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.