Monetary Policy And a Stock Market Comment

Most everyone expects the Fed will leave the Fed Funds
Rate unchanged at 5.25% when the FOMC winds up a two day
meeting tomorrow. This time, the fundamentals the Fed tracks
most closely line up to support leaving the FFR% as is. I
doubt the staff at the Fed was happy to see the Board go
for the pause as early as It did, but the fundamentals have
followed.

The breadth of short rate sensitive economic growth experienced
a cycle peak in mid - 2004, just as the Fed elected to raise rates.
The deterioration of breadth -- number of industrial sectors
encountering slower growth -- has been more gradual than in prior
cycles when the Fed was raising rates. This large component of
the cyclical economy is now much closer to levels that would signal
the Fed it should reduce the FFR%. However, unless there is a sudden
steepening of the slowdown, the Fed may feel no compulsion to ease up
soon.

Looking more broadly, the Fed must contend with two factors. It
needs to make a guesstimate whether the economic effects of a
protracted but gradual round of tightening have been fully
reflected in the economy, and it also needs to study to what
extent the sharp recent deceleration of inflation may engender
growth via a boost to real incomes and confidence. Finally,
since available data indicate continued very slow growth of US
productive capacity, the Fed needs to factor in a longer range
inflationary bias to the economy.

The growth of monetary liquidity has all but halted since the
summer. The Fed has tightened on the liquidity front to counter
the acceleration in growth of credit driven liquidity reflecting
strong bank lending expansion. All well and good, so long as the
central bank remembers to reverse course if and when credit growth
slows.

The stock market is slightly less overbought in the
very short run, but is also now overbought on my six to thirteen
week indicators. Moreover the measures of sentiment I watch have
deteriorated as well. The trend is up but it is well recognized.

Leading Economic Indicators

The leading indicator data sets I follow continue to
point toward slow growth for the US economy. New order
diffusion indices covering both manufacturing and the
service sectors are positive but subdued. The recent
volatility in the services sector new order index is
interesting, because the sector has been more stable
than the more intensely cyclical manufacturing sector.
It may well be that the run-up in the oil price
experienced from late Nov. ' 05 through mid - July
took a toll on profit margins and confidence in this
sector, where pricing power can lag rising costs.

Stock Market Update

The SP500 at 1369 is now not only overbought short term,
but is getting extended as well. There has been talk that
investment managers could be ready to chase stocks, but
there is no evidence from the tape to support the story.
If managers are going to maintain discipline, the market
will struggle over the next week or two. A sharp move up
from here would be the first tangible evidence that the
tight discipline is breaking down. Back in my heyday as
a chief investment officer, it was great to see 'em go up
when they should, but annoying when your guys and others
would start chasing, since that could bring unwanted
volatility down the road.

Stock Market Overbought Short Term

The SP500 has reached overbought levels for the short
run. If you are a short term player, then take note.
Bring up the chart here.

Stock Market Update

The market has worked steadily higher through the
spooky season. Investment managers have shown remarkable
discipline, not chasing the market when it gets 2.0 - 2.5%
above its 25 day M/A, and coming back in on the dips.
So the pace has been cautious and deliberate, and chief
investment officers have had little to yell about. It
remains a low volatility period, plodding along in a disciplined
fashion. Portfolios are being diversified away from
energies and commodities as the relative earnings performance
of these sectors appears set to lag the broad market.

The Fed is on hold as inflation momentum dissipates and the
economy falls into a slower growth mode.Investors are slowly
and deliberately coming around to accepting a successful
soft landing and are beginning to look forward to a strong
seasonal period spanning November through January.

The Democrats seemed to have gained some momentum in recent
weeks, but even if they capture one or both of the houses,
the market will settle for a gridlock scenario.

There has been talk of an October surprise all year. In the
early going, it was widely thought that Bush/Rummy would
bring troops home. The gold bugs remain firm that there could
be a pre-election raid on Iran, but that situation seems to be
processing through the rewards vs. economic sanctions route
for now.

My guesses for surprises are November events -- more troops to
Iraq and a possible Rummy resignation, coupled with more intense
fighting there. These events could raise concerns about the
budget and the US dollar and might disappoint the bond and stock
markets.

For now, I am stuck with the soft landing picture, but one with
possible fiscal complications later in the year.

Economic Indicators

A look at the varied sets of economic indicators I track
shows we should expect further slowing of growth, but the
indicators have as yet to experience the sort of downward
break that would herald a severe slowdown or recession. As
one might suspect, the coincident economic indicators are
starting to flatten out and lose momentum measured year over
year.

The continuing rallies in high yield or junk bonds and in
intermediate corporates also indicate that investor confidence
in the economy remains intact.