The Fed's Concerns

Fed chair Bernanke spoke to the Joint Economic Committee
of Congress today. His concerns:

1. The labor market is tight. Capacity Utilization for
primary processing of basic feedstocks and materials is
very high. Growth of capacity utilization in the US is
low across the board. This combo of factors pushes the
Fed to sit tight and say some prayers that cash rich
corporate America starts spending more on development.
(Europe has a similar problem with labor. The available
workforce does not have the skills needed by growing
businesses. The tech sector is on the verge of blowing
orders because they are coming up short in skilled labor.)

2. Inflation excluding food and fuels is high relative to
target and is proving stickier than the Fed thought it would
be. On top, fuel prices are rising again. The inflation
situation pushes the Fed to sit tight as well.

3. The subprime mortgage market fiasco has surprised them. Oh,
the Fed knew full well that the tightening of monetary policy
would prompt a rise in delinquencies and foreclosures, but
they likely did not bargain for the collapse of credit
underwriting standards and outright fraud that is putting so
much additional pressure on the market. The Fed and the FDIC
among other regulators now have no choice but to embrace
regulatory reform. This will add to the problems in junk credit
markets for the forseeable future, because financial organizations
tend to freeze asset generation until the new regs. are spelled
out and understood. The junk asset-backed credit markets will
suffer. The Fed would like to sit tight on this, too, but they
will have to monitor carefully for spillover effects to the general
economy.

This is the first tough stretch for the Bernanke Fed. We'll see how
they handle it.

Stock Market -- Technical

Readers of this blog by now know that my approach to technical
analysis is far more artful than mechanical. Being artful
involves working with principle and discipline and, in the case
of this type of analysis, idle tea leaf reading is hopefully
banished.

The approaches I use do not give buy and sell signals. But on
occasion I am struck by configurations that are worth mentioning.
The various market charts I follow all show a downdraft in the
25 day m/a. The market would look less vulnerable if the 25
day m/a had popped up on the recent rally. That simple dvergence
is a bright yellow caution light in my scheme.

Secondly, and again, artfully, the rally would have more of a
positive bias if the the SP500 were to fall from today's 1428
down to 1420 - 1410 before moving ahead at a reasonable pace.
That would distinguish it from the kind of madcap short covering
we saw last week.

Another factor is the ADX (shown on linked chart). The whipsaw
action there since late in December is a bit disturbing. Chart.

Stock Market -- Technical

To be upfront, I am not sure what to make of this market.
From my perspective, it still looks unstable, despite the
double bottom between the vertical down and the vertical up.

The internal supply demand indicators, the longer term
momentum oscillator and the buying and selling pressure
gauges leave me with the impression that the market could be
in the same topping pattern it started before the rude sell-off
at February's end. But, no table pounding from me.

First things first, and that suggests it would be nice to see
the market stabilize over the next week or two.

Posting Problems

There is an e-tag somewhere that I am working to have
removed.

Stock Market Fundamentals

The SP500 Market Tracker is about 1550 for March,'07.
The market is nearly 9% below the Tracker at 15.9 x
expected 12 mos. earns (through Mar.). With lower
inflation since mid-2006, the market should be at 17.5x.
The worry is more about the earnings outlook than
inflation. Earnings estimates have been cut, and first
quarter net per share could come in only 5% above prior
year for the "500" and below the Q2 '06 level.

The market model based on the monetary base remains
positive, but the appreciation in the market since the
end of 2005 is considerably stronger than the model
suggests. This is no longer an uncommon development and
reflects investor attention on the growth of credit
driven liquidity which had been accelerating steadily
until just recently. There are a couple of factors worth
noting here. First, money and credit growth most closely
tied to transactional demand within the economy has
slowed appreciably this year. Secondly, with bank funding
needs having eased some, broader measures of money growth
are slowing, especially finance company sales of asset-
backed paper (reflects slower economy and sub-prime mortgage
fiasco).

As I have discussed in a number of posts, the economy can
be very vulnerable once credit driven liquidity starts to
slow or recede, AND if the Fed chooses to let it unwind
and not add reserves to the system in a decisive manner.
The US is at that point now. It is a high risk point in any
US business cycle.

So with earnings estimates coming down and liquidity at issue
investors have moved to discount the earnings cuts and ponder
whether the shallow dip in the road might be a prelude to a
valley.

