Monetary Policy

Short Term Interest Rates
The Fed continues to suppress the very short end of the credit market and there is no firm
indication when It will lift the FFR%. Using a model based on 100 years of short rate,
inflation and credit supply / demand data, the 91 day T-Bill rate should now be around 2.2%
reflecting continuing low inflation but rising short term credit demand. So, the Fed, concerned
with idle labor resources particularly, now trails the curve suggested by the economy by a
significant margin.The hawks on the Board will press Ms. Yellen so long as the economy
does not regress to stall speed.

QE 3
The FOMC today cut the securities purchase rate to $25 bil. a month, on its way to zero later
in the year. Measured yr/yr, QE has added 24% to the Fed Bank Credit through late Jul., but
looking forward to mid - 2015, Fed Credit may well only be 2% higher if the economy holds
up reasonably. Thus, the economy is going to become increasingly more dependent on the
private sector for liquidity growth and as we look out a year, the likelihood grows that short
rates will also start to rise.

There are plenty of discussions out there as to when and and how fast short rates will rise.
I appreciate all that, but I remain keenly sensitive to how well business and investor
confidence hold up as the QE program unwinds to completion. So far so good.

China -- The Boys Have Fired Up The Dragon

Back in early Jun. I posted that the PBOC had turned accomodative with monetary policy
and that the equities market could eventually get interesting for a long side trade. See
China -- Big Red Dragon Getting Cranked Again

That post has a link to the Shanghai Exchange index ($SSEC). This post has a link to the
SPDR China ETF (GXC) which is light on liquidity but has given long side traders a better
bet in recent years than the Shanghai. GXChttp://stockcharts.com/h-sc/ui?s=GXC&p=D&yr=3&mn=0&dy=0&id=p71321227542

The GXC has quietly followed along with the SPX  since late 2011 as a beneficiary of QE 3
liquidity from the Fed while the Shanghai has continued to unwind from the 2006 - 07
major bubble. The GXC hit a record high just above the $100 mark in 2007 and there is
significant resistance now around the low $80s. It is an overbought index and could under-
perform the Shanghai going forward if the Shanghai gets some long missing manic action.
But, GXC has been a nice trade for which I thank the PBOC.

The Shanghai is getting itself overbought, too. Next resistance level for this guy is 2250 with
big time resistance set at 2450. Long time readers of the blog will recall that if folks turn
more serious about China being able to continue real GDP growth at 7.5% annually for the
next several years, that I think the Shanghai should trade up around 2400 - 2500.

If you read the early Jun. post, I argue that China has put its economy in harm's way far faster
than I thought it would. The PBOC may have to be on a loose  / tight policy treadmill to
wring out its badly overextended real estate markets for years to come. This imperative may
provide attractive capital markets trades both long and short over the next several years.

No Stock Market Bubble

There is no stock market bubble in place. For openers, the price trajectory of the SP 500 (SPX)
is not steep enough to qualify. However, there are shifting long term fundamentals you should
keep in mind. Over the past 20 years, SPX earnings per share have grown more rapidly than
over the very long term. Since 1994, earnings have compounded at near 7% vs. 6.5%
historically. That corresponds to a  big change over time. Moreover, despite the rather evident
cyclicality of SPX net per share, investors and traders have tended not to shade the p/e ratio much
at all as earning rise to a cyclical peak.  The SPX has come to be treated more as a stable growth
entity than as a cyclical one.

The SPX companies have been buying more of their stock in over time. This has been a plus
to earnings. Back circa 1980, successful companies were urged to buy in stock when the share
price was below book. The SPX has soared well over book value since then, but companies have
continued and enlarged the practice. This has increased the cyclicality of earnings because
firms tend to increase buybacks as cash flow from operations rises and slash them when net
and cash flow turn down.

There has also been a nearly manic emphasis on boosting profit margin as well. Business return
on assets % is a product of asset turns in sales times profit margin. In a globally competitive
world, achieving the pricing power needed to boost asset turnover is tough, so the emphasis
has fallen on advancing margins. Since the late 1990's business sales growth has fallen well
below the long term trend, but earnings growth has not lost a beat thanks to increasing profit
margins.

Many SPX companies with help from their outside auditors have also adopted the practice of
taking very large writeoffs during business downturns and claiming these losses as "special"
charges which are not counted in operating earnings (but do come off book value). And, yes
most acquisitions and mergers are done on a purchase basis rather than a pooling of interests
basis so that acquired earnings are additive and not dilutive. It is amusing to watch purchase
acquisitions boost earnings during business expansions and when they fail, be written off
as non-recurring expenses.

