Oil Market & Sector

The peak driving season is well underway in the US, and
afterward, in the autumn will come the heating oil season.
In keeping, oil has entered a period of seasonal strength
which can run late into autumn. The oil price bulls are
out in force and the stocks are drawing more enthusiastic
support from analysts and pundits. There's the hurricane
season to worry over and, just to make it interesting,
the heavies on the Security Council have asked Iran to
respond to their proffered basket of goodies vs. sanctions
proposal re Iran's nuclear fuels program by July 5.

The hurricane season is a case of que sera sera. Iran
reacted positively to the goodies, but has been stalling
on responding, so the first pressure point there in a while
comes up this next Wed. the 5th.

This seasonal period for oil may be interesting not only for
issues that may affect supply, but demand as well, as an
uptrending price may, at some point, trigger much more
vigorous conservation efforts which could well come on top of
slower global economic growth. Demand for oil has been
taken as relatively inelastic. Nothing could be further from
the truth. Folks everywhere now know that the real price of
oil has jumped and shows no sign of receding. So, if you are
long the oils and the service companies keep the demand side
of the equation in firm view.

Investment managers tend to sell decelerating earnings
growth. Since oil stock earnings are very leveraged to
price, oil not only needs to rise in price this season, it needs
to rise a lot, say to $80 - 85 a bl. by late 2006 to keep the
yr/yr earnings momentum of the oil stocks at a high enough
level to maintain solid outperformance relative to the broad
stock market. That's another good strategic reason for you to
watch how demand responds to price.

To stay in the powerful uptrend underway since mid-2003, the oil
price needs to stay above $68 a bl. in the month ahead.

Now, a couple of charts. The first is a daily for WTI crude. Sure
enough, the bulls have kicked off the season. Note the nice upturn
of MACD, but note as well that the price is approaching a short
term overbought and important resistance. Click now.
The second chart is a weekly of WTI. The top panel shows the
52 week price momentum.

Monetary Policy

The FOMC is widely expected to raise the FFR% another 25
basis points to 5.25% tomorrow, 6/29. The cyclical case
for higher short term rates is still in place based on data
at hand. However, with the leading economic indicators
now signaling more modest growth ahead, a further increase
or hikes to the FFR% cannot be taken for granted beyond
this end-of-June meeting. The Fed will have a battery
of flash reports for economic activity in June to look
over at the meeting, and this fresh data can be expected
to color comments released with the rate decision.

On the liquidity front, the FOMC has tamed the Greenspan
volatilty in the Fed.'s portfolio and in the monetary base,
with both now trending in line with a shift of restrictive to
neutral. This is a favorable development from a tactical
point of view.

US Economy

Following the devastation of hurricanes Katrina and Rita
in the twilight of 2005, most economists posited a sharp
rebound over the first half of 2006, as business returned to
normal and large storm damage insurance and Federal Gov. funds
went to work. And, that's exactly what we got, with the
yr/yr dollar value of production rising to a strong 8.6%. The
Federal Reserve did not "mop up" any excess liquidity, but
the real economy did. With production growth rising faster than
capacity over most of this period, inflation accelerated, driven
by already high global operating rates for oil and industrial materials.

Unwisely, I suspect, analysts raised earnings estimates for both
2006 and '07, based on the strong showing of the economy over
most of the first half of this year.

The shorter term economic indicator sets I follow point to slower
economic growth over most of the rest of this year. Moreover,
my longer lead time indicators also point to moderation of
growth ahead.

I watch the trend of capacity utilization very carefully, because
that is a critical variable for the Fed in setting monetary policy.
In the wake of the 2001 recession, capacity utilization dropped
to nearly 74% by early 2003. Those very low readings were the
worst since the brutal washout of 1981-82, and reflected a steep
decline for US manufacturing. Since Q2 '03, the US operating rate
has recovered to nearly 82%, and if the recovery trend continued
as is, the economy would hit effective capacity and strong overheat
conditions by the end of 2007. The main or underlying reason has
been the slow growth of capacity in the wake of such a steep
recession for manufacturing.

A six to nine month slowdown for the economy would take some of the
heat off inflation potential. Moreover, capacity growth may accelerate
in the interim since producers may not want to risk the chance of
losing market share a year or two out because they have no new
capacity to meet a higher level of orders.

