Financial System Liquidity

Basic monetary liquidity, the most critical element to starting an
economic recovery, remains in growth mode. The large increase in
this composite over the past year brings the 5 year growth up to a
level sufficient to give the economy a fighting chance at expansion.
It also serves as a major positive fundamental for stocks, as rising
real M-1 lets you know you are betting with the Fed.

The broader measure of credit driven liquidity has continued to
decline and is now down about 1.6% yr/yr. The market for financial
company commercial paper outstanding has sunk another 38%
yr/yr or nearly $600 bil. as the shadow banking system continues to
be unwound. Large time deposits at banks have fallen nearly $200
bil. as banks let C&I loans run off and remain with a flat real estate
book. Even the massive M-2 money measure would be down were it
for the large growth of M-1 primary liquidity.

Both retail and institutional money market funds have declined in
2009. Some of this decline is attributable to the purchase of goods
and services by individuals and businesses, but with market short
rates near zero, investors have extended maturities to capture more
yield and have no doubt used funds to fuel the rally in stocks on
expectations of economic recovery.

Individuals have increased savings by over $500 bil. and companies
have added to their liquidity by slashing inventories, capital expend.
and payrolls. So, the economy does not need an ample supply of
private credit to fund economic expansion in the early stages.

Monetary velocity, measured in terms of the cyclical side of the
economy has plunged despite a 1.6% decline in the broad, credit
driven measure of financial liquidity. This has created a large pool
of liquidity that runs over and above the needs of the real economy,
and, as mentioned above, has fuelled the stock and corporate bond
markets.

The Fed and other central banks continue to maintain a network of
large currency swaps to provide liquidity to serve those trapped by
the major decline of global trade. Peak -to-trough, US dollar outflows
have fallen nearly 75% on a monthly basis as the trade deficit has
contracted substantially.

Credit quality spreads have narroweded globally and liquidity appears
sufficient to underwite the initial phase of global economic recovery.
Banking system liquidity is improving as loans run off, but capital is
still not adequate to fund an extended economic expansion.
However, in the US, rising business cash flow and the appearance
of stabilization in home prices will serve to ease the way for banks
to access the capital markets going forward.

Beach Days

The weather is simply too nice. As a retired gentleman of leisure,
I am taking full advantage this week and will not be posting on
the usual subjects.

Stock Market -- Quick Note

The steep sell down on Mon. of this week did wipe out the hefty
short term overbought. It is interesting that we have had "dip"
buyers in the aftermath, as there is rarely a shortage of guys who
say they will buy a dip, but do not. Volume has been light. The beach
days have arrived.

The market remains overbought looking out 30 days and longer, so
it is unclear whether the recent dip marked but a way station on the
way higher. Traders will be watching to see whether the current
bounce off the Mon. low carries to a new rally high and beyond with
any conviction.

Stock Market -- Fundamentals Profile

Observations

1. The market remains in earnings recovery anticipation mode. SP
500 eps for the past 12 months (7/31/09) stand at $39.70. Investors
are presently pricing in a return to $60. earning power, which
primarily reflects heavy cost cutting and slight growth just ahead.
(Q 2 '09 eps should come in around $14.)

2. On a very long term trend basis, SP 500 net per share for 2009
works out to $75. Using the same model, top-of-the-channel eps
would equal about $85. With 12 month earns running about 47%
below the "normal" $75., you get a good sense of how deep the
recession has been.

3. Investors have not changed the broader valuation framework for
the market during this steep downturn. Specifically, players are
pricing in a return to moderate inflation of 3.0 - 3.5% with economic
recovery and have ignored the mild 12 month deflation readings
witnessed recently. This is important. Should economic recovery not
occur and should deflation pressures continue, the market would be
vulnerable to a downward adjustment of earnings and fears that a
period of more prolonged deflation could signal a lengthy period of
sub-par economic performance. This kind of serious further downside
would not be a foregone conclusion, but it would be a reasonable one.

4. Looking out over the next year, the speed of global economic
recovery should be the dominant feature for the stock market. With
a lower cost structure evident, and with the SP 500 companies now
holding prodigious cash, there exists sizable positive earnings leverage
from economic recovery, even if it is mild in scope. With recovery,
profit margins will expand and earnings will benefit from cash mergers
and acquisitions.

5. Despite the rapid run-up in stocks since 3/09, the SP 500 price level
does not include a presumption of a sizable positive take-off in earns.
In my framework, players are looking at $60 earning power now, with
the potential to scale that number up if recovery does indeed take hold.
My thinking is that in a moderate economic recovery, expectations
for SP 500 earning power of $75. - 80. will take hold sooner rather
than later, and that the market would chart a course for 1250 - 1325.

