fast super short term money, but I have
to confess that textbook bounces like today leave me a bit
leery because the action seems facile. More as the week
wears on.

I owe some links to some interesting art I have seen recently
and I am readying that.

Stocks, Inflation & Liquidity

With the latest inflation readings, the fair value estimate
for the SP500 Market Tracker has been reduced from a range
of 1600 - 1625 to 1575 - 1600 to reflect downward pressure
on the p/e multiple from an acceleration of inflation.
Looking forward, the p/e may be downshifted further, as this
year's surge in the oil price works its way through to the
retail level. The oil price has moved well above parameters
long seasoned traders would be comfortable with, but
speculative interest has been bubbly in recent weeks.

The broad measure of liquidity I favor has been flat since
May, '07, due entirely to the sizable contraction of the
market for financial org. commercial paper. Measured yr/yr,
broad liquidity has dropped from the 9+% level to just 6.3%
through Sep. In turn, the yr/yr % change in the $ cost of US
production has inched up to 4.8%(also through Sep.) Thus,
excess liquidity in the system has dropped from over 5% earlier
in the year to just 1.5%. Much of the rally in stocks since
mid-August then likely reflects the put back of cash raised
during the immediately preceding sell-off. The liquidity
tailwind for the capital markets has thus moderated in
dramatic fashion.

My longer term inflation indicator has turned sharply upward.
Sustainability of trend remains a question as the indicator
is being powered by the oil price which is heavily overbought
and which could turn volatile at any time.

Stock Market -- Short Term Technical

As posted on 10/2, I opted to close out my longs at 1547 on
the SP500. These were good trades, but as usual, I left some
money on the table. The market was overbought and on too fast
an upward trajectory. That frenetic run was broken late last
week and we've dipped to 1549. As the chart below shows, the
10 day m/a has been violated. The market is still well over
the 25 day. As well, the MACD looks set to roll over.

The dip buyers have been frozen out of the market since 9/10
and going long since then has basically involved chasing them
up. Whether today's sell-off was strong enough to pull in
sideline money I do not know. Equally, I do not know if we
will see a test of the 25 day m/a soon, either, although I
sure would like to see it to get a handle on follow through
potential in the wake of the spike following the Fed's 9/18
action.

Look across for the link to the SP500 chart.

Corporate Profits...

Earnings season has kicked off. Expectations for total
yr/yr profits performance for the Sep. Q are the most
subdued for a good several years, with analysts having
circled this Q up as the worst momentum-wise months ago.

For earnings expectations, Q3 results are normally quite
important. It is now October, and analysts have to get more
serious about company earnings potential for the new year
ahead. That's an annual rite. And this year, there is more
on the line since the Sep. Q is widely seen as the bottom
in yr/yr earnings momentum with acceleration in profits
growth foreseen from now clear through 2008.

My top line overview for US only sales is about 4% yr/yr
for Q 3. This suggests some margin pressure and the likelihood
that a number of companies will report mildly down earnings
prior to share buybacks and gimmicks. The smaller cap. companies
with only US operations would be the most vulnerable. Companies
with a hefty export book of products or services will do much
better, as will the larger firms with substantial foreign
operations. About 30% of total US profits is now earned abroad,
and there are a number of SP500 companies with better than 50%
exposure. There will be additional positive leverage to foreign
operations in the quarter as the USD averaged about 80 compared
to 85 last year. Basic industry scored moderate sales growth,
but has nice leverage from continuing pricing power, and has
also exhibited more stability in performance than in many years.
Tech and capital goods are expected to have improved. Oil lifting
profits continue to accelerate, but integrated producers are
experiencing poor refining margins. Financial service revenue
growth for the quarter will surprise to the upside, but as has
been well documented, many providers will show large loan losses
and writeoffs related to subprime.

As discussed last week, the indicators suggest slower global
growth ahead, and it may be difficult for the broad market
to benefit from rising oil and materials prices as well as a
falling USD, as these variables, though positive for sector
earnings and relative performance, are inflationary and are
negatives for earnings capitalization overall.

A positive stock market environment for 2008 may well require
stronger and more balanced US economic growth along with
expanding foreign operations. Such is not in view yet, and
is a critical reason for keeping a strong short term focus.

Stock Market Fundamentals

When I look at consensus earnings estimates for 2007 and
2008, it is easy to build a case for a 1625 - 1650 close
for the SP500 for this year, and 1825 - 1850 for next year.
As a group, analysts expect earnings growth to accelerate
significantly from a very tepid 3rd Q '07, and many
economists are looking for inflation to stay under reasonable
control. The 50 bp. cut to the FFR%, stabilization of key
weekly economic indicators and stabilization of financial
system liquidity have reduced risk and form a decent down
payment on a positive market turn.

