Out Of Synch?

My view for some time has been that we would have a period
of slower economic growth and lower inflation over the 2nd
half of 2006. Inflation potential has diminished significantly
although you cannot take it for granted, since the acceleration
of inflation in this cycle has been driven by commodities prices,
which are inherently more volatile than the broader economy. I
foresaw slow economic growth but no recession in the cards.
In the US, recessions begin after the economy has hit effective
capacity, overheats and undergoes a liquidity squeeze engineered
by the Fed and carried out by the banks and credit markets. No
such conditions hold sway today. There is still idle capacity,
inflation is set to cool and the banks have money to lend.

As expected, the leading economic indicators have weakened, not
enough to signal a downturn, but enough to raise eyebrows. My
view has been that lower inflation would boost real incomes,
confidence and spending before the ax fell. The inflation
primarily reflects hoarding and not overheat. I am
staying with this view and will sweat it out for a while.

To compound my felony, I have posited that 2007 would see a
stronger economy, re-ignition of inflation, and an end to the
"pause" period by the Fed. Next year is a between elections year
and may be an ok time for the Fed to go after inflation further.

Unlike most observers, I expect the stock market to progress in
a reasonably steady manner through the end of this year into the
beginning of 2007 before a top of consequence ensues and the
broad market falls by 15-20% as the environment turns hostile.

The more standard view of the market's prospects is for a rather
weak September and early October followed by a rally of substance
that could carry well into 2007, if not beyond.

One lovely thing about this business is that you get to see whether
you were right or not and to what extent.

I wrote this little screed because it was on my mind and I knew
it would bug me every time I sat down to write something. I am
going to let go for now and re-visit the projection around the
end of the year.

Geopolitical Tension Eases

The Iranian response to the UN Security Council package
re Iran's nuclear enrichment program was accompanied by
wide ranging war games in Iran and not further provocation.
A round of diplomacy may lie ahead as neither side has
definitively closed the door to further discussions.
The tenor of discussions on both sides suggests each is
laying the groundwork to blame the other if it winds up
that Iran moves on with its enrichment activities and faces
sanctions of some consequence as a result. However, no
resolution of the issue is likely right away.

The UN must accelerate efforts to bring a large multinational
force on board in Lebanon to defuse further the tension between
Israel and Hezbollah. So far, both sides are acting with
reasonable forbearance.

My intent is to get back to trading.

Oil Price ($72.65 bl)

The foiled terror plot to blow up in-flight commercial
aircraft scheduled for intercontinental transit from
London to the US created concern demand for J-9 fuel
would fall sharply and turned a normally seasonally
strong month into a weak one for oil -- at least month
to date.

The crude price has bounced this week from an oversold
and must hold $70 - 72 over the next month to maintain
the fierce uptrend underway since the spring of 2003.
Crude has also dropped inside the upper channel line
for its advance running back to 1999. Crude has had
trouble holding above that latter line for long since
the year 2000. Importantly, the issue of whether crude
can maintain the super strong three year trend or will
slide back into a much broader trading range could
well be decided over the next two months.

From a long term perspective, the seasonal outlook for
crude strongly suggests weakness from now through the end
of October. However, that could obviously change if the
US hurricane season spawns a bad one that damages
production or if Iran and the UN Security Council tangle
badly in the weeks ahead. The point here is that some
special event or series of same will likely be needed to
keep crude strong through October.

Envisioning Goldilocks

The stock market as well as bonds are buying into The
Fed's view of a slowing of economic growth coupled with
less inflation pressure. I focus on stock market factors in
this comment, as I am still not interested in bonds, which
I see as overvalued.

My SP500 Market Tracker shows the following readings for the
SP500 (now 1295):

4/06....................1307
5/06....................1270
6/06....................1265
7/06....................1293
8/06..(estimated).......1325

The Tracker did catch the spring dip and the subsequent recovery
in the market. The model has steadily rising profits over this
period with the volatility entirely explained by changes to the
yr/yr CPI%. With the sharp drop of the CRB Commodities Index over
the past 5 days, August is at least off to a good start for a
favorable inflation reading.

