Weekly Wrap-up: The Sixy-Four-Billion-Dollar Question
In a world in which it's very hard to distinguish between economic growth and credit growth, between credit growth and liquidity, and between liquidity flows and technical trends in financial markets...in a world in which financial markets reflexively impact economic growth as much as they reflect economic fundamentals, it's almost fair to say that the Technicals ARE the Fundamentals.
In the world as I've just described it, it would behoove us to take a look at the relative performances of stock indices in order to get our bearings on what these financial markets are telling us about the world we live in...or at least about what these indices "believe" is the case about this world.
Paramount in my mind is the 4-year cycle on the SPX.
While the SPX has been slow in responding to the downward pull exerted by this cycle, the low of which is due in the July-October '06 time frame, the 1966 analogue appears again to be fully in play.
Whether the current 4-year cycle plays out in a Soft Landing scenario like 1994 or with a Hard Landing scenario like 1966 may depend more upon Inflation and on how the FOMC directs policy in reaction to (anticipation of?) Inflation than on anything else. So, before we look more deeply into the relative strength of various stock-index charts, let's look more closely at the Inflation story and why the markets are so fixated on it -- at why the stock market is now trapped in a depraved dialectic with its own doppelganger, in which good news is bad news and bad news is good news.
Why is inflation such a big deal? Because if the FOMC perceives inflation to be increasing at a benign rate (less than +2%/year) then the Committee can let loose the reins a bit and allow the economy to run (grow) at a relatively unimpeded rate. But if the Committee perceives inflation to be growing at a more malignant rate (most would say at greater-than +2%/year) then it will be obligated to pull tight the reins (raise rates, invert the yield curve, and flush institutions out of various Carry Trades), slowing economic growth in order to brake the rate of inflation.
So, what happens in the stock market over the coming 6-12 months will be at some level a function of how successfully or unsuccessfully the Fed deals with the very narrow tolerance between the "Rock" (the need to prevent inflation) and the "Hard Place" (the wish to prevent a recession).
When Deflation was the scary headline topic on everyone's mind the FOMC committed to keeping interest rates low for a "considerable period." However, in the wake of years of loose money, the data now suggests that deflation is no longer a threat, but rather we are at risk of seeing rising INflation.
And it doesn't matter whether you look at the PCE Price Deflator (Headline +2.9% Y/Y, Core +2.1% Y/Y, as shown above) or the CPI (Headline +3.5% Y/Y, Core +2.3% Y/Y, as shown below)...
...the underlying story being told by both these pictures is one of rising Headline Inflation with a lagging increase in Core Inflation.
What's most impressive, thought-provoking, and unique about these pictures is the lack of precedent for the sustained disparity between Headline and Core Inflation. And this lag has led to a generally too-high level of complacency about the prospects for either CPI or PCE Inflation going forward.
What makes me say, "too much complacency?"
Let's think for a moment about the logic behind WHY the CORE number is so much more highly regarded than the Headline number. It's because the Headline number tends to be more volatile and potentially deceptive. So economists look to the Core number in order to discern the real underlying trend. But the underlying trend in WHAT? Is the Core number the "end" that economists seek? Or is it the means by which they try to prognosticate the trend in the HEADLINE number?
Obviously, the answer is the latter. The value of the Core Number is that it has often been a better gauge of what the HEADLINE number WILL BE than has been the Headline number.
But how about now? How about during this unprecedented 2-year period when Headline CPI and PCE Deflator have diverged upward from their respective Core counterparts? Have the Core numbers been better indications of what aggregate inflation will be? NO!
Because the countries from whence we import finished goods (e.g., China and Japan) have been engaged in competitive devaluation of their currencies, artificially pressing down on Core Inflation, while the countries from which we buy raw materials and many hard commodities (oil, gold, silver, copper, etc.) have been much less active in playing Devaluation Dominoes.
I would submit for your consideration that Devaluation Dominoes in the FX markets has fooled economists into believing that the prospects for future inflation are more benign than they indeed are. And the mechanism by which economists have been fooled is the sustained artificial depression in Core CPI transmitted via inordinately devalued Asian currencies in which are denominated the wholesale prices of a significant fraction of our finished goods.
With the end of Japan's Zero Interest Rate Policy (which should work to strengthen the Yen) and with China steadily (if slowly) allowing the Yuan to float higher, Asian currencies are generally bound to likewise appreciate relative to the dollar. Consequently we should see the Ex-Energy Imports begin to appreciate in price as well, forcing Inflation at the Core higher.
Note: Either or both of 2 factors are most likely to prevent a significant rise in inflation: 1) a drop in commodities prices, especially in Energy and Metals, 2) an unanticipated further surge in productivity.
All of the following 6 indices retraced about 50% of their October-May advances, except the Dow Industrials which gave back slightly less than 50%.
These indices have all completed 3-day bounces up from severely oversold conditions. Note that the Dow Industrials and the OEX continue to show positive Relative Strength in the 2nd pane (Rel. Str.) while the other indices show marked deterioration on that line. The bias over the past 2+ weeks has been to put money to work in the very-Large-Cap names.
The CRB Index, the Morgan Stanley Cyclical Index, and the Dow Transports have all retraced somewhat less than half of their October-May gains.
Apparently the market continues to believe that any cyclical slowdown will be modest in scope. I suspect that these indices will show markedly negative Relative Strength before the market is done with retrenching the past 3+ year's gains.
These Speculative Indices have been underperforming for quite some time, with the except of the Nasdaq Composite, which has only show deterioration on its Rel. Str. Line since mid April.
Biotech has been lagging since late February and retraced about 85% of its May-Feb. advance. That index's Rel. Str. Line has just crossed about the Rel. Str. 20-dma and may be showing initial signs of life. The NDX has likewise retraced about 85% of its Oct.-Jan rally, but its Rel. Str. Line has been less robust over the most recent 3-day rally. The SOX has filled its November continuation gap, but has yet to fill last October's breakaway gap, down to 430-35. We continue to expect that gap to fill before the mid-term retrenchment is complete.
With one exception the following charts are showing essentially positive Relative Strength.
Financials, Consumer Staples, and Utilities held up well during the market's recent sell-down. The Health Care sector (XLV) pulled all the way back to its October low. The 4 charts that have held up well are essentially no higher than they were last November. They have resisted going down only because they had not run up.
If this is what the market calls leadership, then, Houston, we have a problem.
The consensus estimate for all 3 of our Earnings lines achieved new all-time highs again last week. However, it is difficult for the stock market to take these estimates seriously in the face of the potential for accelerating inflation.
If inflation picks up, then Real GDP Growth will have to be slowed by policy decisions. And if that happens, EPS will have a lot of trouble matching expectations (bad for the market). However if inflation is slowed (headline is leading core, and that means ENERGY and METALS would have to drop in price), then Real GDP Growth can be allowed to continue apace, and EPS may meet or beat current expectations (good for the market).
Can the FOMC flush the speculators out of the Energy and Metals markets without inducing a recession? That's the Sixty-Four-Billion-Dollar Question.
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Best regards and good trading!