We have the down payment, but a fair measure of uncertainty
remains. The global economy is more likely to slow down
before it would regain sufficient positive momentum to support
the presumed earnings outlook. We still have to see whether
US liquidity will turn sufficiently positive to support faster
growth, and just as important, we have to see whether faster
liquidity growth will drive commodity prices sufficiently to
produce an acceleration of inflation pressure and a consequent
reduction of the market's p/e ratio.

It is reasonable to assume that managers of large pools of
equities are thinking that the Fed will attempt to do what's
needed to keep the economy growing. After all, 2008 is a wide
open national election year, and the Fed would not like its
failings to be a major campaign issue. I agree with this view,
but like many other greybeards, know the Fed does not always
succeed at what it intends in a timely fashion. However, recent
Fed action has likely earned a measure of investor and politician
patience.

So, it is easy to lean positive. Yet, I think it could take
five or six months before the uncertainties inherent in the
economic environment are resolved. This translates to thinking
about return potential in the context of elevated uncertainty.

My SP500 Market Tracker currently has the "500" fairly priced at
1600 - 1625. The market closed at 1562 today, suggesting some
continuing investor wariness despite the recent strong advance.

I am anticipating elevated volatility through Q1 '08, and am more
interested in trading than taking investment positions.

Economic Indicators

My leading economic indicator composite declined again
in September, and is now sharply below the interim
cycle high seen in June. The data do imply that the
economy should expand slowly. The major reason for the
drop off in the composite since June reflects sharp
declines in the breadth of new orders for both the
manufacturing and services sectors. The same pattern
is repeated for the global indicators, signaling that
worldwide economic growth should slow further as the year
winds down. The trends are not healthy, but there are no
tangible signs of recession yet, either.

With the magic of data revision, the decline in US payroll
jobs originally reported for August has been replaced by
a reasonable net gain to compliment the 110K jobs allegedly
added in September. Wouldn't you know that the error for
August made it easier for the Fed to cut the FFR% on 9/18.
It is OK to cook the books once in awhile, but the employment
data is getting sloppier than normal. The more positive
jobs data for recent months will ease talk of recession and
may prevent the Fed from being pushed into another rate cut.

The short and longer term inflation indicators are rising,
signaling increased inflation pressure ahead. Main culprits are
oil and agriculturals.

Stock Market -- Short Term

In the 9/24 post on short term prospects for the market,
I suggested the shorter run trend was clearly up and that
the huge jump in the indices in the immediate wake of the
Fed's announcement that It was shaving 50 bp off of the FFR%
produced a likely bullish or healthy heavy overbought. Last
week saw more of a consolidation than clear profit taking,
and yesterday's spike brought the market into strong over-
bought territory once again. The last strong entry point was
Mon. 9/10, with the SP 500 at 1452, and frankly, the trajectory
up from that date seems awfully fast. So, I have moved to the
sidelines as I am trading and not investing at present. From
my perspective, technical conditions do not warrant a short or
put position at this time.

On a lighter note, the 50th high school class reunion was a
terrific experience. As I look back, I was fortunate to have
attended high school with such an exceptional group of boys
and girls and to have gone to a school that emphasized
personal achievement as firmly but quietly as it did. I missed
the ones we lost and the ones who did not attend, but the
turnout was still large and it was great to see old friends
again. If you are in pre-geezer mode like me, I strongly
recommend you attend your 50th whence it comes.

The beautiful wife and I also hit the Big Armonk, NY art show.
It is just mind boggling to see all of the fine arts media
and the very high quality throughout. I'll put some of the
artists' websites up as links in coming days.

Be Back Next Week...

Heading out for a long weekend lark. I'll be attending
my 50th high school anniversary reunion for our class of
'57. Then on to the galleries and the big Armonk Art Show
(IBM). Then come Sunday, I take the younger set out for a
bite and a screening of "Resident Evil". No blog entries
until early next week.

Stock Market -- Short Term

Following the larger than expected cut in the Fed Funds
rate, the market quickly surged to its heaviest short term
overbought in a good several years, as the SP 500 rose to
about 4.5% above its 25 day m/a. That kind of early overbought
is normally a bullish development. Yet, the market has been
exhibiting a deep staccato uptrend since the mid - August
low, and it could be that such a pattern may continue for
a while. From a strictly technical point of view, the short term
trend is up, and a few of the intermediate trend indicators
have turned positive as well. A round of profit taking in the
wake of last week's big overbought would hardly be an unnatural
development. I would happily concede we could see some more
jittery selling pressure, but the market favors the long side
of the trade until we see some technical damage.

Resolution Could Take Time...