By my analysis, the fitful rally underway since mid-June primarily
reflects short covering and the expenditure of portfolio cash
reserves. My broad M-3 equivalent money measure is up 9.0% yr/yr
through July, while the yr/yr change in the $ value of production
is up 9.2% over the same interval. Although this has been a good
environment for profits and dividend growth, the real economy has
drained liquidity from the financial markets. The bottom line
is that the stock market likely needs both slower growth and
inflation to sustain an uptrend.

Moreover, if the M-3 equivalent measure begins to lose steam, The
Fed will have to move in quickly to provide monetary liquidity to
avoid a squeeze. An easy way to turn a soft landing into a harder
one is for the Fed to be late with this step.

Inflation in the new century has been driven by commodities prices,
especially fuels. Because commodities are so volatile, stock
players need to remember that changes in the levels of commodities
composites can quickly add to or diminish stock values. Oil has
dropped about 10% in price over the past month. It is oversold in
a seasonally strong period at present, so stock players have to
watch it closely. Note, positively, that since the production side
of the economy has been growing faster than consumption in past
months, inflation does face a headwind until production and
consumption come into better balance.

The earnings / price yield for the SP500 is now 6.3% This compares
to a 5.1% yield on the 91-day T-bill (risk free rate). The spread
is positive -- normally good for equities -- but rather thin. So,
again we see the importance of maintaining reasonable growth coupled
with more progreess in reducing inflation.

The yield curve is flat. This does not bother me as long as the banks
are lending, and lending they are at a good clip. Note though that in
an economy where production growth slows, credit demands moderate
and banks get edgier about lending. This brings us back to the point
made earlier: The Fed has to be ready to move on a slowing of credit
demand and liquidity growth.

The moral of the story is that engineering a soft landing which segues
into a "goldilocks" period is no mean feat. Recognize the elevated
risk potential.

Brief Stock Market Note

Strong rally today. My basic trend index, which measures
demand vs supply in the market, has not yet turned positive
so I am on the sidelines. Geopolitical risk remains high,
although a significant short term component of that risk
will settle out if the cease fire holds in Lebanon.

Hezbollah did its jack in the box routine to unsettle Israel
and do some strategic damage as well. It has been a bust to
date. They failed to lure Israel in to a guerilla style
battle in So. Lebanon, hit Haifa but no other strategic
targets, and now face a 30K man armed force which will
take up residence south of the Litani. Iran has pumped
about $5 billion into this operation over the years and
when it really needed Hezbollah to distract Israel from
Iran's nuclear program, Nasrallah and the boyz flopped.
Iran may hold Nasrallah's tootsies to the fire in the days
and weeks ahead, as it plays out its own nuclear program
cards. So, Nasrallah may get another shot short term, which
means this situation could remain live.

Changing Tactics

The stock market did provide a profitable rally to trade
over the 7/18 - 8/3 period, for which I am thankful. But
my view is now more cautious for the short run. My basic
trend index -- which measures buying pressure net of
selling pressure and is not a price index -- has remained
in a waterfall decline since making its high on 5/9 of
this year. the main reason has been the strong down volume
behind the declining issues over so many days since 5/9. It
suggests a relatively steadily deepening oversold for the
broad market reflecting pressure on small and midcap issues
and positive rotation into the more narrow SP500. I have
no problem with a rotation toward big caps, but I do have a
problem when the key broad barometer I use does not confirm
a positive turn in the market. At this point, I think risk
a bottom and stay out of the market until my basic index
shows some authority to the upside. For reference, the
1700+ issue Value Line Arithmetic ($VLE), a non cap weighted
index, is a price index I like.

I am also happiest trading when things going on out there in
the world are not nagging at me. I am concerned about Iran's
adventurism in Lebanon and how It will express its decision on
the incentives vs sanctions deal re its nuclear fuels program
set for Aug. 22. My concern here is that Iran, now on quite
a geopolitical roll, will overplay its hand with consequences
not good. This is a personal decision and not one I would offer
as advice to others. I have no insider insights to share on
this, just a deep concern.

