Stock Market -- Fundamentals

Well, the SP500, a laggard during this cyclical bull run,
closed at a record 1532 today. The Market Tracker has the
SP500 fairly valued at 1540 - 1550 through July. It appears
investors are still comfortable with a 17 p/e based on
rolling twelve month earnings and an inflation assumption
of roughly 3%. Measured yr/yr, the CPI has been running a
little below 3%, but the market has yet to show an appetite
to factor in a lower inflation rate.

SP500 consensus earnings are projected to rise 7.3% in 2007
and then crack the century mark in 2008, with a 12.6% rise
to nearly 106.00. Earnings acceleration is projected to
begin late in 2007 and carry over into next year, with
expectations for telecom and tech earnings leading the way.
Implicit here is a moderate acceleration of US economic
growth and decent global growth.

My inflation indicator has picked up some so far in 2007,
primarily because of a surge in US gasoline prices.
However, the indicator is still relatively quiet. Given
how commodities have driven inflation in this current
expansion, it is understandable that investors have a
conservative bent regarding inflation expectations.

The market's earnings / price yield has dropped to 5.9%.
The premium to the 91 day T-Bill is slightly over 100 basis
points, and the e/p yield premium to prime commercial
paper is a scant 65 basis points. The narrowing of these
spreads points to increasing market vulnerability to a
rise in short rates.

The SP500 price premium to the SP500 price level implied
by my monetary base model is rising significantly and
reveals growing market dependence on credit driven liquidity.
No problem so far, but risk from this measure is rising.
Keep in mind also that an acceleration of economic growth
coupled with even a mild pick up of inflation pressure can
rapidly use up the excess liquidity now being generated
through the credit window.

Stock Market -- Psychology & Technical

No momentum this week, so a day of profit taking was
in the offing. But there was also a frisson of concern
as well. What if the economy is close to re-accelerating
and perhaps doing so in a less than benign inflation
environment? That could freeze the Fed. Worse, the Fed
could tighten down the road...This little thought is
supported by data showing strength in orders and home
sales as well as a weakening bond market and a slight
tilt up in the dollar. Even the gold bugs are showing
hesitation. Well, it is worth keeping in the back of your
mind.

Most know the market got itself overbought and extended and
that a key indicator -- MACD -- has turned down. Watch the
market against the first two lines of trend defense -- the
10 and 25 day moving averages. Here is the SP500 chart.

If a correction is about to unfold, the 10 day M/A will turn
down, break below the 25 and lead both down behind the market.

Gasoline Price

The price of gasoline has been an important inflation
driver in the US this year. Ostensibly, supply has been
constrained by a series of spot refinery outages. The
futures contract price for gasoline is juicily volatile
and, interestingly, is looking overbought, with an MACD
near the top of the scale and with yr/yr price momentum
high but past a recent peak. Check $GASO.

Stock Market -- Longer Term Perspective

With 1995 as base year, the SP500 is tracking an 8.8% positive
trendline, right in line with earnings. Coupled with a 1.8%
yield, the implicit return is 10.6% per year. I have assumed a
3.0% inflation rate to compute the multiple. So, the market is doing
fine, based on trendline growth of 8.8% and a moderate inflation level.
Now, it is critical to notice that 8.8% growth is well above the very
long term norm of 6.0 - 6.5%. Over the past 10-15 years, ROE% has
risen strongly up to over 17%. The dividend payout rate on earnings
has dropped below 40%. With a high plowback of earnings, the SP500
has implied eanings growth potential in excess of 10%. Most companies
generate more cash than they can profitably re-invest, so they buy
back shares and generate acquisitions. Balance sheets are stronger
now but are still aggressively managed. Many companies could pay out
more in dividends without harming growth, but since senior management
bonuses are so often tied to maxxing out eps, they keep more cash.
Companies have also been skimping on capital expenditures, but there
is still excess capacity in the system.

US only earnings growth has decelerated with an economic slowdown, and
this has recently lead to greater interest in the big multinationals
which have large foreign bases of revenue and have been benefiting
from a moderately weaker US$ and faster offshore growth.

This longer term view of the market helps drive home the point of
the need to recognize how the market has been led by a historically
rapid rate of earnings growth backed by high growth corporate financial
internals. Fretting bears have consistently missed the importance of
a powerful earnings trend, and longer term bulls risk taking this
performance for granted.

When I look at companies, I am more interested in return on total
assets (ROA%) than ROE%, since companies can pump the latter through
borrowing and share reduction. In looking at ROA%, I am interested
not just in a company's ability to maintain profit margins but asset
turnover -- sales divided by assets. You would be surprised how many
companies can cover over declining asset turn with increased leverage.

Liquidity Check

The Fed reversed the big infusion of two weeks ago, so the
growth of monetary liquidity remains modest. The temporary
liquidity injection may have added modestly to the basic
money supply, which needed a transfusion.

The broader, credit driven liquidity measure I utilize did
accelerate markedly in April as banks returned to the
real estate market and C&I loans moved up. Yr/yr, my M-3 proxy
is now up 10.2%, high, but in line with the growth of short term
credit demand. Seasonally, we are moving in to a stronger period
for home sales, but I was still a little surprised by the
size of the move up in the real estate book.

