Stock Market Profile

S&P 500: 1220

I continue to employ a "pocket change only" exposure to
the US stock market. We are well past the low risk / high
return phase of this still extant cyclical bull market.

Risk to the market continues to rise, but in fairness to the
bullish, the risk is coming up from extremely low levels seen
in Q4 2002. Moreover, confidence in the economy remains fairly
high as well. But it is not the type of "easy money" period I
favor.

My S&P 500 market tracker stands at 1150. It declined sharply
with the surge of the CPI in September to 4.7% yr/yr. I have
given some thought to smoothing out this unexpectedly large
lurch in the CPI to give the market a somewhat higher multiple,
but decided not to so as to avoid fiddling each month with
the inflation input. I doubt we will see yr/yr inflation stay
at this high level for too long, so the value of the market
may be understated at 1150 or 15.3x current operating earnings.

My earnings model has been holding up well, but there has been
some internal slippage, as the continuation of reasonable top
line or sales growth is increasingly more dependent on pricing
rather than volume growth. Cost inputs remain under control
reflecting good productivity growth and mild wage/benefit
pressures. So, many companies should still be experiencing
profit margin expansion.

To qualify as a "normal" cyclical bull market, the S&P would have
to reach 1360 by year's end or early Jan. 2006. Statistically, that
is a tall order at this point. The earnings underneath the market
have held up very well, but the market p/e ratio has been clipped
by the acceleration of inflation starting in mid-2004.

I have not given up on this market yet. With the overall operating
rate for the economy below 80%, we are far below effective capacity
and not in imminent danger of over heating. Secondly, the progress
of the market relative to a broad liquidity measure such as M-3
has not been so strong to date as to leave one concerned.

So, there is plenty of upside, but to realize it, the surge in
commodities inflation which has been driving inflation higher needs
to at least level off so that the Fed does not have to put the
economic expansion at ever greater risk to choke inflation pressures.
For now, the drivers in the commodity sector are fuels -- oil and
natural gas. We are in a seasonally weak period for fuels right now,
so a better test of the power of fuels pricing trends likely awaits
the closing days of 2005 and early next year.

I have been looking for weakness in oil and gas prices, but the
declines to date off the Katrina induced highs have fallen short
of expectation. Recovery of US production has been slow, and OPEC's
solemn promise to boost its output appears to have been a bluff.

I am guessing now that late January, 2006 will be a critical time for
the market and for the Fed as that will be an important window to
measure continuing inflation pressure, economic progress without some
of the recent distortions, and the arrival of new Chair Bernanke.

More on the stock market in upcoming days.