I think the scheme outlined above is pretty much what the Fed is
aiming for. To stay out of the political fray, the Fed may want to
pause raising the FFR% ahead of Nov. '06 elections. That would
give them 2007 to tighten further if need be, so that when the
2008 presidential election rolls around, they may again be able
to stay out of the political limelight.

My shorter term inflation indicators have softened in June, and
the longer term reading continues to show a moderate downtrend.
But these are volatile series, with a wide band of commodities
prices playing a major role. In this regard, it is easy to see
why the Fed has insistently jawboned the commodities markets in
recent weeks. Breaks in oil and other key materials would make
the Fed's job easier.

Just A Thought....

Well, the gold munchkins will not be calling Mr. Bernanke
"helicopter Ben", at least for a couple of weeks. And, Maria
Bartiromo, CNBC's sensuous, langorous reportress, may even
be having second thoughts about getting Ben all riled up
with her scoop about his feeling misunderstood concerning
the implications of monetary policy. The aftermath, of
course, has been the "Maria bears all" episode for the
markets.

Wait, there was a thought here. I got it. I suspect the main
target for all the tough Fed talk about inflation is the price
of crude oil. It is a primary capital input for many businesses
and when it inflates, the effects are infectious. The boys at
the NYMEX were planning a glorious run for crude this summer,
what with the hurricane season and Iran tripped out on its
show of power. Good for the NYMEX guys and the oil producers,
not so good for most of the rest of us. And so the Fed, knowing
the market is currently awash in crude, may have taken aim at
this market, hoping to scare folks away and induce a sell-off.
That would also help a little to unsettle Pres. Ahmgonnabebad of
Iran. Just a thought....

Gold -- $608 oz.

Gold macro fundamentals turned up sharply as early as 1998
and were strong through 2005, save for the 2001-2002
recession period. The main factor has been the inflationary
growth of central bank credit, followed by the price of oil
which rose an unexpectedly strong 65% since the end of 2004.
I believe a temporary sharp jump in Federal Reserve Credit in
the wake of Hurricanes Katrina and Rita helped spark the recent
gold mania. Without good productivity growth in the US, China
and Japan during the current global economic expansion, US
CPI readings could be steady at 4.5% instead of the 3.5%
average.

My gold macro indicators have started slowing in 2006, and
have not had anywhere near the momentum to support the parabolic
run in the gold price up to $732 oz. in May. As expected over a
$100 per oz has come off the gold price since then. The Fed
presently plans rather moderate liquidity growth, and global
system liquidity growth could be further constrained by
evidently growing liquidity tightness in Japan and the ECU.
Moreover, the US trade deficit has recently flattened out, which
crimps liquidity flows in emerging economies especially.

A major issue in the US concerns the continuing strong growth of
real estate lending. It should start slowing soon as housing, the
major sector, has been weakening. BUT, it has not shown up yet.
This keeps credit driven liquidity strong. The Fed has been allowing
basic monetary liquidity to inch up to counter an expected slowing
of the broader credit driven liquidity. This may be smart policy as
it will allow a smoother transition to a milder Fed policy once
private sector credit reacts to a slowing US economy. The growth of
the broad money supply has supported gold, but this may end as the
economy loses some more momentum.

On balance, the macro fundamentals suggest an eventual further retreat
for gold, perhaps down to the $525 - 550 oz. range. This may not
come immediately as gold has found trend support at $608 and is
heavily oversold short term. Moreover the hurricane season is here and
resolution of the course of Iran's nuclear fuels program remains
unresolved. Under circumstances of damaging storms and/or a decision
by the UN Security Council to reject Iran's position and impose a
program of economic sanctions, we could easily see spikes in oil
and petrol which might entice the gold players to run the market up
again. Finally, my macro indicators are cyclical and do not cover the
large grain markets. It's quiet there now, but you never know.

A short term bounce in gold is growing overdue. Since the metal has
not tended to make gradual tops or bottoms in this cycle, I have been
using the 5 day M/A against the 10 to tell me when a turn may be at hand.

Fedblitz

Over the past week or so, Fed governors have painted the
news tape with speeches focused on the economy, inflation
and the US dollar. Analysts and pundits have had to scramble
from one speech to the next to look for nuggets of info and
hints about monetary policy. By design, the speeches have
featured different shades of emphasis and perspective. This
is an old Fed tactic which they deploy to tell people to
lay off them and start doing their own homework. What prompts it?

