Uncle Al Warns.......

Mr. Greenspan, speaking by satellite hookup to a business
conference in Hong Kong, warned the US economy could surprise
and slip into a downturn in late 2007. My guess is that
Greenspan is reminding Fed chair Bernanke and the rest of
the FOMC not to fall asleep at the switch as the year moves
along. As recently posted, the time honored indicators of
Fed policy are currently pointing toward ease. These
indicators -- the ISM mfg. survey, production and the operating
rate and the balance of supply and demand for credit were
mainstays for the Greenspan Fed. As I have pointed out a few
times, The Fed would prefer not to have to ease until later this year
if then, as they continue to weigh the viability of the soft
landing of the economy. Greenspan did note that the housing decline
has not yet had substantial spillover effects on the economy. His
concern is with manufacturing. See further.

Inflation Indicator Ticks Up

The inflation indicator has ticked up in February, reflecting
higher crude price realizations and strength in the industrial
commodities composite. The crude picture partly reflects colder
than normal weather in the US but likely also belligerent talk
from both the US and Iran re: Iran's nuclear enrichment program.
Iran loves a higher oil price and the oil patch pals of GWB and
The Shooter do not mind it, either. 'Tis not smart for the US to
get too verbally nasty because these are tender moments for the
economy. The oil market is not overbought, and there is resistance
all the way up at $64. Yr/yr price momentum remains negative and
thus is a continuing drag on industry profits. Oil chart.

Stock Market Technical Note

The work I do with unweighted composites suggests that the
broad market is a little extended short term but not overbought.
The SP500 needs to end next week ahead of today's 1451 close to
hold a decent trend.

My intermediate term (13 week indicators) now clearly suggest the
rally underway since 6/06 has entered a topping phase. This need
not be cause for immediate concern, since, by these measures, a
topping phase can take up to 6-8 weeks to complete.

Stock Markets

US Fundamentals

My Market Tracker implies the SP500 should be trading at
1535 rather than the 1460 it closed at today. The Tracker
has risen rapidly since June '06 reflecting rising earnings
and a sharp bump up in the p/e ratio owing to a substantial
deceleration of inflation. The p/e on the "500" should be
around 17.5x but is down at 16.6x (12 mos. eps through Jan.).
However, the p/e on my larger 1,750 popular stock universe
is 18.9x. So, I conclude the market is a little richer than
fairly valued. In turn, the SP500 is trading about 11.5%
above my long term dividend discount model. Not a big
premium, but a premium nonetheless. I also look at the
market against the progress of the monetary base. The base
is rising -- a positive -- but not nearly as fast as the
market. This means investors have become increasingly
comfortable with an economy and market riding heavily on
credit driven liquidity, which happens to be rising
faster than the economy itself -- another positive. By the
same token, the risk level in the market is rising owing
to that increased dependency on liquidity, since it can
evaporate in a slow economy. I conclude that although the
fundamentals are tracking positive, there is little
value and rising risk.

The Shanghai Express

I have received over twenty e-mails since year end 2006
alerting me to a parabolic rise for the Shanghai Composite.
Most of the guys who sent e-mails along are greybeards like
me and are getting a big kick out of it. For a peek, check
here.

This parabolic looks very nearly complete. Most parabolic
trends end in a blowout, although such need not be fatal
as there can be a bounce back. Interestingly, the Shanghai
could fall 40 - 50% over much of the rest of the year and
still be in a longer term bull market. This market is not
one I follow closely, but it sure looks like there
could be some volatility ahead. It will be fun to watch.

Monetary Policy

Weakness in production, declining capacity utilization,
a narrowing of producers with a positive outlook, a
flattening of short term business credit demand. It's
what the US has now and long term Fed practice clearly
suggests a cut to the Fed Funds Rate. The tenor of recent
comments by chair Bernanke and others on the Board point
away from a rate cut. Current Fedspeak says rates may have
to be raised if inflation surprises to the upside.

What gives? My guess is the Fed sees the run offs of excess
housing and goods inventories as the prelude to eventual
recovery of production and later, housing investment. So,
the Fed is forecasting that rising final demand for
consumer goods, services and exports will lead to this upcoming
recovery of production and housing. Implicit of course, is the
notion that weaker production and housing will not produce
increases in joblessness and weakened confidence that could
bring the economy down. The Fed may also not mind if the economy
stagnates for a few months, if it makes it easier to squelch
inflation pressure further and create enough slack to goose the
economy later this year for a clean run through 2008.

Whatever, the Fed may be waiving off long standing practice and
you should keep that in mind in assessing the outlook for both
stocks and bonds, since the dynamics of the US economy can
fool the best of us at moments like now.

