Stock Market

Well, there has been a roundtrip back to the Jan. / Mar. '08 closing
lows. The rally off the Mar. lows was a bit of a rocket, but it lasted
a couple of months and provided solid trades. The news needed to
ratify it as the opening run of a cyclical recovery -- evidence inflation
was set to moderate plus evidence that earnings would soon be
turning the corner -- was not forthcoming. So, the market has fallen
back.

There could have been a panicky downside breakaway move today,
but there wasn't. There could have been a hard driving rally off
important double support, but there wasn't. The SP 500, now near
1280, is deeply oversold on measures out through six weeks and
down enough to perk up trader interest. Guys who are thinking
"nice oversold and a triple bottom, no less" may be prepared to
move right in on Monday, an hour or two after the opening.

For my part, I think I'll wait a week or two. Today's wind up just
above '08's closing lows is too pat for my taste. Moreover, I would
like to see how much punch the bears have left in the short run,
and whether the bulls are more discouraged after a deflating round
trip.

I am also interested in whether this week's "in your face rally " in
the oil pits will go anywhere. They have called the Saudis' bluff and
have given an increasingly agitated US Congress the finger. Given
the damage a new and strong oil price breakout may do economically,
it will be well worth a look to see if producer and consumer leaders
are willing to turn a little nastier, and to what effect.

I have all my deck furniture spruced up and set up. The glass pitchers
are ready for whisky sours and vodka collins's. I have some nice hand
rolled leaf and my lighter at the ready. That's where I'll be this
coming week.

Monetary Policy

As expected, the Fed kept the FFR% at 2% today at its FOMC
meet. No surprise there, and no surprise on the more hawkish
talk about inflation (See 6/16 post).

Looking at the long history of the Fed's decisions regarding the
FFR%, this latest pronounciamento puts them about where they
should be, and maybe 25 bp. to the low side.

A current favorite among the pundits is that the Fed is "between
a rock and a hard place" or "caught in a box". The news here is
that the Fed is always between a rock and a hard place, since it is
charged with fostering full employment economic growth and riding
herd on inflation.

So, It is on now to incoming data. This being a national election year,
the Fed is going to be keen to see whether the current round of tax
rebates can spark an economic rebound over the summer.

Gold Price ($892 oz.)

The gold price remains in a well established long term uptrend
which is supported by my macro and micro economic indicators.

Since topping the $1000 oz. mark in March, gold has diverged
negatively from the fundamental indicators which have remained
in uptrends. This is the first substantial such divergence since
the bull run for gold started in earnest in 2001. It appears to
reflect a pullback from a super extended position for seasonal
reasons coupled with development of an interim bottom in the
value of the US$ following the Bear Stearns rescue.

By my dim lights, gold goes into bubble mode above $1000 oz.
It is interesting that after topping that milestone, gold has
retreated instead of taking off. Well, despite the recent correction,
gold remains in mania mode nonetheless.

My macro and micro economic indicators are attuned to the gold
price as an inflation hedge. I do not include currency values in
the calculations. That would be redundant from an inflation
hedge perspective, but not so in the case of financial crisis, when
there may be flight from a range of currencies.

As of now, the fundamental inflation hedge oriented indicators
suggest gold should be at a new high. With seasonal commercial
demand set to strengthen, it will be interesting to see whether gold
can regain the high ground, or whether this current consolidation
process is a prelude to the discounting of weaker commodities prices
and lower inflation in a more sluggish global economic environment.
In this regard, a break in the gold price below the $850 level might
be telling.

For a weekly gold chart, click here.

Jidda Bugs

Oil producers and consumers meet in Jidda, SA this weekend to
hash over the oil market. Since it's the king's dime, the Saudis
can be expected to put out an ass-covering spin, and also to
announce another moderate hike in production. On background,
the Saudis maintain they can add 500k bls daily production this
year to bring them above 10 mil. daily in total. They also claim
that by later in 2009, new fields output would give them production
capability of 12.5 million bd. More than a few think they are
using funny leaf in their water pipes.

At any rate, if the producers / consumers are smart, they will look
for ways to insure greater spare capacity than the current 2 mil
bd, whch has been a linchpin for the run up in the price. And they
will look at agreements to secure production when disruptions
could be at hand. A little co-noodling here and perhaps a dash of
fraud in the way of arriving at a larger surplus production estimate
would help. If the Saudis do have the goods, this would be a good
time for them to show off to the arriving poohbahs.

If I was in attendance, I would also urge the producers and the
major consumers to start fiddling in the oil and dollar futures
markets to make the speculative ride in these markets grow more
painful to the folks who have had rather a free ride for years now.
Periodic bloody noses for the hedgies, indexers and pension funds
might just build some respect. Unlikely? Maybe. But lots of guys
in the room can deliver and take delivery on crude and currencies,
and dropping a few $bil in the process may be much cheaper than
what transpires if oil remains on its happy course skyward.