It would be a breeze here for the Fed to ease if capacity growth
was accelerating nicely and a dose of monetary liquidity would
push the economy into a higher but more balanced growth mode.
Such was the case in 1995 -- the last big "soft landing" play.
It is not the case now, as capacity growth continues to lag that
of demand growth potential. To ease now, the Fed would be
gambling not only that productivity growth would soar, but that
capacity growth would finally accelerate. Perhaps the FOMC will
shed some light on this issue at tomorrow's meeting.

I came into 2007 cautious on the stock market and I remain so. The
absence of balance between economic supply and demand remains and
continues to leave me with more questions than answers.

Gold

As discussed in the 12/27/06 post on gold and the USD, gold,
then $628 oz., was in a strong seasonal mode and could run some
if it could take out $640-650 resistance. It was also noted that
the positive seasonal window could run through Jan. Gold did
oblige, rising to close to $700 oz. in late February before
selling down to the current level of $643. Gold is now in a
seasonally weak period that could last through April.

Gold remains in a long term bull market, moving in nice tandem
with the broader grouping of industrial commodities pricing.
These markets have all enjoyed positive demand growth and very
high operating rates, as capacity additions involve long lead
times. The impetus to gold from the growth of monetary liquidity
has slowed appreciably from late 2004, but the strong liquidity
underpinning from the late 1990s through 2004 paved the way for
a powerful industrial economy that has only recently begun to
slow. The oil price was also a major factor in gold's rise, but
has likely been a drag since mid-2006, as the oil market
has moved into a better balance of supply vs. demand.

For the gold price to hold the accelerated uptrend underway since
mid-2005, gold must hold above $640 - 650 oz. over March and April.
A break below this rising support line would suggest gold might
return to the more modest uptrend it established from 2001
through mid-2005. It will be interesting to see how gold fares
during this period of seasonal weakness.

My macro indicator for gold declined from mid-2006 through October,
but is now trending up. The trend trajectory suggests gold could
be around $550 for the end of the year, and implies that the
gold price excess generated over the past fifteen months has not
been fully wrung out. The macro indicator prices gold as primarily
an inflation hedge asset and not as a geopolitcal play or as a haven
during times of financial stress. There is no shortage of gold bug
sites that play up the latter two avenues of interest.

The macro indicator has a modest positive trajectory now because of
a quiet oil price and also because the monetary liquidity
indicator component remains in a sluggish uptrend. As I have discussed,
I think the Fed would like to hold off giving the economy a goose
for as long as it can this year. Obviously, if the global markets
continue to reflect the slowing of global liquidity in place, the Fed
and other central banks may have to relent. There are no doubt gold
players who are betting strongly on that very point, while hoping their
baby does not go out with the bath water in the interim.

Economic Comments

The leading indicator sets are consistent with real growth
of 1.5 - 2.5%. Order rate measures for both manufacturing
and services signify mild growth, but remain in downtrends.
Employment, as measured by the larger, more current household
survey, shows no growth in jobs since 12/06, reflecting
weakness in construction and manufacturing. Measured yr/yr,
employment growth is up 1.8% and hourly wages rose 4.1%.
The 12 month employment and wage data support economic growth,
but the recent flattening in jobs growth is of concern. So, I
would conclude we are headed for a Spring showdown as far as
economic direction is concerned. When the economy is slow, mixed
readings from various data series are common, so it is not easy
to maintain perspective from one news release to the next. It is
not appropriate to be complacent but still too early to be alarmed.

Stock Market -- Short Term Perspective

Today's big up move extends the market's instability.

Can there be a "V" bottom -- a one day lead in to a positive
move without a retest or a period of base building? Sure can.
It is an against the house bet, but not a foolish or even
unreasonable one. Note though that investors have tended to be
more circumspect about jumping long on a significant dip since
the 2000 - 2002 bear.

The market remains oversold in the short run.

The market is also in a seasonally weak period, with sharpest
risk coming up over the second half of this month. Interestingly,
since the market nearly made a double bottom in early 2003 before
the big take-off, it is worth remembering that the four year cycle
low could occur in early in 2007 rather than 2006 as most players
had previously expected. If so, the SP500 could easily fall another
7-8% over the next several weeks. Cycles are usually too imprecise
to warrant being dominant in one's thinking, but the savvy player
keeps aware of them.

