Too Many Bond Bulls

10Year Treasury Note: 4.07%

The $USB chart shows that the 10 year note is mildly overbought. The Market Vane survey of bond trader sentiment has reached 74% bullish, the highest reading in over two years. Over the past fifteen years, bullish sentiment readings in the 70 - 80% area on the MV survey have been consistent with interim tops in prices and lows in yields. If this heretofore strong relationship holds, the yield on the ten year note should reverse by between 50 - 100 basis points, which would bring the yield on the note up to the 4.50 - 5.00% area at some point in the next several months.

Federal Reserve In The Real World

The Country needs a good five cents cigar. But even more, It needs a good five cent nickel. The roles of the Fed and the Treasury are to provide and maintain sound money. But the Fed Chair and the Treasury are there to serve the President, not the other way around. When sound money must confront realpolitik and its agenda, sound money is going to lose at least nine times out of ten. The Fed Chairman is necessarily a political operative and when the political agenda challenges sound money, it is his job to sand bag as he can and try to minimize the damage. There is no room for an adolescent hissy fit and resignation. Do that and you will not eat lunch in D.C. again.

Volcker, an anti-inflation and globalist fanatic, got in the way of a sensible political agenda and lost his job. Greenspan has been very different. A better politician, he learned to get out front of the Clinton agenda and lead it. Both Chairs made big, costly mistakes.

The internet is crammed full of the commentary of sound money advocates. Well and good, although the preachy sanctimony of most of these commentaries is an irritant. As an investor, I have always looked at the Fed as operating in a political maelstrom and have tried to figure what They are likely to do first and what, from a value judgment perspective, They should do second. You should too, because if you do, you will better understand the continuing situation on the ground.

Lately, Greenspan is under the glare of questions about whether the current level of short term rates is appropriate. The sound money gurus worry rates are too low. The growth advocates worry rates may be too high.

With 3% inflation, the Fed Funds rate should be 4.25 - 4.50%. But the Fed has been concerned with nursing the large US manufacturing and related industrial and commercial products and services sector back up from near oblivion. Nearly five million jobs have been lost here. From the prior peak (6 / 2000) to trough (2 / 2002), factory shipments fell nearly 20%, the largest decline since The Great Depression. Sales then languished until mid-2003, and it was not until early this year that shipments finally exceeded the 2000 peak level.

Easy money in recent years has triggered a housing boom and sharp growth in consumer spending. Have excesses been created? Likely so, but the policy pulled the industrial / commercial sector out of a deep nosedive which was its intent (including, perhaps, a planned assist from the war in Iraq).

Now, with the industrial sector back on its feet, the Fed has a freer hand to tackle other issues. More on the new game plan will come in future posts.

Stock Market Profile -- Cyclical

S&P 500: 1197

The market has meandered off-trend, but remains a cyclical bull, having again successfully tested its longer term move/avg.

To qualify as a "normal " cyclical bull market in a conventional four year cycle, the S&P 500 should move up to 1360 by early 2006. My market tracker (a model based on regressed p/e x earnings) has it moving up to 1310 by early next year.

Ordinarily, I would be reasonably comfortable with these projections. The economy is expanding, is not overheated (there's capacity to spare), and the stock market has not burned up all that much liquidity in its advance since late 2002. However, we are well beyond the "easy money" period of an advance, when earnings are in the "V" shaped recovery mode, short rates are falling, monetary liquidity has accelerated and confidence in business has turned up. Now, the pattern of earnings growth is maturing, short rates are rising, confidence is on a plateau and liquidity has recently turned mildly restrictive as the Fed presses on to contain inflation pressure.

As I read the situation, the Fed's efforts to "remove accomodation" over the past year have been ineffectual. The economy would have slowed anyway, as the recovery in the industrial sector from its deep recession low was too fast not to cool down. Moreover, there have not been the kinds of breaks in energy and commodities prices overall that would suggest the Fed is yet succeeding in containing inflation pressure. Yes, we could see some seasonal relief in primary sensitive prices in the months ahead, but the trends continue to point to higher prices down the road.

So, I read the recent drift of monetary liquidity into more restrictive territory as an attempt by the Fed to squeeze the structure of primary materials prices a little harder. What makes me a bit uncomfortable is the recent divergence between the stock market (in rally mode) and the tightening of the monetary reins. Risk is on the rise.

I see the US as in an economic "fine tuning" mode, where bullish or bearish views on the stock market are freighted with assumptions. For my part, It is an environment for putting nickels and dimes to work short term, not big bucks. I like the investment world simple, and the fewer assumptions that have to be made, the better.

I also use a dividend discount model to value the market. The current reading is 1125 for the SPX. The market has moved into overvalued territory. Valuation is a poor method to time the market, but excess valuation can act as a headwind from time to time.

If this round of "fine tuning" works -- the economy expands while inflation pressures abate -- the SPX has a good shot at 1360 by early '06. But, as in any case of such "tuning", good fortune will have to smile on us.