The oil market is now range bound between (roughly) $130 - 140 bl.
The sharp intraday volatility of late reflects uncertainty in the
market. If Jidda is to be more than a Saudi PR show, the boyz in
attendance best come away with some actionable ideas to create
pain and suffering for the long side only whiz kids.

Notes on Profits, Economic Liquidity

Corporate Profits

Measured yr/yr, the $ value of production came in at 4.1% for May.
This matched the April reading, and the two months taken together
suggest that many US companies are experiencing intensification
of downward pressure on profit margins in the quarter. Even
offshore operations, where yr/yr physical volume comparisons may
be better than in the US, cost pressures are nibbling at margins.
The exceptions would continue to be primary materials producers,
many of whom have maintained pricing power that compares
favorably to cost pressures. In all though, and looking ahead to the
release of Q 2 results in July, we may find more somber reading.

Economic Liquidity

I like to compare the yr/yr change in the $ value of production with
the yr/yr change in the broad measure of financial liquidity to see
how much of the financial resources are being claimed by the real
economy. For May, $ production was up 4.1% compared to 5.1% for
the liquidity measure. The 1 point spread for May compares to a
5+ point spread in favor of liquidity over much of the middle part of
2007 when the stock market was strong. Now, the liquidity tailwind
for the stock market is far more subdued.

The modest readings for profit margins and economic liquidity
reflect a continuing sluggish economy, elevated inflation pressure and
the effects of the subprime fiasco on the banking system.

Interest Rate Comments

Of late, Fedspeak has been hawkish on inflation and has spoken
fondly of the US Dollar. Itchy trigger fingers? Well, inflation has
exceeded the Fed's expectations, and the economy has not yet
developed the deeper weakness the Fed has feared.

For example, take the ISM survey of manufacturing. This broad
diffusion index made an expansion cycle low of 48.3 for 3/o8. A
reading below 50 on this index signifies contraction, but it
usually needs to fall below 43.5 and stay down for awhile before
recession is confirmed. Importantly, it is rare for the Fed to
elect to raise short rates before a recovering ISM index breaches
54 on the way up. If the Fed stays true to its longer term behavoir,
the ISM index (now 49.6) and other critical data such as the capacity
utilization rate would suggest a FFR% increase could be down the road
some, especially since it is not clear that the economy has bottomed.

The entire Treasury yield spectrum has risen since the March
shotgun marriage of Bear Stearns / JP Morgan Chase. The 91 day
T-bill yield has moved up sharply from a panic low of 0.5% to nearly
2%, or in line with the Fed Funds Rate. Comparably, the 30 year
Treasury has jumped from 4.11% to around 4.80%.

Quality spreads at the short end remain quite elevated and are in
line with recession levels. So too at the long end. The panic in the
wake of the subprime bust may be over, but most players are
indeed conservative and are not yet avidly chasing yield.

The Treasury market is too low in yield relative to the inflation
rate. A 2% bill is a loser compared to the recent 4% yr/yr CPI
readings, and the bond market puts you out over 20 years just to
earn modest amounts in real terms. You have to assume that the
big money which needs to own Treasuries to match liabilities (such
as retirement funds) is hedging with oil or gold or other commodities.
So too, foreign players may also have been carrying long
euro positions on top of inflation hedges.

To wrap up, I have long found it tiresome to try to psyche out the
Fed. It is understandable with the run up in oil et al that They
would like to get back to spotlighting inflation. But well observed
history says that action to match this new yearning is premature.

Stock Market

Back on 5/29, it was noted that the stock market rally off the March
lows was discounting both an economic rebound and a moderation
of inflation, and that good news in both categories was needed "very
soon" to hold the rally in place. The news since has suggested the
advent of neither. Fundamentals are not good for short term
timing, but it was obvious back then that the rally had traveled a
fair way without the kind of positive news it needed and that
investor and trader patience was getting thin.

Now we have a substantial short term oversold developing, and
a further drop in the SP 500 from today's 1335 close down to
1320 or lower would yield the kind of decline that shorter term
players might well find interesting for a week or two play on the
long side.

The daily SP 500 chart is linked below. Note the RSI is moving
toward a tradable oversold. The chart.

Stock Market -- Technical

As discussed in the 5/27 post, the short term outlook for stocks
had turned shaky, as one could see the 10 and 25 day M/A s set
to roll over. And so they have on the SP 500, with the market now
mildly oversold in the short run.

Back in late May, it was mentioned that the market was also
working off a powerful intermediate term overbought (6 - 13 wks).
That has been completed and we are now neutral on the
appropriate oscillators. I am a little concerned about the 14 week
stochastic. That is on a mechanical sell (See chart link below). The
stochastic can whipsaw around, so I use it in conjunction with a
number of other measures.

From a trading perspective, I would not mind seeing the market
correct further as that would set up a decent short term long
trade. But alas, not being a timer, I would have to say the
intermediate indicators are in a "no man's land" as far as direction
for the next several weeks is concerned.