As I have said since near year's end, I am in 100% cash equivalent
because I seek some resolution regading how the economy might play
out over the eighteen odd months. I am not bearish, just cautious.
During periods like this, I usually sequester the spread between the
short rate yield and the inflation rate and play the options market
at hopefully opportune moments.

Stock Market

The Boyz on The Street tried to turn it around today by
purchasing signal baskets of stocks like the Dow 30, but
to little avail. The SP500 broke critical short term support
at 1380, thus ratifying the turn in the market.

The short term trend is down, but the market has developed a
substantial short term oversold condition. At this point, only
traders with acute timing sense should be trading ahead of the
trend.

My intermediate term indicators (30 days +) have turned down and
are flashing a strong caution. Moreover, the trends in the buying
and selling pressure gauges are still gradual enough to suggest
that any further correction and subsequent base building period
could take several months, although the depth of any further
correction need not be severe. The intermediate term technicals
have yet to reach comfortable oversold levels.

The fundamentals remain positive, but are more subdued as earnings
estimates may be trimmed ahead of the end of Q1 '07. Risk levels
remain elevated as the US economy continues to pass through the
slowdown phase. However, housing and business inventory corrections
have been well underway.

As discussed in prior posts since 12/06, I remain cautious on the
market and have stayed fully in cash since late last year. Unlike
many players, I am still most curious about whether a resumption of
stronger economic growth a little later this year will be balanced
enough to allow for continuation of a cyclical bull market into
and through 2008. I still think that will be the more important
question this year.

The sets of leading economic indicators I follow continue to point
to ongoing growth at a subdued pace. The one surprise with these
indicators has been the volatility recently seen in the services
sector. I suspect sensitivity to fuels and materials prices may be
especially important here.

Stock Market

It took no less than Uncle Al to remind players that trying
to soft land a maturing economic expansion carries risk. He
focused on weakness in manufacturing and production and to
point out that the economy is not immune from downturn. That
sent the export driven Asian stock markets into a tizzy and
knocked the US market off its smooth running uptrend. Yes, we
saw panic selling on Tues. and on the open today. Yes, there
is evidence of climatic selling. Yes, the SP500 tested important
support around 1380 today and bounced up nicely. Yes, the
market has turned down.

Got to be the first kid on the block to have THE right answer
for the short run? Go for it. Me, I am in no such hurry. I am
content to wait a couple of days for the market to exhaust the
furious bull vs bear fight and stabilize. Let's give everyone
the weekend to sort their thoughts out.

At this point my internal supply / demand indicators suggest
only that a shorter run overextended position is being corrected.
It is a down market, but the work does not suggest yet that it
is a broken market. The fundamental indicators are still tracking
positive, but business risk levels remain elevated as I have
discussed, and the recent sharp downdraft in stock prices indicates
a substantial hit to confidence. Again, my vote is to give everyone a
pass until Monday so we can assess the fragility of the collective
psyche. Too much zigging and zagging right now.

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.

The Fed, Economy and Stock Market

The FOMC's decision to keep the FFR% at 5.25% was widely
expected and was well discounted in the markets.

The preliminary GDP report for Q 4 '06 was better than
expected, featuring moderate real growth and a low inflation
number. The markets liked that. Measured Q 4 yr/yr, real GDP
rose 3.4% and real final demand rose 3.5%, reflecting an
acceleration of inventory run-off. Final sales to US purchasers
rose 2.8% -- in line with underlying demand. Real GDP topped
sales to US purchasers reflecting substantial improvement in
the balance of trade in recent months. Personal consumption
advanced 3.7% -- on the strong side-- compared to real disposable
income growth of 3.1%. Dis-savings shrunk but not as much as I
had hoped, now that short rates are well above inflation.

Final demand growth has pulled ahead of production growth and
this could continue into the first quarter, but the US now may
be setting up for stronger production growth. Capacity growth
in the US continues to lag both production and final demand,
which keeps the internal inflationary bias of the economy in
place.

It was a "goldilocks" day for stocks as investors moved in on
the moderate growth / low inflation combo.

To add zesty irony to the day, GWB, the ultimate plutocrat, came
to Wall St. and admonished the captains of corporate America
about over the top fat cat compensation practices.