6. The problems the banks and investment banks have experienced
coupled with exceptional weakness in sales over the past year or so
have left a residue of investor fear and no willingness yet to take the
concept of a decent global economic recovery for granted. We have
now entered a period where there is substantial downside price
risk to a failed recovery as well as continuing large upside price
potential should recovery proceed smoothly. This means that eyes
will be fixed on progress, and not just benefits from cost cutting, but
from a resumption of top line growth as well. Given this risk / reward
profile, there is good potential for elevated volatility over the next 6
odd months as investors monitor news carefully for indications of
progress.

7. The SP 500 dividend stands at $21.50. With recovery, the dividend
will likely increase to about $30. by Half '1 2011.

For more detail on SP 500 earnings, go here.

Coincident Economic Indicators

The CEI data sets I follow posted a small increase form the preceding
month in July, for the first month on month increase in the past 14.
So, the US economy appears to have expanded modestly in July.
On my indicators, the growth reflects a 0.1% increase in real retail
sales plus a 0.5% positive in industrial production.

This increase in activity came right on time relative to the turn in the
leading indicators. However, I would have to say that the gain in
inflation adjusted retail sales was quite low, and we are going to have
to see the pace of recovery in sales pick up markedly in the months
ahead if the US economy is to have anywhere near a normal first year
of recovery.

In passing, I would note that both US exports and imports did gain
in June (latest month available).

Measured yr/yr, the coincident indicators declined by more than
6%, reflecting deep declines in real retail sales and production. The
one bright spot remains the change in the real wage, which reached a
record high 4.6% for the 12 months through July. In past recoveries
a large positive change in the real wage of this magnitude would likely
have triggered much stronger consumer spending. But with the
depth of the recession coupled with large losses in home values and
equities portfolios, folks have skewed activity toward building savings
and paying down all manner of revolving credit. The balance needs
to tilt away from emphasis on liquidity and more toward spending
if there is to be a recovery worthy of the name.

I would note that the momentum of job losses is declining rapidly,
and more level sales and production could continue this sharp reversal
in job losses, as companies did make dramatic cuts to employment
and will not want to blow orders because they are short on people.

But, bottom line, I would chalk up July as a month favoring those
who are the more conservative regarding the economy, and this on
the basis of scant progress in real retail sales.

Stock Market -- Technical & A Note

The short and intermediate uptrends remain intact, although the
new intermediate uptrend line has not been tested since the SP 500
touched the 879 level on 7/10. (I link to the "500" chart below and
it features an extended MACD you might find interesting.)

The current shorter term upleg started on 7/13. Since then, the
SP 500 has shown hefty price momentum overboughts daily and
is now materially overbought on RSI (% of "up" days) as well. This
kind of strong positive action has trashed the shorts and has forced
many long side traders to chase stocks.

The market is also registering significant overboughts on breadth and
on positive spread over the 13 and 40 wk. moving averages. You have
to go back to the 1995 - 2000 period to recapture the upward drive
we have seen recently.

the SP 500 chart is here.

Note: On the fundamental side, the market has fully discounted the
positive bounce to earnings from sheer cost cutting alone. Extended
strength from here would imply players are moving on to the
assumption of the commencement of rising sales for businesses and
the prospect of improving profit margins.

Monetary Policy & The Banking System

The Fed has convened its normal 2 day FOMC meeting. The basics
for rate setting that I follow continue to point to maintenance of a
low short rate. Business activity in the US has moved sharply from
deep recession to sufficient breadth to be just below the expansion
threshold. Change has been very rapid so far in 2009. However,
expansion must proceed apace for at least several months before it
would signal it was time to raise rates. As well, capacity utilization
remains depressed and would normally be expected to improve
substantially before the Fed reversed course. Finally, the short term
credit demand / supply pressure gauge continues to move in favor
of slack, as C&I loans run-off as expected. So, a change in FOMC
rate posture would be quite a surprise.

Now, since there has been some inflation pressure from the petrol
sector, and, since economic recovery is now expected to begin sooner
rather than later, the markets and the many observers of the Fed are
likely to begin questioning how long the Fed may maintain its several
large liquidity injection programs. This latter issue is distinct from the
rate setting function, and at some point soon, the Fed may well have
to provide more specifics about keys to closing out these programs.

There is a potential kicker here for the markets. Fed diligence in
framing out how it will move to restore long term integrity to its
balance sheet could have significant consequences for the US dollar,
Treasury securities and precious metals and commodities prices.
The impact of Fed commentary on this issue for equities is less
clear, but could be important nonetheless. Bottom line: the Fed
will want to show it is supportive of recovery but is also increasingly
sensitive to restoring monetary integrity. The sooner it does this,
the faster worries of substantial eventual inflation should dissipate.

