The Bernanke Appointment

As was widely expected, GWB selected Ben Bernanke to replace
Uncle Al come the end of 1/06. This was a wise choice. The
Bernanke facial countenance reminds me of a rotogravure of a
nineteenth century British scientist, someone like the great
empiricist John Stuart Mill. Unlike Greenspan, who, when all is
said and done, was a laissez-faire theorist on the economy
and the markets, Bernanke is much more sharply focused on
the-matter-fact and how economic developments cumulate to
produce the future path of an economy. In contrast to Uncle
Al, he is at once more of a pragmatist and far more plain
spoken as well.

His primary interest from a policy point of view is to have the
Federal Reserve provide a monetary environment of stability and
to avoid policies which are so one sided as to increase economic
volatility and produce economic trends which may be extreme.
His concern is that once extremes are met within the economy,
reactive processes may be needed which in turn will produce
their own excesses and deficiencies, thus taking positive,
directional initiative away from the Fed. Thus, he is at once
an anti-Greenspan and an anti-Volcker who sees the past twenty
five years of policy as having been needlessly tumultuous and
risky.

He has also expressed a strong interest in inflation targeting,
suggesting a longer term low inflation rate consistent with
assuring a stable, growing economic environment. This will not
be an easy sell at the Fed, since many on staff will be tempted
to say that they have been endeavoring to do that. Bernanke
wishes to de-mystify this process and to foster much clearer
communication with all constituencies. However, what most
interests me about the concept is that it may well free up the Fed
to use its tools -- rate setting, liquidity provisioning and
reserve regulation -- in more flexible and pragmatic ways.

Bernanke's practical and empirical approach is very congenial to
me and I am happy to give him the benefit of the doubt.

Inflation For Idiots

In its 9/05 CPI report, the Bureau of Labor Statistics again
but still belatedly acknowledged the growing impact of rising
fuel costs on inflation. The whopping 1.2% increase in the
monthly CPI puts the yr/yr rate of inflation at 4.7%. Note
though, that the BLS is still fibbing about the "core" rate of
inflation which it posted as 2.0% yr/yr. ("Core" inflation
excludes the volatile foods and fuels components of the CPI).
Apparently, no one at BLS ever goes shopping, because if they
did, they would know prices are popping up like dandelions in
springtime.

The statistical scam here, I think, is to more fully load the
fuels prices into the CPI first, which they are doing, and then
to start loading the effects of the several year fuels price surge
into the core, with the hope that the worst of the price surge
in the food and fuels component is now behind us. Then, as the
"core" inflation rate rises, the Street can say, "look the
leading edge of inflation is simmering down."

Now, don't get all indignant, Presidents have been cooking the
economic statistics for years now. Johnson and Nixon were
heavy handed chefs. Clinton was by far the most earnest and
attentive fibber, and George W. is just in-your-face cynical.
Fed chairmen from Arthur Burns to Greenspan have been their
willing accomplices.

Some of the idiots out there are going to try to keep the old
scam going. Here's Morgan Stanley chief economist Steve Roach:
"Energy is being driven by a unique set of forces -- supply and
demand -- that are not bearing down on other goods and services."
Guess Steve does not go shopping either.

So, where does all of this leave us? Well, based on 4.7% inflation,
Fed Funds should be at 6.5%. Long Treasuries should be at 7.5%
and the p/e ratio for the S&P 500 should be 15.3X with an index
value of 1146. Interest rates are so low relative to these indicated
levels because rates are being priced off the low "core" rate readings.
Depositors are being ripped off and bondholders are surrendering
wealth after taxes on the income streams are figured in.

I am expecting fuels prices to ease because those markets should be
coming into better balance. I also expect the "core" inflation rate
to go up. For example, US produced auto prices have returned up to
ordinary retail from the employee discount levels. Moreover, the
BLS will have to start showing the effects of higher fuel costs
on all items or the fib will grow too large to correct without major
dislocation.

My best guess now is the CPI, measured yr/yr, will slowly drop back
into a range of 3-4%. From my perspective, that implies that interest
rates remain too low and that the current market p/e of 15.9x estimated
12 mo. operating earns. through 9/30/05 is reasonable.

Realistically, given the hanky panky with the inflation rate,
each player has to decide for himself or herself what a reasonable
inflation estimate is and factor that into his/her return
expectations for the capital markets.

