Economic Comment

The flash GDP report showed the economy grew at only a
2.5%AR for Q2, confirming expectations for a slowdown.
Viewed yr/yr, the broad economy grew by about 6.5 - 7.0%.
This compares to yr/yr growth of dollar production of
9.0% and suggests there is inventory in the system
which could be worked off in the current quarter via
reduced production growth schedules. In turn, that may
take some pressure off industrial commodity prices, but,
it will also result in potential earnings shortfalls among
the industrial and commercial service sectors.

The stock market also took heart this week from a weaker
oil price, which reflects growing appreciation of how very
high cover stocks are.

But note that the US is just moving into a seasonally strong
period for commodities and energies, so even though a slowing
industrial sector can weigh on the commodities markets, it
in no wise follows that significant inflation moderation is a
done deal. Click here to see recent April - July lulls in commodities
price action.

"On The Way.....Wait"

Grizzled army vets will recognize the expression above as the
communication by an artillery or rocket battery that a round has
been fired. Hezbollah / Syria / Iran are calling the shots in the
beleagured country of Lebanon at present. They likely have plans that
may scuttle the current round of negotiations regarding a ceasefire
between Israel and Hezbollah and open the way to further expose Israel's
vulnerability to attack from the north. I suspect Hezbollah may have
missiles that can be fired from well north of the Litani river and
which can strike hard well into the Israeli heartland. Such a development
would greatly increase tension and danger not only in Israel and
Lebanon, but beyond.

Iran bankrolls Hezbollah and is simply calling in markers -- "Time to
earn your keep." Syria is on Iran's pad, too and is in it for the revenge.
I believe Iran wants to show the West and others on the UN Security
Council just how much clout it can wield in the Mid-East. By putting
Israel in greater danger, its message is that it can cause profound
upset in this troubled region, and that the US and others must think
long and hard about the imposition of sanctions on Iran should it elect
to proceed with its uranium enrichment programs. In short, is it worth
a broad Mid-East war to sanction Iran?

Iran promised to respond to the UN sponsored package of incentives vs.
sanctions re its nuclear programs by August 22. That gives it a little
over three weeks to have Hezbollah further increase tension and peril
within the region. As Iran sees it, this will greatly increase their
bargaining power when it comes time to talk turkey on its nuclear
development.

I lay this all out to highlight the potential for sharply increased
volatility in the capital and energy markets in the weeks ahead. All
players need to be extra diligent about positions and interests as
events unfold.

Iran accuses the US and Israel of seeking to remake the Middle East
in a way that suits them. What we are seeing is blowback from Iran
and Syria as well as Iran's declaration that it is now to be seen as a
very big player in the region. If I am right that Iran has a nasty card
or two to play prior to August 22, market players must be prepared
for another round of escalation should Israel and the US decide on a
strong reaction.

I hope I am wrong about all of this, but it just seems like straightforward geopolitical hardball to me. It need not end badly. Iran, with its additional
leverage could secure a deal acceptable to all in exchange for curbing
Hezbollah and working to cool strife in Iraq. But, since no one player
controls all the pieces on the board, matters can slip out of hand once
Iran puts its next strategic piece into play.

Stock Market -- Technical

As discussed in the July 18 post, the broad market is oversold
and due for a rally even though the basic trend is weak. Analysis
is complicated by the fact of rotation. Risk aversion has grown
since the May 09 - 10 market top. Players have moved out of small
and mid-cap stocks more aggressively than they have with the large
caps, as represented by the SP500. Through Friday 7/21, The SP
Midcap was 12.8% off the May '06 high and the SP Smallcap was down
13.9%. This compares to a 6.4% decline for the SP500.

Going into today, the SP500 is up modestly from its 6/13 low and only
mildly oversold in the short run. The weekly chart shows a deeper
oversold on a 6 - 12 week basis. The broader market is deeply oversold
across both the short and intermediate terms, with the NYSE TRIN at
a high 1.22 for the 60+ trading day span since the May top. This reflects
the compressed strong selling pressure in the small / midcap universe,
especially among the cyclicals, including business technology.

Going forward, the case for a rally reflects the strong oversold condition
of the broad market plus entry into a brief seasonally strong period which
could run out through US Labor Day (9/04). The SP500 could provide
continuing leadership, as the mood of increased risk aversion may not
reverse so quickly.

My primary indicators show a down market. Thus even if a tradable rally
is developing, it is simply unclear whether it would be durable enough
to reverse the downtrend. The work I do with NYSE breadth measures shows
that selling pressure has been trending up since early in the third
quarter of 2005, while buying pressure has naturally been trending down.
Since these volatile trends could extend for another 8 - 10 weeks before
resolving, I intend to be reserved about making market direction calls
beyond the very short term.

Stock Market -- Technical (SP500: 1227)

Back in April, I mentioned that the stock market looked best
suited to go sharply lower. In May, I put a guesstimate of
1200 as a low point for the SP 500.

I am not a sharp enough technician to know whether the market
will drop down to 1200 or not. My work indicates that the
market is weak and is growing progressively oversold. My
quandary is that my primary indicators are pointing lower,
but some key measures of oversold conditions indicate we are
very close to a tradable low.

So, as a guess, I'll go along with the idea of a low in the next
four to six trading days followed by a healthy rally.

At any rate, I am looking to go long, but since timing is not
my forte, I will wait for an upturn and some confirmation that
long is the right side of the trade.

Window Into Vulnerability

Like many others, I have been keeping up with the geopolitcal
developments of the past few weeks. There were no real surprises
until yesterday when a souped-up Katyusha rocket fired by Hezbollah
struck well into the port city of Haifa. That Hezbollah and perhaps
Hamas might now have even mildly upgraded weapons systems puts a
dangerous new spin on the Israeli - Arab conflict.