> Scrutiny by analysts becomes so intense, it is intrusive.

> The Street, the media and financial pundits shift from analysis
to trying to shape the Fed's agenda and manage them via pointed
editorializing.

> The chairman comes under personal attack for not telling analysts
what most might want to hear.

When the governors pop off and seem to be all over the map, their
intent is to wear out the horde that is reading the semantic tea leaves
to elicit policy info.

This device often works because so many Fed watchers do not have a clear
understanding of how the Fed actually develops and implements policy.

Fedblitz

Fed governors have been painting the tape over the past
week or so with a variety of comments about inflation, the
economy and the US dollar. In some cases, perspectives and
conclusions differ.

This is an old Fed tactic. It grows out of resentment that the
Street, financial pundits and investment managers lately have been
on their necks like white on rice, following every word, exploring
every nuance and, sin of sins, have been trying to manage
Them by continually setting the stage and trying to lay down
the rules of engagement. It is a transitional economic environment
yet the players want the definitive word. So, the Fed puts out
lots of views instead. The message? Back off and do your own damn
homework.

The Fed is also running another little caper here. On balance,
their remarks have been hawkish on inflation, especially Bernanke's.
The game here is to intimidate the commodities markets by talking
tough and keeping them off balance. The Fed wants to verbally
squeeze the speculators for added effect to compliment a slowing
economy.

Stock Market -- Fundamental

S&P 500: 1275

The fundamental models I use continue to put fair value
for the "500" at 1290 - 1320.

The models point to rising value. At the same time the
gauges of market risk are also on the rise, although not
yet at critical levels. So, the reward vs risk profile
is deteriorating although still positive.

Both short and longer term economic indicators point to a
return to more moderate growth. My profits indicators likely
made an interim peak in April, but still look solid. What
I do not like here is that analysts are raising estimates
for company earnings for both 2006 and 2007. Up earnings
are still indicated, but I suspect this is not a good time
to be raising estimates.

The case for a cyclical rise of interest rates has been
unabashedly strong since mid-2004 (Unlike Uncle Al, I would
have pushed up rates faster, but so be it). Now however, the
case is starting to weaken some. Manufacturing new order rates
are losing steam, and the yr./yr. growth of commercial and
industrial loans, although still strong, may well have rolled
over. The indicators still point to a 25 basis point upmove
in the FFR% for late this month, but the case for an additional
push beyond that is getting a bit "iffy."

Most disturbing near term is the upturn in the shorter term
inflation measure reflecting the recent rises in oil, petrol
and base metals prices. The longer term read on the indicators
is still tilted toward less inflation, but with atlantic hurricane
season here and Hurricane Khameini whirling in Iran, the outlook
is, shall we say, open.

This is not an easy time for investors in stocks to keep their
confidence levels up. Economic growth is going to slow, it is
a little early to be calling for a pause in the short rate uptrend
and there is uncertainty regarding the outlook for inflation in
the weeks ahead. Expect more volatility as investors struggle
to master this transition period.

Stock Market Update: S&P 500 -- 1278

Short term, the SP500 has been stabilizing in a range 1260- 1280
following the sharp drop from the early May interim high. Now at
the high end of this tight range, the market has moved up from
moderate oversold levels. My favorite indicators are headed toward
positive, and a break and hold above 1280 would turn the standard
MACD positive. That, in turn, might invite in some more money.

In quick review, the cyclical bull remains intact, reflecting trend
and the direction of the 40 and 69 week M/As. Six week measures of
the NYSE A/D line and market momentum are down but both have held
important support on a daily basis. The six week measure of internal
supply/demand is even-steven, but may tilt up some this week. The
market has been below its 13 week M/A for two weeks, and it could
easily stay down for another two based on experience in the current
bull campaign. The 14 week stochastic -- a good measure of bottoms --
is close to registering a full oversold. My 13 week momentum
oscillator has turned down, but it shows no break away yet. In sum,
there has been intermediate term damage, but no decisive break.

I had been expecting a sharper downward break in the "500" to the
1180 - 1200 area reflecting very strong overbought readings in the
leadership of the broad market and the period of extended breadth
and momentum compression that preceded the recent correction. The
market has failed to comply so far and is near a short term move
to the upside. I will likely wait a few days for confirming signs
before I would initiate a long position.

I plan to update on fundamentals in the next post.