Liquidity Factors

With new bank concerns having surfaced regarding the sub-prime residential
mortgage market, it is timely to benchmark the various liquidity factors.

Monetary Liquidity -- Here we look at the building blocks of the basic money supply: Fed Bank Credit and the Monetary Base. The Fed has kept a tight rein on these composites for over two years to enforce the raising of short term rates and to maintain the current structure. Over the past year, Fed Credit has increased by 3.7% and the monetary base has risen but 2.2%.

Credit Driven Liquidity -- I use an M-3 analog to capture bank system funding. Since early 2005, this composite has increased from a twelve month growth rate of just under 5.0% to 9.4% through Jan. 2007. the major step -up in the growth of time deposit and commercial paper issuance has been to fund a sharp acceleration of commercial and industrial loans ("C&I"), but banking system real estate lending exposure has also continued to grow at a 10%+ rate as well. The slowing of the C&I sectors of the economy over the second half of 2006 resulted in reduced working capital requirements and has resulted in a flattening of C&I loan demand. It will be interesting to see whether concern over lending exposure to the residential mortgage market triggers a slowing in the growth of the banking sectors' real estate book. If the latter were to occur along with a more leisurely pace of C&I lending, funding requirements would slow, credit driven liquiditywould decelerate and the Fed might be forced to add more monetary liquidity to the system. A transition of this sort can be risky business for the general economy if the Fed delays too long.

Economic Liquidity -- I derive this measure from comparing yr/yr rates of growth of the M-3 analog with the $ cost of production growth. When the broad money supply grows faster than the $ cost of production, excess liquidity is generated in the system, and this excess can fuel speculation in financial markets where there is already positive interest. There has been a surge of excess liquidity since mid -2006, reflecting a modest pick up in broad money growth and a sharp deceleration of current dollar production growth owing to downticks in unit production growth and a sharp deceleration of inflation pressure. This development has no doubt helped the stock and gold markets, but since the money and production growth measures are dynamic measures, you have to monitor their interplay continually and be careful to watch for trend inflection points.

Trade Driven Liquidity -- This is a simple measure to monitor the gross dollar outflow from the US as a result of the trade deficit. When the dollar outflow is rising, it provides additional liquidity to the international economy and markets, and when it contracts, the opposite occurs -- all with a lag. The dollar outflow through the trade window remains very large but has not increased over the past fifteen months or so. This development suggests it is fair to temper one's thinking somewhat concerning international economic and market prospects.

Economic Indicators

The leading indicator sets I follow point to continued
economic growth paced by consumer spending, export sales
and the service sector. The housing sector is continuing
to work off a still sizable inventory overhang, mortgage
applications remain range bound, and new concerns about
the sub-prime mortgage market will no doubt lead lenders
to tighten standards further, at least for the short term.
The manufacturing sector has shown an improvement in $
order levels, but only about half of the group is recording
improving order flow. On the plus side for goods producers,
distributor inventories have accelerated a run - off which
can set the stage for a rebound. On balance, growth potential
looks to be about 2.8 - 3.0%.

The longer term inflation indicator fell sharply again in Jan.
but is bouncing up here in Feb. on the sharp rise in oil prices.
A turn to unseasonably cold weather this month is helping this
market, and requires close scrutiny as a run up in oil cuts
into real consumer incomes -- the bedrock of the current period
of economic growth.

Stock Market -- Technical

The powerful, compact uptrend that began in mid-July '06
was destroyed by a brief, fast sell-off in late Nov. But
the market righted itself and has embarked on a new uptrend
running from 11/27 through the present. The momentum is
decent but less ambitious than the Jul.-Nov. run. In
both runs, the dips have been bought quickly and so have
been shallow. The surges up are moderating, as profit takers
are moving in more quickly as the rally goes along. On
balance, the advance has been orderly and disciplined, with
none of the divergences evident that would signal a speculative
blowoff. Sentiment measures are bullish enough to warn, but
are not yet egregious.

The rally blew right through the seasonally shaky days of Sep.
and Oct. February is a seasonally weak month, and attention
should be paid. From a cycle perspective, the latter part of
March may hold even more risk of some damage.

An intermediate term overbought condition developed in late
autumn of last year, but this was largely relieved by the
sideways action running from mid-Dec. through mid-Jan.
However, the strong price action in the composites since
the end of January has re-introduced an overbought and has
turned my breadth model and my favorite non-cap. weighted
index, The Value Line Arithmetic ($VLE), short run over-
extended.

Short term, I like to watch the market against its 10 and 25
day M/A's. In a rising market, a break below the 25 day M/A
catches my attention, particularly if the "10" follows suit.
See here.