So, faster earnings growth over the past 20 years involves both solid productivity gains to
boost margins and smoke and mirror elements to help net per share on the way up and
artificially cushion it on the way down.

Investors have loved it all -- poor sales growth but improving profit margin and add-ons
to earnings from share buybacks and accounting gimmickry.

At peaks in the business cycle, we now have cyclically elevated earnings plus earnings
overstatement to pore through. In short, there has been an era of bubbly earnings coupled
with investors who have not discounted such performance until too late.

Net per share growth in the current cycle has yet to reach extended levels that should raise
eyebrows and given the available resources in the system, that moment may be a ways off.
The best bet is not just to watch  market price action and the p/e ratio but the aging of the
cycle itself and the excesses that be developing.


True stock market bubbles are rare but exaggerated cycle peaks are not. 

SPX -- Daily Chart

The failure to take out the late Jun. high of 1985 today has the average toppy. It may smoothly
blow above 1985 as the week progresses, but a nearly month - long double top signals more
attention from you if you're a player since these minor fails can sometimes herald that a little
trouble lies ahead. SPX Daily

Economic & Profits Indicators

Coincident Economic Indicator
My CEI rose by 2% yr/yr again in Jun. This has the broad economy running at roughly  2/3
speed. Industrial production growth, paced by oil and gas output, was the strongest component
followed by real retail sales at 2.3%. Measured yr/yr civilian employment growth remains at a
mild level, rising 1.5%. Real wage growth again declined as senior managements pay themselves
royally and leave table crumbs for the rest of the workforce. With banks now lending, it is the
greed of business at the pay window along with significant fiscal drag that keeps the economy
below its potential.

Profits Indicators
My proxy for business sales -- the dollar value of industrial output -- rose again at 6.5% yr/yr
through Jun. Good volume growth coupled with a slightly favorable price / cost measure
suggests profit margins probably expanded again in Jun. yr/yr. SPX quarterly earning power
is very near to $30 per share, and annual earning power is around $120. for a p/e of 16.5X
(assuming the SP 500 companies can hold the $30).

Liquidity Factor
The business economy is growing faster than is private sector liquidity. Since business demand
normally trumps the financial markets, stocks, for example, have become increasingly
dependent on the Fed's QE program, which is wending its way way down to shut - off this
autumn, as well as asset allocation strategies of the big markets players. Interestingly, money
market levels have remained at comparatively modest levels for some time. Ready cash is
flashing slim pickings.

SPX -- Weekly

I have been expecting the stock market to make an interim or intermediate term top here in Jul.
The SPX was becoming substantially overbought on the weekly chart, and the weekly cyclical
fundamental indicator has lately failed to progress reflecting a flattening of sensitive materials
prices as well as a lack of progress in the reduction of unemployment insurance claims. The
SPX is trading a little below its 7/03 all time high of 1985, but it has hardly rolled over. This
leaves the question of whether a top is in place open. SPX Weekly

The heavy technical overbought remains in place, but one always has to realize that overbought
markets reserve the right to get themselves even more overbought. As the chart shows, such
occurred in May, 2013 when the SPX bolted higher before registering a pull back. Back then,
of course, the market had the powerful tailwind of the full-on QE 3 program, a luxury it no
longer enjoys to the fullest. For my part, we'll just have to see whether the bulls can push it
significantly higher or not.

Oil Price

With concerns about Iraq's production capabilities near term in abeyance, West Texas crude
is trending down to a normal seasonal low through July toward $98 bl. The mild uptrend in
crude since late 2013 makes it clear supply is not substantially constrained relative to demand.

The next period of seasonal strength for the oil price runs from late Jul. until the end of Sep.
Barring a major supply disruption, hopes for a big upside finish in the price are fading. My
guess here is that the best oil can do through Sep. is about $110 bl. Moreover, the sharp break
in the price since fears of Iraq production cuts have abated, suggests that the expected  $98
seasonal low which lies just ahead may not be all that secure. WTIC Crude

The deal restricting Iran's nuclear materials output is supposed to be inked on Jul. 20. There
has been a little more progress in recent days, but the ayatollahs are getting balky on the
premise that Iran should have greater freedom over the long run to develop their program.
So, it may be that Jul. 20 will pass by without a firm deal. If so, there will be calls to give the
negotiations more time. Some in the Congress here will say nasty, hawkish things, and Obama
will come under increased pressure to nail down a strong deal. With all that though, it may still
be early to drag the 'bomb Iran' scenarios out of mothballs. However, if there is no deal soon
the hawks in D.C. will use the impasse to flog Obama ahead of the Nov. off year election and
Bibi in Tel Aviv can be expected to weigh in as well. Oil traders will have to pick up the
threads soon.