On a long term basis, the SP 500 is going to need to rise above 1400
and stay there from here on out by mid - 2008, or else the secular
bull case will need some significant revision in terms of the plot
going forward. With 1982 as a base, the secular case is fast fading.
However, I have long preferred the 1987 low as a base because so
many fundamental pro-earnings growth changes were implemented
in the corporate world in the wake of the '87 debacle. Since breaks in
a well established long term price trend should never be ignored,
we have a topic that will require more discussion as the year
progresses.

The weekly chart for the SP 500 is here.

Economic Indicators

The weekly leading indicator data sets fell very sharply from
06/07 through the end of Feb. but have stabilized since. In
line, the monthly data -- built primarily around new order
measures -- has moved up some off the Jan. - Feb. lows.

The weekly data indicates a US recession is a lead pipe cinch
based on historical comparison. The monthly data is holding
well above recession levels so far. The monthly lead indicators
suggest a slightly weak economy with a large and growing
export book offsetting much of the pronounced weakness in
housing and autos.

As mentioned earlier in the week, global supply management
surveys indicate sweeping increases in costs. Productivity
remains strong, but indications are that profit margins are
continuing under pressure.

The underlying economic power measure for the US -- yr/yr real
wage growth plus total employment growth -- looks to be around
-0.3%. This number understates potential now because it does
not factor in the current round of tax rebates and because the BLS
admits it may be overstating job weakness for seasonal reasons.
All that said, short term growth potential remains very subdued.

A massive short squeeze and some dumb, threatening remarks
by Israel's transport minister Mofaz directed at Iran pushed the
oil price to a record $138 today. This gets the inflation thrust
measure off to a strong start for June. Isn't it interesting how
quickly folks come out to kite the price when there is some
weakness? Not long back Goldman's guy did it and this week it
was Morgan Stanley's guy with a $150 call for July 4. If I was not
such a supremely dispassionate and logical guy, I'd be inclined to
say there is a concerted effort to push oil higher.

Inflation -- Longer Term Potential

In recent years I have discussed in this blog how a strong upturn
of commodities prices, particularly oil, initializes an acceleration of
inflation. I am comfortable utilizing this approach to projecting
inflation in the near term, but not in the long run. For longer term
inflation potential, I prefer to work with long range broad money
growth detrended by real economic growth potential. Forget this
method for short run forecasting and also realize that other
credit and economic factors can work to bring in longer run
projections well off the mark.

For money, I use M-2 (cash, checkables, household savings and
money market funds). I detrend 10 year growth with 10 year
real GDP growth potential. Since the 1950s real GDP growth
potential has dropped from 4.0 % to 2.8% currently. From 1989 -
1999, detrended M-2 growth was a scant 0.3%. Inflation pressure
subsided, interest rates fell, and the stock market p/e ratio soared.
However, from o5/'98 through 05/'08, M-2 detrended grew by
3.5% per year. Thus, the US, thanks to Uncle Al, has transitioned
into a moderately inflationary environment, with sufficient excess
liquidity to support the tightened supply/demand fundamentals in
the commodities markets, and re-launch a new inflationary epoch.

As it turns out, the CPI over the past 3 years has averaged close to
the 3.5% mark as indicated by the model. Since 10 year M-2 growth
does not change that rapidly, the 3.5% benchmark is likely to be
around for a while.

Interestingly, there are monetary and credit factors at work now
that may reduce inflation pressure going forward. One is the now
nearly $700 billion blowout in the commercial paper market over
the past 10 months. This has led to a large decline in the growth of
the broader measure of credit driven liquidity. As well, monetary
liquidity, which influences the cash and checkables component of
M-2, has been growing very slowly for several years. Note though,
that these measures need time to work.

This is stuffy stuff, so fear not, I shall not belabor you with it
often.

Inflation Situation

The inflation thrust indicator through May was again very strong
on a yr/yr basis and is consistent with 12 month readings on the
CPI of 3.5% - 4.8%. Inflation pressure still stems largely from
the powerful uptrends in energy and other commodities indices.
An array of purchasing management surveys show that an
ever increasing majority of companies are paying higher prices
for materials and services, and this, on a global basis. So far
in this global expansion cycle, the pass through of the longer
run surge of commodities has been muted, but as more
companies face profit margin pressures, pass through will come
easier as the costs of maintaining or increasing market share
pile up. Wage pressures in the large block of OECD economies
have remained subdued, to the detriment of household buying
power. Sluggish Western economies reduce labor mobility, but
when faster growth does return, mobility will pick up swiftly
and the cheapskate companies will start losing their better
people, the threat of outsourcing notwithstanding.

Short term, the energy markets -- oil, gasoline and natural
gas -- are all extended even against powerful uptrends. This
does leave the door ajar for some inflation relief, if only
seasonally.

At some point ahead, the major emerging economies like
China and Brazil will feel the effects of the slowdown underway
in the large developed economies. Perhaps then operating
rates for a broader range of energy and industrial commodities
will begin to decline. Interestingly, US primary materials
providers were still operating well above long term averages
through April, '08.