My approach to understanding the US economy and the capital
markets has left me in an uncomfortable position at this
point. I do key heavily off the liquidity cycle on a
fundamental basis, and as of today's available data, liquidity
is flat or down some in the short run. I think it can take a
good six months to determine how positively the economy will
respond to changes in the liquidity picture going forward.
With the 50 bp cut in the FFR% to 4.75%, the Fed is signaling
that it is prepared to provide faster growth of monetary
liquidity via open market purchases of Treasuries and other
securities. It is far less clear when and how rapidly credit
driven liquidity will resume its growth.

The broad economy has yet to show the sort of imbalances that
assure a recessionary period, while on the negative side, the
level of residential construction is still running well
above levels seen in prior downturns, and could fall considerably
further before settling out. I also remain concerned that
system capacity growth continues well below underlying demand
growth potential. In this latter regard, should the economy
respond positively and quickly to an easing of monetary policy,
more sustainable inflation pressure could appear.

I have maintained since late 2006 that I would let the other guys
do the forecasting. I had hoped that by autumn of this year, the
horizon would be easier to discern, but, regrettably for me, the
economic horizon has a heavier layer of fog on it than it did
going into the year. For now then, I'll maintain a shorter term
perspective, since I cannot say with conviction that this stretch
of bumps to confidence and higher volatility has ended.

Benny B Jumps Through "The Window"

Yesterday, I suggested that if the Fed deemed it warranted to
cut the FFR%, They should give it a good go. So, we got 50 bp
on both the FFR% and the DR%. 'Twas the uncertainty of it all
that got them. "The Window" of course was the moderation of
short term inflation stemming heavily from a weaker gasoline
price. Bernanke and the Gang also departed again from the
formulaic approach that had governed policy for many years.

The problem as set out yesterday, was that there may be
inadequate liquidity in the system to fuel economic expansion.
Federal Reserve Bank Credit -- the raw material of the basic
money supply -- has grown a paltry 0.8% this year as the Fed
"leaned against the wind" to counter rapid credit growth.
Credit driven liquidity came to a screeching halt in August,
and since the Fed cannot be sure when the system will fully
unlock, It cut rates and may add monetary liquidity more
rapidly to shore up the reserve base of the banking system.
As I pointed out at the end of 2006, the Fed would wait as
long as it could before refueling, and the rate cuts say the
time is nigh.

The process of liquidity restoration sufficient to restore
stronger positive momentum to the real economy may happen
quickly, but could easily take up to six months. More on
all of this in the days ahead.

Monetary Policy

As most know, the Federal Open Market Comm. meets
tomorrow to decide on interest rate policy. Most Fed
watchers are looking for the FOMC to cut the FFR%,
although there is less of a consensus of by how much.

The time honored indicators that have made it relatively
easy to surmise the direction of policy over the years
may count for less with the Bernanke Fed. Those indicators
described a weakening of manufacturing and capacity
utilization in late 2006, and signaled a FFR% cut for
Jan., 2007. The Fed passed over that signal and kept the
rate at 5.25%. As you will recall, Mr. Greenspan quickly
followed with mention that the odds of recession for the
US in 2007 had risen to one in three. The economy did
rebound over Q 2 of this year, and now the same indicators
imply it is too soon to cut the FFR%.

The Street and many name economists are putting substantial
pressure on the Fed to follow up on the recent cut to the
discount rate with a cut to the FFR% in the hope that it will
further ease credit crunch conditions for weaker credits and
preserve the economic expansion. Within the technical domain
of money and credit, there is an issue of whether there is
sufficient liquidity in the short run to fund a growing economy
properly. This may be only a transitory matter, but it goes to
the heart of the uncertainty Bernanke says the FOMC faces.
Moreover, the speculative run ups in gold and oil along with a
weakening dollar in the forex arena are all signaling a
deterioration in the inflation environment should the Fed follow
through with rate cuts.

We'll see soon enough what the Fed intends. For the short run,
my suggestions for the Fed would be to cut the FFR% by well more
than a slim 25 basis points if They deem a cut is needed, and to
not fear reversing course within a few months if inflation
pressures materialize. Trying too hard to mimimize volatility
in short rates and in the economy creates unnecessary volatility
in the liquidity data and may be inappropriate for an economy
that is bound to be more volatile anyway now that inflation
pressures are showing up more often.

Stock Market -- Technical

One check I like to make on markets involves comparison
against the simple 10 and 25 day moving averages. the $SPX
is trending up as is the 10 M/A. Moreover, both have come
up through the 25 M/A. Interestingly, the 25 M/A has just
perked up a touch after a basing period. Check the chart.
The 25 M/A is likely to show some additional improvement next
week as well. It is a development that commands my attention,
as it is an additional sign that the market is turning positive
in the short run. There is much to cavil, of course. The volume
has been on the light side for several weeks, and the $SPX has
had trouble staying over the 1480 level. As well, it has yet
to take a good run at shorter term resistance at 1500. Note also
that there may be sharply increased volatility next week as the
FOMC announces on the Fed Funds target rate. Finally, recall
that many savvy technicians are looking for a retest of the
August low around 1371.

