Stock Market -- Fundamentals

S&P 500: 1152

I have us as remaining in a cyclical bull market in the USA. True
enough, the market is no higher than it was a year ago, and has
been in a correction phase recently. But the action of the market
is merely repeating what happens after the powerful initial phase
of stock price and profits recovery in the wake of recession. Once
profits complete a "V"pattern recovery and move into the expansion
phase, it is common for inflation pressures to intensify and for interest
rates to begin to rise. This is what we experienced over 1964-66,
1973, 1983 and 1994.

The process of inflation containment has grown easier over the years
for three reasons: 1) The Fed has learned to move more forcefully;
2) It has attacked inflation earlier in the cycle; and 3) accounting and
tax policies have made inventory speculation less attractive for
businesses. The Fed did fail to extend the expansion and the bull
market over 1973-74, as companies pursued aggressive inventory
speculation via FIFO accounting -- "first in, first out" -- which led to
large but unsustainable earnings gains, inventory imbalances and
recession.

The process of inflation containment to extend economic growth and
the bull market could be difficult this time. The current inflation impulse
or impetus is the strongest The USA has encountered in nearly thirty
years. As well, the Nation's financial system has more weak spots for
the Fed to worry over. For now, the policy seems to be to maintain
money and liquidity growth at moderate rates and to let inflation
pressure cut into growth so that the resulting slowdown will create
enough slack to cool inflation pressures and allow the Fed to ease up on
the monetary reins subsequently.

As of now, the data suggests the economy may slow in the months
ahead but that inflation stimulus still remains strong, particularly in
the fuels sector. Since there is slack already in the system, the policy
still has a reasonably good chance to work.

Now the hard truth is that during these inflation containment periods, the
stock market can easily decline by 10 - 12% even if the program is a
success, as uncertainty during the process can take a toll. Thus, it
should be no surprise if the S&P 500, already down 5.5% from the recent
interim high, falls another 5 -6% to the 1085-90 area. Much should
depend on how fast we see progress on the containment front and how
confidently investors react.

Success here is very important. Giving the economy "room" to expand
another three-four years will help fill the US Budget coffers with regular
income revenues as well as capital gains taxes from a rising market.