Earnings Trend Factors

I use a variety of economic data to try and track earnings
growth and momentum on a monthly basis. Some observations:

The recovery of SP 500 operating profits off the Q2 '01
recession low was very powerful, with quarterly earnings
basically doubling to $18. through Q1 '05.

Sales rose far more rapidly than costs, leading to sizable
improvement in profit margins. But other specific factors
were important, namely a weak dollar, large inventory profits
for basic industry and especially for oil and gas producers,
and the fact that many companies took huge writeoffs over
2001-02 that were not captured in operating earnings.

As is normal, earnings momentum is now decelerating after
such a remarkable bounce.

Business sales growth measured yr/yr peaked at nearly 10%
during Q2 '04 and has now slowed to the 6-7% area. This
still beats estimated cost growth of 5.5-6%, so gross margin
is still expanding, although far more modestly.

Currency translation gains are evaporating rapidly reflecting
a much stronger dollar, and basic industry inventory profits
have also levelled off. On the plus side, oil and gas
inventory profits are still surging.

Forecasters expect yr/yr earnings growth for the SP500 to
average roughly 10% each quarter through the end of 2006.
This is a reasonable projection provided sales can continue
to grow at 6-7% and margins can continue expanding via
further productivity gains.

What is troubling about the consensus expectation is that
it implies absolutely ingenious and faultless fine
tuning of the economy by the Fed. The continuous 10%
growth expectation is too high relative to the current
direction of monetary policy (now restrictive). I sure
do not know if the Fed can move through policy with such
perfection.

I guess I will be following my earnings indicators more
closely than I have recently, because the market seems to
me to be priced heavily on the assumption of strong earnings going forward.

Short Rates & Bank Liquidity

With the economy expanding and business short term loan
demand in a pronounced uptrend, The Fed still has
significant leeway to push rates higher without having
to drain the reserve base. A 4.00 - 4.25% FFR still looks
OK for year's end.

The banks remain in good shape as far as liquidity is
concerned. I define "liquidity at the margin" as the
ratio of C&I loans to US Gov't. securities holdings.
That ratio now stands at .85. This compares to a
reading of 1.48 at the last top in C&I demand in
March, 2001.

Yuan to Speculate?

Hu Jintao has authorized a baby step revaluation of the yuan, 2.1%.

Presumably, this will keep China under the radar when the US Treasury
again reviews currency management in Sept. '05. Hu is hard to take
seriously and Treas. boss Snow will look equally silly if the US
does not hammer China this autumn for damaging currency manipulation.

The dinky revaluation of the yuan sets promise of further dinky
ones to come. This will keep the speculative money flowing in and
will feather the nests of the Beijing power elite.

If this is the plan, US business and other foreign companies can
continue to invest in China with a wink from Snow.

Risk will rise even higher in China as more money flow will further
tax an already overburdened and corrupt financial system. Prospective
upward revaluations of other Asian currencies against the dollar
will up speculative flows to these spots as well, such as Malayasia.

Hu will be headed here some time over the next month or two. He
has earned the frostiest of greetings, but don't count on him
receiving such.

Stock Market Comments

Henry To of Marketthoughts was nice enough to invite me to be
a guest commentator. I chose the occasion to tie in recent
observations on the economy with the market outlook. Click below
fo more:

http://www.marketthoughts.com/

Stock Market -- Near Term

The rally in force since the spring tested important support last week and remains intact.
It continues impressive in breadth but not so in volume. Momentum in the popular major averages like the S&P 500 is subpar, mainly because there is continuing rotation into
mid and smaller cap. stocks. Fittingly, I do not have the large cap. indices as short term
overbought, but the broader NYSE Adv / Dec line is.

The S&P 500 is falling behind the course for a normal cyclical bull, partly reflecting monetary liquidity restraint but more so because of rotation toward smaller stocks.

My Basic Trend Index (NYSE A / D line adjusted by daily TRIN)remains in an uptrend and
is not yet overbought because TRIN readings have not been that low.

I have the S&P 500 as exactly fairly valued given the prevailing inflation and earnings levels.

The S&P 500 is trading at a modest 10% premium to my dividend discount model (Premiums or
discounts to the DDM of 25% or more require much greater due diligence).

My monetary liquidity trackers suggest the Fed is still tightening, which increases fundamental earnings risk in the market and keeps me with occasional, light exposure to
the long side.

Market risk is higher than that indicated by my work on monetary liquidity for two reasons:

> Oil and natural gas prices may be seasonally elevated, but the sharp long term uptrends
remain in force (inflation potential);

> Continuing rotation into higher p/e smaller caps puts many portfolios at greater risk if a correction ensues for valuation and market liquidity reasons.

I AM STILL HAVING TROUBLE WITH WINDOWS, SO POSTS WILL REMAIN EDITORIALLY PRIMITIVE FOR A
WHILE LONGER.

System Problem

Key blogger pages not accessible today. I'll try tomorrow.

Stock Market & Monetary Liquidity

Data for the Fed's own portfolio show a sharp rise in Treasury holdings, both via direct purchase and through the Repo window for the week ended July 6. It was a larger than normal holiday liquidity injection. The data was released late yesterday, and no doubt caught public notice. There are one or two other positive divergences in the liquidity data, but it does not yet add up to a more compelling case for stocks from my perspective. Even so, it all represents the first good news on the liquidity front in over six months.

The way I align the liquidity data, it does not add up to a case for a low risk / high return market. So for now, I continue to play nickel / dime on the long side with a very large reserve. I have done no shorting since 2002, and have not given it much thought this year.

I plan to do a more thorough analysis of the market over the weekend.

Monetary Policy -- Liquidity

According to the Fed, the Fed Funds rate is still at an accomodative level. Monetary liquidity trends paint a different picture. Liquidity has become increasingly restrictive. The economy has been growing faster than the broad money supply (yr/yr). Thus, the velocity of money is rising and, correspondingly, liquidity is shrinking, relatively speaking. As most know, short rates tend to rise with velocity. We do not have a full liquidity squeeze, because banks have their credit windows open. Monetary velocity is not rising fast enough yet to signal an economic downturn, but is consistent with development of a more pronounced slowdown. Timing is a tough issue, because the banks are friendly. Businesses are not stressed in meeting expanded working capital needs because cash flow is still on the rise and companies are tapping credit lines easily.

The Fed can let the economy coast this way for a while, but to avoid a serious crimping of growth or a downturn, It will have to begin providing fresh liquidity sooner or later. The Fed is interested in a long growth cycle because that assures a rising revenue take for the Gov. which must progress in reducing Its deficit. When the moment comes for the Fed to reverse course and ease up, follow through will have a substantial impact on the markets.

The liquidity deficit relative to the real economy began to show up over March / April, 2004. You will note that since then the stock and gold markets have made little headway, the 10 year Treas. has been rangebound, lower quality credit yields have moved up and even the US dollar, which been strong this year, is still a notch below levels of early spring, 2004. Only the Long Treasury has been able to hold a rally.

So long as the Fed allows liquidity to taper down, the capital and commodity markets are at elevated risk. Even the Treasury market is vulnerable, since players may turn bearish if they come to think that the process of slowing the economy to wring out unwanted inflation pressure may take longer than earlier anticipated.

The smart money knows that liquidity trend is every bit as important as the level and direction of the Fed Funds rate. In fact, the Fed may well signal an easing in policy first in the liquidity area, particularly if business credit demand begins to ease off. One place to watch is what the Fed is doing with its own portfolio (For this series, click here).

Finally, for an excellent e-chartroom briefing on the economy, click here.