Israel will obviously want to re-establish buffer zones in southern
Lebanon as well as Gaza. Moreover It must make a fresh assessment
of its vulnerability to rocket fire, and It will want to probe
Hezbollah and Hamas positions to discern whether It may be
subject to other upgraded weapons. At a minimum, Israel will
want to establish large enough buffer zones to better protect
population concentrations. The hits on Haifa put the President of
Iran's recent comments about the destruction of Israel and Zion
into a more concrete context.

Of course, Israel always knew this day would come, when its
vulnerability to larger scale destruction would become more apparent.
To me, it adds a major new element of uncertainty to the usually
precarious mid-east military calculus.

Perhaps near term Israel can chase Hezbollah and Hamas far enough
away from its borders to secure its position and bring the
several hundred thousand Israelis up from shelters. Longer term,
Israel will have to look at how it might disable these two
hostile factions because allowing them too much proximity to its
borders could prove extremely dangerous if we are at the beginning
of an era when terror can bring heavier destructive payloads.

The easy thing for a veteran investment professional and trader like me
is to sound worldy about the current crisis and advise that we have
seen it all before and to be ready to jump on opportunities that may
come up as geopolitical tensions further rattle nerves in the markets.
But, critical differences arise from time to time, and we may have one
now with Israel in a tighter squeeze than usual.

I'll be lokking at the markets over the weekend, but I plan to study
the Israel vs. terror groups conflict with even more emphasis.

Banking System

The investment portfolio of the banking has remained on the
flat side over the past year, with banks concentrating on
expanding loans and leases. The big movers have been C&I
(business) loans and the real estate book, with both advancing
13.5% yr/yr.

With indices of mortgage origination and refinance down
substantially over the past year, it is evident that banks are
growing market share in the financing of real estate. C&I
loans have reached a level relative to the banks' investment
portfolio, where it may be expected that banks may begin to
size up loan opportunities more cautiously as system liquidity
has run down rapidly since mid-2004. Liquidity depletion is
not worrisome and has proceeded in a normal cyclical fashion,
but it is time for a "heads up" nonetheless.

Banks have funded the sharply expanded credit opportunities with the
sale of jumbo deposits -- up over 20% yr/yr -- and commercial paper,
which has increased by more than 15%.

The Fed has eased up on the brake for primary monetary liquidity,
having moved from substantive tightness through most of 2005 to
a more neutral stance. So far, I would rate this a sound move,
as demand for short term business credit can run down quickly
once an economic slowdown takes hold. Failure to anticipate
such a development can result in a painful liquidity squeeze.

Gold Note ($633oz)

Both gold and oil are moving into strong seasonal pricing
periods that run from July into October. Commercial demand
for both strengthens into the autumn.

My gold macro indicator, which jumped higher last autumn,
has progressed slowly in 2006 and has been flat since the
mid-May blowoff top for gold. Since an economic slowdown
is developing and since the Fed has moved liquidity up
only modestly this year, the best bet for gold would be
a strong showing from oil and natural gas prices as we
progress into Fall.

I noticed in browsing various sites that bullish sentiment
for gold has jumped at an astronomic pace since the recent
quick bottom and upturn in price. The gold gurus have been
piling on to the bandwagon.

My micro economic work on the gold market puts fair value
at $450-460 an oz. The macro work puts fair value at $500 -
525oz. On a short term technical basis I have gold as strongly
overbought at $665-670oz.

Interest Rate Profile / Bond Market

By my nearly 100 year regression model of short rates vs.
the consumer price index (CPI), Fed Funds should be 5.75%
rather than the current 5.25%. The Fed is pricing off key
GDP account deflators which yr/yr have moved up to 3.0%
and suggest an FFR% of 5.25%. Since I believe the CPI,
despite its many flaws, is a more realistic inflation
estimate, I conclude short rates are still on the low side,
and provide a negligible incentive to save.

Based on data at hand, short rates should still be trending
higher. However, and as mentioned in the 6/29 note, such
may not be the case by the mid-August FOMC meeting, as the
economy is slowing. In fact, my bevy of cycle pressure gauges
are nearing breakdowns, signaling milder growth ahead.

The national yr/yr CPI through May is 4.1%, about the same as
for the New York metro area. With 4% inflation, there is little
incentive for me to buy bonds, and I have stayed away from this
market for over a year. With 4% inflation, I would like to see
a US Treasury at 7% instead of the current 5.27%.

The yield curve is essentially flat in the Treasury market. A
flat yield curve normally suggests a significant slowing of economic
growth is at hand. This is because a flat to inverted yield curve
signals a liquidity squeeze is developing and that credit
availability is coming into question. Such is not the case now.
The US economy is slowing, but credit remains ample. Thus the
flat yield curve represents not so much a dark view of economic
prospects as it does the opinion of the market that a moderate
economic slowdown will reduce inflation pressure and ultimately
allow the Fed to ease again. This is born out by the continuing
tight yield spread between top quality corporates and "A" rated
intermediate bonds. The forecast implicit in current bond yields
goes beyond what I would care to sign on to at present.

The long Treasury has been rangebound between about 4.25% and 5.50%
since 2003. The market has been very sensitive to the momentum of
production growth and the trend of industrial commodity prices over
this period. Accelerating production growth and rising industrial
prices have lead to rising yields, and decelerating production
growth and quiet or declining industrial prices have provided
the bond market rallies. We may be moving into a period of
lower production growth and quieter industrial pricing that could
last for several months. So, there could be a rally in bonds. I
doubt it will carry far if the Fed keeps short rates on a plateau
which I suspect is the course it will follow. A more powerful
bond price move could occur if the economic momentum decreases too
sharply, but my indicators do not suggest that drastic a slowdown
at this point.