If in the interim the market gets itself into high gear one way
or the other, I may trust its wisdom and play. But for now I
am in cash and on the sidelines until the geopolitical faultlines
clarify some. I will of course keep up the blog.

FOMC Meeting

The several cyclical indicators that correlate best with
changes to the Fed Funds Rate all remain strong, although
growth momentum has either rolled over or is peaking. By
my reading, the FOMC should elect to raise the FFR% yet
again.

Should the Fed elect to pause the FFR% at the present level
or perhaps signal a pause is in effect after one final boost
today, they would be operating more on an economic forecast
than on data in the can. Such a move would not be without
precedent, although the Fed usually prefers not to use a
forecast as its decision tool. The forecast that might drive
such a decision would be that the slowing of housing and
consumer spending is sufficient to lead to a slowing of
manufacturing and production growth coupled with an interim
peaking of capacitiy utlization and an eventual sharp
reduction in the growth of business short term credit demand.
These are realistic expectations, but one may have to allow the
FOMC leeway to seek a little more in the way of confirmation.

Gold Comment ($660oz.)

Gold has entered its strong seasonal period to reflect
higher commercial demand for the forthcoming holiday
and South Asia wedding seasons.

My macroeconomic gold price indicator, which went flat
for several weeks right after gold came off its May, '06
parabolic top, is again trending up, albeit modestly.
This model suggests a fair value for gold of $515 - 520oz.
With the global economy to slow further, the best bet
to keep the indicator trending up in the short run is
if oil, also in a seasonally strong period, continues to
advance.

In a 7/6/06 note on gold, I mentioned that gold would be very
overbought if it rose from its then current price of $633 up
to the $665 - 670 area. It did, and the profit takers came
in with a vengeance when the overbought was achieved.

With gold now in the $660 range on a rising 200 day M/A, the
upside limit goes to $685 - 690. First of course, gold would
have to push through last resistance up around $670.

Now that gold is off that parabolic run, traders are resorting
to more normal technical disciplines. This factor plus the
current elevated price of gold relative to fundamentals suggests
continued price volatility likely lies ahead.

Stock Market

I started out the year thinking the SP500 would wind up
2006 up about 12% to 1400, and that progress to that mark
would be relatively smooth. I have been around far too long
to take projections of this sort too seriously, preferring
instead to re-visit them for diagnostic purposes.

Right now, the market is running about 4.5% behind the
projection on a straight line basis. Given moderate volatility
standards, that is no big deal. However, the diagnosis is
of interest. The economy and corporate earnings have proceeded
about as expected. Inflation has been stronger than anticipated,
with the prices of oil and gasoline the main culprits. This
latter development has resulted in some additional shrinkage
of the p/e multiple.

Now, the economy is slowing reflecting further weakness in housing
and sluggish consumer spending. No surprises there. With the
consumer and housing slow, the production and business service sectors
can be expected to follow suit. Yr/yr % earnings comparisons will
dwindle some in the second half of the year, but the chances for a
strong market would still be pretty good if inflation pressures
were to diminish. That would allow the Fed to pause rates and
would bolster the case for a significant bump up in p/e.

The strong trend of commodities prices during the current economic
recovery has added substantially to corporate earnings, particularly
in the areas of oil and gas and industrial materials. But this same
trend has also driven the inflation rate up, resulting in
retardation of the p/e multiple. As it now stands, the strong
price trend for the commodities market overall remains in place.
Now a downshift of inflation normally follows an economic
slowdown, and there are still five months to go in 2006. At the
same time, I would have to say that the tenacity of the push in
fuels and materials prices has been something to behold, especially
since bull moves in commodities can be easily tripped up by the
development of speculative inventory imbalances.

Looking toward 2007, I am still of the mind that a decline approaching
bear market proportions is in the cards. I am guessing that the Fed
will pause short rates before this critical November off-year
election, but that It will resume raising rates at some point
next year as the economy again strengthens and inflation pressure
resurfaces.