Stock Market -- Technical

S&P 500: 1177

My primary technical indicator gave me a sell signal on 8/16 with
the S&P 500 above 1230. I paid it no mind because I could see the
market in a compression zone. I got a short term buy signal on
9/6 with the "500" at about 1215 and ignored it as well for the
same reason. I then got another sell signal on 10/4 at 1214 on
the index. This one is more worth notice, because it heralded
a break down from the compression zone and raised the question
of whether a more substantial decline might lie ahead,
with the prospect of the "500" falling to about 1075.

For fundamental reasons I have been playing only with pocket
change since March, 2005, so I am not at risk on the long
side. Moreover, we have moved into respectable oversold
territory, so I am not contemplating a short position.

I have not yet given up on the idea we remain in a cyclical
bull market, which makes me doubly loathe to short this baby.
So, I am going to see how resolution of the oversold
develops before taking action, although my sense is the
time to trade has drawn nigh. Frankly, I also remember my
days on Wall St. where we had a amusing rule: Sell on Rosh
Hashanhah (10/4 this year) and buy on Yom Kippur (tomorrow
10/13). It's a fun contrarian rule if you know the holidays
and not a bad one at that. So, I'll wait to see what the
next few days bring.

US Economy

Since this spring I have been pointing out that the
Federal Reserve was engaged in a classic form of
Greenspan fine-tuning, to wit, gently but persistently
raising interest rates and curbing basic monetary liquidity
with an eye to slowing down the economy enough to produce
a flattening of or deceleration of inflation pressure.
The Fed also desires to raise short rates enough to restore
a better balance between savings on the one hand, and
consumption/investment on the other.

A slowing of economic growth was a "gimme" since it had
already began decelerating even before the Fed first swung
in to action in mid-2004.

The Fed, as discussed in past months, has not had any real
luck with the rest of its plan. Inflation pressure has
accelerated and broadened, and there has not been enough
of an incentive created to get folks to boost savings.

When I extend present trends on the relevant economic
charts, I see we are headed for trouble by the end of the
second quarter, 2006. By then the US would be at effective
capacity, inflation pressures would have intensified
further, and short rates would have reached levels high
enough to curb credit demand and produce an economic
retrenchment. This scenario would be entirely
consistent with development of cyclical bear markets in
both stocks and bonds prior to yearend, 2005.

And, as we have seen in recent weeks, investors are
already beginning to shade the market multiple and to
push up yields.

I have also argued that the Fed should be moving in
50 basis point increments with Fed Funds, but that appears
to be neither here nor there as things now stand.

I am standing back from the bearish scenario because I
suspect fuel prices have risen to levels sufficient to
induce rising conservation and a rethinking of household
and business budgets. My best guess is that should
such eventuate, fuel prices would roll over and come
down substantially from present levels. This adjustment
would temporarily pressure economic momentum but might
allow the US to escape far more serious trouble next
year. I also need to direct attention once more to the
continuing very low growth of productive capacity, which
in turn puts more of the weight on demand suppression,
if the US is to escape a nasty time.

Short term, I am going to be focusing on commodities
prices, the leading inflation precursor, and on personal
consumption factors, for these are the two spots where
it can best be determined if the softer landing can be
achieved. At this stage, a pick up in the growth of
productive capacity can only be devoutly wished for.

Stock Market -- Technical

Well, my momentum and internal market supply / demand
measures continue to show a pattern of compression which
could extend up to another 2-3 weeks. I have avoided
trading since early August, since the extended compression
period has left me bereft of a sense of direction.

My guess is that to have a positive breakout from this
compression interval, we may need to see a rotational
change in leadership to groups that might benefit from
a weakening of oil and gas prices. The prevalent
psychology in the market is that the fuels sector has
advanced enough to damage profit margins for a broadening
array of companies, enough so that improving margins
for fuels producers will be more than offset by reduced
profitability for net fuels consumers. Players have also
been shading the market multiple to reflect expected
higher inflation readings near term. Thus a rekindling
of positive momentum of oil and gas prices and the
energy stock complex could produce a fuels led rally
that might not lead far at all, whereas as a rally
led by beneficiaries of lower fuels prices could be
explosive.

But first, let's get through the compression period.