The financial system is generating more liquidity than is required
for current dollar economic output, leaving excess liquidity in the
system to fuel financial and commodities markets in favor. since
the volume and diversity of derivatives also continues to grow there
is rich leverage behind the markets. On top of this, the US trade
deficit widened in March, sending more $ abroad. To this hefty brew
we can add the new rule change in China which allows its commercial
banks to diversify IM accounts away from Chinese securities (It will
be interesting to see whether the "big" money in China starts to
exit Shanghai and Shenzen to leave the smaller retail accounts holding
the bag.)

There is a small but growing chorus of markets observers who are
starting to warn of the risks of markets inflated by credit driven
liquidity. I have mentioned a number of times that markets powered
by credit driven liquidity are riskier than when markets are supported
by monetary liquidity growth. In the latter case, you have central
banks on your side.

One economic possibility that all need to watch concerns the US. If the
domestic economy re-accelerates and there is a little bounce in inflation
pressure as well, the excess liquidity will fizzle quickly, gobbled up
by the real economy. I have been cautious on stocks this year because I
am interested in seeing how well the balance of economic supply and
demand may shape up once the economy shakes off its torpor. So far, that
concern has proven premature given a sluggish environment. Perhaps worse
for me, I may well wait until autumn to see whether the cautious approach
pans out or not.

Shanghai Express -- #2

There is a link to the Shanghai Stock Composite at the end of
the post. As all but the dead know, this market has been in a
very sharp parabolic upmove since early 2006, as China's retail
investors rediscovered their market following a long drought.
There is a mania underway. To qualify as a bubble under my
tough parameters, the SSEC, now just over 4000, will need to top
6700 by late 2008. That is a tall order after the run-up so far,
but a true bubble is far more spectacular than most realize.

There is long term trend resistance by some measures in a range
of 4000 - 4200. A tightly drawn parabolic curve had the market
topping out at prior trend resistance of 3350 in March, but
the market has taken that all out in a nearly vertical assent.
There is a broader, looser parabolic loop that has a top up
around 4500. Suffice it to say, this is a doozy of a mania.
Moreover, despite mentions of mania and bubble in the Chinese press,
the folks are still flocking in to open accounts and buy.

It is worth watching, not only because it is exciting, but because
the Chinese authorities could, at some point, try to stop it. And
this could involve policies that might reverberate in other markets.

I warned several times over the years that when mercantilism turns
greedy as it has in China, temendous mania activity and eventual
financial and economic dislocation can occur. And here we have a
case where rampant real estate speculation has shifted to the
local equities market.

Keep a weather eye on this baby. The SSEC

FOMC & Monetary Policy

Most observers expect the FOMC to leave the Fed Funds rate
(FFR) unchanged at 5.25% at tomorrow's regular meeting. The
key data I track for monetary policy trended down over the
second half of 2006, but have stabilized recently, particularly
capacity utilization and manufacturing activity. It should be
said that the Bernanke Fed may have diverged from the Greenspan
Fed in electing to hold the FFR% at 5.25% despite evidence of
a weakening economy over Half 2 '06. I guess the Fed can coast
on this data for a while if it wants to.

The leading economic indicator sets I follow show a sharp firming
up for the month of April. As Aristotle liked to say -- one swallow
does not a summer make -- so the upturn needs to be carefully noted
but not raptured over. If the Fed does elect to mention that the
economy could be regaining strength in the FOMC meeting statement,
it could give the markets a shiver, since some players would
immediately conclude prospects for an eventual FFR% cut are out
while potential for a FFR% increase later in the year is in. So,
the FOMC wordsmithing tomorrow might be of special interest.

I also note that FOMC added substantially to its portfolio last week
both via outright Treasuries purchases and RPs. It is not clear
why they did this, although cash in the system is very low, and they
have been stingy in recent weeks. The Fed Bank Credit portfolio will
be worth watching carefully over the next week or two as well.

SP 500 At Fair Value (1500+)

The SP 500 closed above 1500 today, so I have it as fairly valued,
having caught up with the higher price level dictated by lower
inflation and a still positive earnings progression.

To stay in a bull market in the US, here is what is needed:

1) The US economy must gradually resume growth of about 2.75%.
SP 500 profits need to resume yr/yr growth of at least 8-10% well
before the year is out. This implies moderate pricing power at
the top line coupled with 1.5% productivity growth and continued
moderate wage growth. Look for continued share buyback programs
as too many companies have implied internal growth rates that
cannot be satisfied by internal investment (Book ROE% is high and
earnings plowback is high, yet the global economic pie is not
growing fast enough to accomodate internal redeployment of all that
capital).

2) Inflation must stay contained at 3% or lower when viewed on an
intermediate term basis. US economic growth of 2.75% will put upward
pressure on domestic operating rates. Thus capital investment must
expand rapidly enough to keep operating rates rising only slightly.
Capacity growth has been too slow to date in this current economic
expansion.

3) Further increases in the Fed Funds rate -- now 5.25% -- would be
an unwelcome development as it would reduce the relative attractiveness
of SP 500 ROE% at market value.

3) There are obviously a host of exogenous factors that could make things
better or worse, but factors 1-3 are the time honored critical ones.

Economic Quickie

The Inst. For Supply Mgmt. report on manufacturing turned
up sharply in April, signaling faster growth in this sector.
Most interesting was the very large increase in the breadth
of companies experiencing higher new order flow. This ISM
report can be volatile, so the very positive turn in the data
could be a fluke. However, since I use the ISM new orders indices
as leading indicators, I'll take it as a heads up on a possible
turn in manufacturing. The jump in new order breadth for April
breaks a downtrend underway for some time.

The ISM site is worth a tour. www.ism.ws