Keep The Oil Price In Mind

The price of oil has dropped by about $10 a barrel since early April. The rallies in the stock and bond markets and, to a lesser degree, the recent break of trend in gold heavily reflect the weakness in oil and its implications for inflation. The recent tape talk and US oil inventory data have favored lower oil. But oil is heading toward a short term oversold position and the bond and stock markets are heading into overbought territory. If you are a short term player in the capital markets, this situation begs to have you watch the oil market as carefully as your stock and bond positions.

Thanks, Al...We'll Take it From Here

The Danish philosopher Soren Kirkegaard argued that to embrace the Almighty, and by implication, all else not at all apparent, requires a great leap of faith. What we have in the stock and Treas. markets is a "Kirkegaard Rally"....You gotta make the leap....Fed tightening is now seen as having corraled the inflation beast, making it safe to think about a benign economic expansion ahead. Plus, no doubt hedgies are rolling out of oil and commodities as they sell off and are jumping on the equities and Treas. bandwagons. A "done deal."

The Fed has succeeded in this kind of maneuver before as discussed in recent posts, so it comes as no surprise that some would jump the gun and and run 'em in anticipation of success. Be careful with this. For example, do not use the "john" during trading hours, or have a ticker moved in there so you can stay on top of the action.

Running Dogs of Capitalism

That's what Mao and Chou used to call the US establishment in the 1950s and '60s. Now we have the fastest running dogs of capitalism in China itself. Yesterday, Treasury Sec'y. Snow pulled his punch on currency manipulation by China and greenlighted the dogs to run for at least another six months. This was a mistake. China's remarkable growth over the past ten years has far outstripped the development of its banking system and financial controls generally. There have been several bank bailouts and the private or "stir fry" economy has been allowed to circumvent the banking system entirely and flourish. The banks in fact are used as ATMs by thieving employees, the political leadership, and their lackeys (another favorite Mao term). Lengthy discussions about unpegging the yuan from the dollar and letting it float have drawn in extra billions of speculative capital awaiting a hoped for positive revaluation of the yuan.

Allowing the peg to continue for months more will give the speculators more time to pour more hot money into China, some to remain liquid and some to go into an already vastly overbuilt real estate sector. This will put increasing strain on a shaky financial establishment, already outgunned by the warm unofficial welcome given to speculation. It's big bucks for the mandarins in Beijing, but the house of cards, now well under construction, seems destined to grow as a result. Economic risk will continue to rise in Asia.

The US went through this with Japan in the 1980s. It mistakenly took a soft line on rampant Japanese mercantilism. Billions of speculative capital flowed into Japan behind the trade dollars, creating real estate and equity market bubbles the popping of which was long term ruinous to Japan. The US, faced with dealing with a large budget deficit, is currently poorly positioned to ride to the rescue should events knock China's house of cards down. The US is willing to take a possible upward hit on its long term rates in the shorter run to avoid the costs of financial catastrophe and destablization it foresees in China.

For now one can just hope that the ace of spades is not added to the abuilding house.

Gold -- Near a Breakdown

A break in gold below $420 an oz. would be a violation of the uptrend in place since 2002. It would not mean that the bull market in gold is over, but should a break occur, it would at a minimum signal a lower upward trajectory for the metal going forward. The Federal Reserve has been shrinking the size of its Treasuries / repo portfolio since year end 2004. This means anti - inflation determination on Their part. The US dollar has responded positively and gold
has entered a correction with support in the $410-415 area. The gold players have stepped up buying on prior dips, so the next week or so will be a good test of resolve. The XAU gold/silver stock index faced a similar test very recently, and broke decisively below its uptrend line. The dollar will figure in too, as it is approaching a short term overbought for the first time in a number of moons.

CRB Commodities Index -- On Fed's Monitor List

CRB Commods: 293.9

Q1 seasonal commodities price spikes in '03, '04 and a big one in '05 have contributed significantly to the acceleration of inflation. In this link you will see that the CRB is trending down fast. A further decline below the pivot line of 282-283 would tell the Fed that inflation pressure may well abate noticeably going forward.

Stock Market - Technical

SP500: 1154

1. The cyclical bull market which began 3/03 has had two distinct uplegs so far. #1 ran to late 3/04, and #2 ran from 8/04 until late 3/05.

2. The market then entered a 5-6% correction. A counter-trend rally began in mid - April from a significant oversold. The rally did produce very short term buy signals on a number of technical indicators. I have not chosen to play this advance so far. The main reason for staying out has been the mediocre price momentum of the major composites. As a consequence, key intermediate term indicators have yet to turn positive, although the NASDAQ Comp. is getting very close to making the turn. I approach a counter-trend rally with caution. Thus, I have been thinking that I might also consider buying only above key pivot lines such as
DJ 10400 and SPX 1180.