Banking system lending has been flat now since mid-2008. No
surprise here at all. A deep recession brings lower private sector
credit demand which can persist for a while even as recovery begins.
C&I loans are running off, the real estate book is very sluggish, and
home equity loans, which did spike up over Half 2 '08, have begun
to level off as borrowers grow more confident about the security of
those lines. The real estate book for the industry is now running
about $800 billion below the longer term trend.

Even with the loss of momentum to real estate lending, total bank
lending is running about $1 tril. or 17% above its 10 year trend. This
suggests continued vulnerability of the banks to further significant
loan losses ahead. Bank net interest cash flow has flattened out, but
bank profitability can still improve markedly if loan losses come in
below recent horrific levels. Capital remains level and system
liquidity is improving as borrowers rely more on their internal
cash flows.

Economic Indicators

Leading Indicators
The data, both weekly and monthly, continue to trend strongly
upward from the deeply depressed levels of late 2008 - early
2009. The data suggest the US economy is closing in fast on
expansion, with the global economy moving in a likewise fashion.
The same may be said for profits recovery. The volatility of the
indicators remains remarkable. My new orders diffusion index
suggests an expanding book of mfg / commercial business at 100.
It fell from 103.3 in 5/08 to a startingly low 73.8 in 2/09, but has
since bounced back up to 103.4 for July. The weekly and monthly
leading indicators are just now starting to show positive trend
reversals.

Economic Power Index
This somewhat longer term index foreshadowed significant
recession by falling from 4.0% (yr/yr) to -2.5% by 8/08. The
index then rallied sharply through year end on a powerful rise of
the real wage as hourly rates kept rising while inflation fell quickly
away. This exceptionally positive development did portend
eventual economic recovery in the US, which I hope is at hand.
However, as I have warned, the growth of wages in current $ is
slowing with growing slack in employment, and the power
index will falter more later in this year if the real wage erodes as
expected and if the drag effect of job loss momentum does not
abate. As of now, job loss momentum, measured month-to-month,
is quickly easing so that the yr/yr measure may soon show some
improvement from the current sharply negative -3.8%.

There are current offsets -- higher social security payout, tax cuts,
unemployment insurance and the ramp up of federal spending for
projects. Consumers also have the option to finance more of their
spending. However, over time, low or no real wage growth coupled
with a weak job market will not sustain economic expansion.

Inflation Indicators
The inflation pressure gauges I use have stopped signaling deflation.
These measures have turned up, and now suggest a return to mild
inflation (measured yr/yr) by late 2009. This development
underscores the need to see the monthly rate of job losses continue
to be cut very quickly as the year progresses.

Commodities Market

The CRB composite closed around 267 today, which puts it just
slightly ahead of initial long term resistance of 265 (dates back
to the latter 1970's). Interestingly, even if the CRB is poised to run
much higher, it may well test 265 as support before moving on.

Historically, commodities are most sensitive to liquidity and
monetary policy conditions and are likely to rise as central bankers
ease monetary policy. Commodities are also sensitive to a basic shift
in direction of the leading indicators, and have been particularly so
this year, accelerating when weekly leading indicator data reversed
positively during 3/09. All sensible enough.

The action of the CRB so far in 2009 has been somewhat unusual
in that the dramatic rise in the petrol sector, which has come early
in the new liquidity cycle, has provided it with a strong tailwind. So,
the CRB is perhaps a bit ahead of itself, to the extent that the oil
price has lifted off so early.

The broad commodites market has been deeply oversold over much
of the past 9 months, but with the rally since 3/09, it has tended to
veer toward modest short term overboughts. However, we have yet
to see the sorts of surges that signal too racy a market.

The potential for the CRB is to move higher in the context of an
expected continuation of monetary ease. But I would note that since
the weekly economic lead indicators have jumped so sharply, the CRB
could be vulnerable to moderation in the dramatic progress of these
indicators (there is some overlap between the two series).

I hope this post might prove timely in that the market is just a little
above long term initial resistance, a factor most well seasoned traders
will have in mind.

Recent CRB action here.

Stock Market -- Shorter Term Alert Still In Force

A modest rise in the aggregates over the past week keeps the
market in overbought territory, and it is extending out past
the very short term. In a strongly rising market, there can be
shorter term overboughts that can drag on for several weeks as
more players pile in from the sidelines to get on board. This type
of situation can be very difficult to short for a quick play, and it
can be frustrating for folks who are trying to maintain discipline
and buy dips that seem to be erased quickly. But best you know
that they have started to chase them a little bit.

On the fundamental side, the SP 500 is, I believe, now fully
discounting $60 a share in 12 month earning power, and further
near term upside would imply that players are moving beyond
recognizing earnings benefits of cost cutting to the expectation of
earnings driven more by a recovery of sales volumes. This is also
worth noting, since not everyone may be ready to make that transition
in their thinking, and so you have to realize there may be some profit
takers who may decide to wait for some confirmation of this
important transition in the weeks ahead.