Put / Call -- Speculative Zeal Apparent

The CBOE all - equities put / call is a good measure of sentiment because it represents real
money down on the table and not just advice. The $CPCE has been in a downtrend since
late 2011, signalling increasing bullishness as calls purchased has steadily outpaced put
buying. In recent weeks the longs have reached their most adventurous yet based on the 6
wk m/a of the put to call ratio. $CPCE Weekly

No law says the zeal of the bulls must end here, but experience suggests we have a fairly
extreme reading as we head head into next week and it may portend an exhaustion of sentiment
sufficient to suggest a short term top. Riding the long side when the p / c starts falling from
.70 and above on down has been a decent trade since 2011, but the low p / c readings have
warned of consolidation or market weakness ahead. A low $CPCE reading may only suggest
mild market trouble ahead, but traders at least should be aware.

Setting Germany Straight

The US State Dep't charted Germany's geopolitical ambitions prior to WW 1. We have
neither liked or trusted Germany ever since. We spy on Germany now and we will in the
future. The fanciful notions of friendship and alliance between the two aggressive, ambitious
and resourceful countries served both well during the Cold War and its early aftermath.
Despite Putin's grand ambitions for Russia, only inertia keeps NATO intact now as its mission
is vague at best.

Germany sees itself as a major merchant state to the world and even fancies itself as one of
the premier democracies. As it veers toward breaking out of the post WW 2 cocoon it has been
in, it shall eventually have to define its place at the table of nation states. Its democracy has
not been tested in the fire as has the US's a number of times. As Germany asserts its
independence, the US has no choice but to let that happen and to adjust accordingly. We'll see
how Germany does and whether it can keep itself out of trouble. Obama, after some eye
opening visits to Berlin, sees Germany for what it is now, although the next US president may
try to rebuild rapidly fraying ties. 

In viewing recent US espionage the German political establishment has been puffed up with
sanctimony and has been throwing out the idea of how stupid the spying is. Older Americans
like me listen to the rhetoric coming out out of Germany and hear the same vain sense of  tactless
arrogance we have endured for generations. We are not your friends Ms. Merkel. Far from
it. So the US will go right on snooping.

SPX -- Waiting For A Correction?

The  SPX daily chart shows the the market has been playing "peek-a-boo" with corrective
action for a couple of months only to break higher and cream the shorts. SPX Daily
Look first at the successful little series of tests against the 25 day m/a in over Apr. / May.
Now look at the succession of scrapes with the 10 day m/a since Jun., all resolved in favor
of the longs.

I have argued in recent weeks that the SPX was significantly overbought on an intermediate
term basis and appears toppy (scroll down). But the insouciance of the bull traders has been
fun to watch: "Hey if you think it's overbought, watch what we can do with it. we can make it
more overbought."

More and more seasoned and successful investors have been coming out to say that a market
correction is due if not well overdue. But the minor sell offs see the bulls quickly regroup and
tenaciously push it higher.

 As of today,  the trend off the Apr. low is still intact with no breakdown apparent.

Liquidity Cycle

Peak US system liquidity growth (including the Fed's balance sheet) hit 11.6% yr/yr in late
2013. Through June it is down to 9.4% yr/yr and by year end 2014 it will be an estimated
7.1% yr/yr. The powerful growth of liquidity from late 2013 through mid - 2014 strongly
suggested faster economic growth through the year, and we have seen that in the monthly
data so far save for bad winter related weakness in early 2014. System liquidity growth will
perhaps slow further in 2015, so the economy and business profits may have less of a positive tailwind as 2015 develops.

As QE 3 zeros out, a major source of easy money support for the stock market will have ended.
The SPX rose 30% last year when QE was in full bloom, but is only up about 6.5% this year
despite a slower but still bountiful pace of QE. My view has been that the wind-up of this
large program by the Fed would suppress the market's p/e multiple and perhaps substantially.
So far this year, the SPX has held up pretty well especially given that players are factoring in
the cessation of securities purchases that are additive to Fed assets by late 2014. It is fair to
say that so far this year, investors have ceased aggressively chasing stocks, but they do not
seem to be very intimidated by the withdrawal of this major source of strength for the market
since the bull began in early 2009. That may change as the zero hour approaches late this
year, and it would not be surprising if it did. But for now, confidence in the economy and the
markets is holding up pretty well.