3. It is a critical time for the market on a technical basis. Nine month and twenty week cycle low intervals are imminent. At the same time, recent failure of the market to successfully challenge its 50 day MA and deteriorating intermediate term price momentum suggest the possibibility of a resumption of the correction.

4. Since I do not have to be the first kid on the block to do anything, I am going to wait a bit to see whether the market can develop stronger positive momentum. Click on this link and you will see the weekly SPX is nicely oversold (14 week stochastic) but that MACD is just now basing with no upturn at hand.

Oil Price & The Stock Market

The oil price broke above $35 per bl. in 4/04. This was the first time in over twenty years that oil moved above its inflation adjusted price, and marked the end of a lengthy period of "cheap oil". Since then, the stock market has been sensitive to the near term direction of the oil price, with investors sensing that expensive oil may have detrimental economic consequences. It now appears that the oil price needs to be added to the list of economic variables, such as interest rates, that must be factored into any analysis of the stock market. After all, like the cost of money, oil is a major capital input for business, and can have a significant effect on profits and capital budgets. So too, oil like interest rates, will affect consumer confidence and purchase decisions.With oil currently rebounding again, it needs to be taken into account in gauging the short term outlook for equities, as a rising oil price may inhibit the recent rally in stocks.

Short Term Interest Rates

Fed Funds Target Rate: 3.00%

The Fed is on track to have the Fed Funds rate at 4.00 - 4.25% by year end 2005. A growing number of observers now think the Fed may quit raising rates at either 3.25% or 3.50%, citing evidence of an economic slowdown.

The Fed undertakes to raise rates when: 1) economic growth is strong, 2) capacity utilization is on the rise, 3) inflation pressures are intensifying and 4) short term business credit demand is advancing at a faster clip than is monetary liquidity.

For now, only condition (1) is clearly suspect. Capacity utilization is still in an uptrend, credit demand is very strong (up 11% yr/yr) and inflation indicators have not settled down enough to warrant a clear call that the latest push up on inflation has ended.

Since the speculation about a an interim top in rates will continue, below are some benchmarks that might prove helpful in benchmarking the action:

A. The Fed would take notice if the ISM index for manufacturing purchase management was to dip below 50%. It is now in a downtrend, with the April reading at a moderately strong 53.3%.

B. The capacity utilization rate, which is trending up, begins to flatten out. Important here besides the growth of production is the growth of capacity itself, which is advancing at a very slow 1.2%.

C. The CRB Futures Index, now at 300.5, dips further and confirms a solid seasonal topping pattern. The CPI registers a couple of months of 0.2% or lower readings.

If it looks like the economy is clearly slowing and inflation pressures are abating, the Fed would likely wave off the sharp rise in credit demand, believing that it reflected financing of inventory accumulation with the latter being seen as unsustainable.

Inflation Note

The US economy has been experiencing the strongest inflation impulse or impetus in nearly thirty years. Since mid-'02, the yr/yr CPI % has moved up from a low 1.1% to 3.2% through Q1 '05. The pressure reflects large increases in the prices of cyclically sensitive materials as well as energy. Operating rates in these areas have risen to high levels reflecting strong demand resulting from the economic recovery in the US as well as strong demand from Asian economies, with the latter now having a much larger economic base because of the rapid growth of China and India, particularly.

In addressing inflation pressure in 2005, the Federal Reserve has elected to continue a course of progressive but moderate tightening of the monetary reins. In essence, the Fed is betting that the recent run-up in the prices of oil and natural gas reflect very strong seasonal demand and that oil and gas prices will weaken signicantly as buyers realize there will be ample supplies in the months ahead. The Fed is also aware that with manufacturing and business-commercial sales having outpaced consumer spending and export demand for months, inventories are trending up sharply. The eventual re-balancing of business output relative to consumer demand is expected to result in slower overall economic growth and some price concessions.

If the Fed's judgment is correct, yr/yr CPI% could eventually slide from 3.2% to the 2.5 - 2.7 % range at some point over half 2 '05. It will be an interesting period, because this is the first time in a good several years that the economy faces an inventory overhang. Moreover, since operating rates for finished goods show continuing significant slack, inflation pressure could dissipate readily if the fuels and sensitive materials price composites exhibit weakness.

At present, inflation thrust measures are still too strong. Oil, recently $50-56 a barrel, would need to move down to $42-47 a barrel and stay there for several months if inflation is to decelerate as the Fed hopes. Likewise, The CRB Commodities Futures index would need to go to 285-290 area from the present 300 (While I fiddle with setting up links, you can go to stockcharts.com and pull up $WTIC, $CRB and $NATGAS to play with).

There is a longer term issue here. If the Fed's tightening gambit works, It will find that, as It moves to ease up on the reins down the road, inflation pressures will likely return.It may have to contend with new surges in fuels and sensitive materials prices, and in addition, end stage processing prices may firm faster because slack may be used up quickly.