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.