The US is still a heavily leveraged economy and the Fed went to large QE programs and a
ZIRP to keep the deflation wolf away from the door so as to avoid a downward spiral of
deflationary debt liquidation that would have produced a deeper depression. It has been five
years since the economic emergency that prompted the Fed's actions and although the
recovery has been slow, perhaps there is enough confidence throughout the system and its
markets that these programs can be laid to rest and more normal policies pursued. If it turns
out to be a case where short memory works to our advantage, my extra caution will have
been misplaced.

Stock Market Overview

Fundamentals
Primary: Positive but starting to fade. Easy money policy is still in place with ZIRP and strong
primary liquidity growth. But, evidence suggests the Fed is now suppressing short term interest
interest rates and the QE3 taper program is progressing and is now below 50% of the original
$85 bil. in monthly securities purchases. Bond yields are above their absolute cyclical lows but
are not threatening.
Secondary: Business sales and profits are expanding and there is sufficient economic slack to
support a couple of years of further growth without overheating and toppy earnings. The
expansion has broadened out, but there is still a drag effect imbalance between demand and
income, with the real wage not progressing. Consumption is becoming more reliant on credit
generation. But, note that the banking system is quite liquid still. Somewhat faster economic
growth is absorbing more liquidity now, and QE3, although shrinking in growth, continues
to provide liquidity in support of the capital markets. Keep the QE erosion in mind as it
will become more of an issue.

Valuation
The market is significantly overvalued on trend earnings and investors are being asked to pay
a slight premium multiple on elevated cyclical earnings. It can be argued that with companies
having moved over the past 20 years to an elevated rate of earnings plowback (60%), there
should be a premium for the faster earnings growth that a higher plowback implies. But since
the global economic pie has not expanded to meet this improved potential, earnings have
become more cyclically volatile as companies have had to shuck a greater number of losing
or sub par investments when the economic environment softens.

With elevated valuation, investors are looking further afield at foreign markets, PMs, selected
commodities and bonds (chasing yields down to levels unsustainable longer term).

Technical
The cyclical bull is in place and it has been strong enough off the 2009 low to suggest that a
new longer term bull may be underway. It is a an extended market on a long run basis, but
lacks the spectacular trajectory that indicates a price bubble is underway. Just remember
about this latter point -- there does not have to be a price bubble to have a very nasty cyclical
bear market or even a sudden crash - like decline.

The SPX is now getting quite overbought on the weekly chart. The weekly comment recently
passed anticipated the strength of just prior days, but it may be now that an interim top is fast
developing. SPX Weekly

It is interesting to note that there has not been a deep oversold since the autumn of 2011.

Global Economic Supply & Demand

Global economic demand has accelerated moderately this year as expected, with industrial
output growth rising about 4% yr/yr to a more normal level. Operating rates have improved
slightly but not enough yet to cut heavily into still formidable industrial excess capacity. After
a very rocky start to the year, world trade began to improve in the spring but trails the growth
of global output. Pricing pressures are starting to build but are moderate so far, although CPI
advances are broadening out. Overall, the results have been modest given the very heavy easing
action by the world's major central banks.

With an improving picture for global economic demand, and, belatedly for trade, US investor
appetite for foreign stocks has been on the rise. But, the SPX has been the better performer
against the rest of the world since the kick off of the large QE program by the Fed in late 2012.
However, with the tapering of the QE program now well underway, the momentum of
improvement for the SPX vs. the rest of the world has itself tapered off considerably. Since
US industrial output is now running 4% yr/yr against an improving global picture, it could be
tougher for the SPX to hold the lead as we go forward. SPX vs. MSCI World (Ex. US).

Emerging Markets -- At Resistance

Back on Feb. 4, I wrote a piece on emerging market bond and stock funds. Back then, I found
both the emerging bond (EMB) and the emerging equities fund (EEM) at interesting technical
junctures. With global industrial output slated to perform moderately better in 2014 after a
sour period, it seemed appropriate to dust off these two trades. Now both are up at important
resistance levels Emerging Markets (Click on link and then click on the EMB and EEM Charts.)

The JP Morgan EMB has since moved up from the 106 level to 114.6. It has followed US
Treasury prices and is now well overbought and with Tresuries stabilizing after a good run, this
more volatile fund could be a bit risky following a nice recovery.

The EEM never reached the 35 level which would have made it a more prefect trade, but it
has rallied up to three year resistance and with the SPX weekly now moving up into overbought
territory, traders should keep EEM in mind as short term vulnerable.

Both the markets may be interesting over the next year, but the preference here is to let the
overboughts at resistance play out in the short run.