Did I damn the $SPX with faint praise? Maybe. But there is a
noteworthy positive development to be observed nonetheless.

Oil Price Tizzy

Crude futures tapped a record $80 a bl. today. Traders
blew off reports that OPEC intended to boost production
by 500K bd., preferring to focus on reports of tighter
crude inventories in the US and the rapid development of
a tropical storm just south of Galveston, TX and west of
major offshore producing fields. Storm warnings went up
from Houston east to Lake Charles, LA.

This is a strong contra-seasonal move for the oil price.
It also brings oil into clear overbought territory, as
it has a high weekly RSI and is now trading well above
its 40 wk. moving average.

Interesting moment. Traders are pushing oil higher as we
near the eve of the FOMC's forthcoming meeting on interest
rate policy set for the 18th. The Street and many leading
economists are busy steamrolling the Fed into cutting rates,
and now the price of crude remains on a role and hits new
highs.

Let's see how the traders handle a strongly gathering
overbought on crude with this interesting mix of variables.

Economy & Stock Market

My leading economic indicator composite fell sharply in
August after rising significantly over the first seven
months of the year. It signals possibly sharp moderation
of growth in the months ahead. There are no recession
warnings yet.

The BLS household survey of civilian employment, the
broadest and most current measure of jobs, shows no growth
of employment in the US for the year to date. Measured
yr/yr, civilian employment growth has decelerated from 2.0%
early in 2007 to 0.8% through August. Real wages are up
about 1.5% yr/yr through August. The combination of real
wage and jobs growth is 2.3%. This is a modest but not yet
perilous level. It does contrast sharply with the comparable
3.9% level seen early in the year, and is moving in the wrong
direction from a growth perspective. The subdued jobs data
seems out of synch with a rising level of corporate profits,
and I am not confident I fully understand it.

Headlines notwithstanding, the US banking system seems to be
functioning normally. C&I loans continue to trend up and
the real estate book has even inched up a little recently.
Part of the rise in C&I loans is however likely attributable
to deals stuck in the pipeline.

The change in inventory levels, which was strongly positive over
the second half of 2006, has been quite trim over the first half
of this year, a favorable development.

The economy is not on thin ice yet. The problem of course is that
thin ice comes along quickly, especially when liquidity flattens
out the way it did in August. As Mr. Bernanke recently said,
uncertainty is deeper in the short run.

The stock market seems almost haplessly unstable as investors and
traders try to handicap the economic outlook. The US economy is
the largest, and it is deeply diversified and stable. It is now
under stress from sizable pockets of disorder in the financial
markets. It would be nice to say something more positive than
"keep an eagle eye on it", but sometimes you have to suck it up
and go along until matters clear a little.

Inflation Issues

Inflation indicators have been volatile this year, reflecting
wide swings in the price of crude oil and gasoline. Both oil
and gasoline have been ticking up recently, partly for
seasonal reasons and partly in view of speculation concerning
hurricane activity.

Strong upswings in both gasoline and oil from 01/07 well into
the spring pushed up the inflation rate sharply. Real wages
declined over the first half of the year as a result, and this
development has undercut the near term economic outlook. That
fast surge of inflation no doubt influenced the Federal Reserve
to maintain inflation pressure as its primary target
through July. The Fed is concerned not only that inflation
will raise the cost of capital, but that real household income
can be threatened as well, since wage rates change far more
slowly than does inflation that is heavily influenced by
volatile commodities prices.

Now as autumn approaches, oil and petrol prices are expected to
ease as driving conditions fall off the seasonal peaks in the
northern hemisphere. Shorter term inflation pressures may subside.
On balance, the longer term inflation indicator, although rising,
is still in benign territory.

Traditional bedrock indicators of monetary policy certainly do
not yet support a cut in the Fed Funds Rate, but if the Fed
remains concerned about financial market liquidity and its effect
on the economy, there is a "window" of seasonal weakness ahead
in key petroleum price composites that might offer "cover", as
headline inflation could remain modest. Naturally, the Fed also
knows that strong upward pressures on the petroleum complex
can develope over the first half of the new year reflecting
continuing demand for heating oil and the start of accelerated
gasoline production. the Fed must also contend with commodities
speculation, should the FOMC vote for rate cuts. The pit bulls
could well reason that monetary stimulus would eventually lead
to a stronger economy and higher demand for a variety of crude
materials.

There are a couple of other points worth remembering. Modest
inflation through year's end will lead to faster real household
income growth, providing the economy remains stable. Also, note
that the Fed has a little "breathing room" on the FFR at 5.25%.
With inflation running at 2.5% measured yr/yr, the Fed could
take the FFR% down to 4.75% and still leave savers with some
protection.