ContraryInvestor - Market Observations

MARKET OBSERVATIONS

WHAT A CREEP !

MARKET OBSERVATIONS - 2/1

What A Creep!...No, not Greenspan. Not Abby either. It's inflation. We all know it's been readily apparent in financial and real estate assets for some time. The bulls have tried to fool themselves by hiding their collective heads in the government economic reporting sandbox. It's quite possible that the current sandstorm in the financial markets will reveal the bullish talking heads for what they are. Full of hot air. Last week's GDP and Employment Cost Index numbers force the Fed's hand. Yesterday's report indicating that December consumer spending outstripped income growth by a measly 167% throws a bit more gasoline on the embers. (Of course personal savings again registered new lows. What else do you expect?) Nothing like a little visual stimuli to get the old thought process going. As Ed Hyman has recently described, inflation is "creeping" higher. Here are the four horsemen of inflationary change:

It's not a massive change relative to our experience this decade, then again, the NASDAQ has not carried a perfection 200x's P/E multiple over the last 10 years. If this were a stock chart, technicians would be describing a breakout from a long term downward trend line. It's happening despite the three rate increases already unleashed by the G-team.

We've had many a rally based on low CPI reports. Unfortunately, most market participants focus on the absolute number relative to "expectations" (so, what else is new?). Our favorite friend ,"rate of change", tells a different story - slowly, but surely, CPI is creeping higher and higher. Rate of change has doubled since the bottom seen shortly after the LTCM fiasco. A perfect coincidence with the ramp in money and credit creation over the last few years?

Yeah, we know energy is strongly entering the PPI picture. Nonetheless, rate of change in PPI is also creeping higher, food and energy or no food and energy. Another perfect coincidence with the acceleration in credit/money creation post LTCM? We think not.

It's probably also a natural that the rate of change in hourly earnings peaked when global excess capacity was unleashed on the US in late 1997/early 1998. The tsunami of imports into the US since that time has kept wage inflation under control...until now. We're "creeping" back up again.

Is inflation running wild in the streets? Of course not. These charts do not suggest that inflation is hitting records. Rather they collectively suggest that to maintain perceptual credibility, the Fed needs to push farther into monetary tightening territory. They display that until proven otherwise, the rate of change is to the upside in inflationary pressure. One last point. We're not alone. Globally, overall measures of inflation are trending higher. As you know, we have had plenty of pump-priming in Asia. (Maybe too much. We'll save this one for a later discussion.) Likewise, a good bit of currency debasement in Europe has helped the cause. Could it be that a US financial market priced at a level at best described as stretched isn't equipped to accommodate this type of simultaneous pressure? The matron of inflationary pressure is yelling from the back porch, "Allllllaaaaaaaaan, where arrrrrrrrrrrrrre youuuuuuu?" Let's hope Alan isn't locked in his bedroom checking the superficial productivity stats of our "new economy" on the Feb website.

The Scorecard...Maybe what the above charts say is that the G-team just can't keep pumping "monetary go-juice" into the veins of our financial system. And pump they haven't...so far this year. They are not exactly "mopping up" their excesses of late last year, but nothing extravagant is being added. For the week ended last Thursday, the Fed bought back a few billion Treasury securities, but that's about it. For the year, repo's purchased late in December have been expiring (Fed credit shows a decline), the Fed has conducted a few intra-week repos and bought back a few Treasuries. Clearly credit is not being created within the Fed system with anywhere near the ferocity of 4Q 99. Funny how the market is gasping for air now that the financial oxygen tank has been turned to low, now isn't it?

Bondlands, You Gotta Live It Everyday...Last week's seemingly abnormal activity in bonds may be trying to tell us something. Last Thursday we questioned whether the long bond was rallying for "all the wrong reasons." Friday's action was a bit spine tingling as we watched the intermediate term Treasuries swing in a yield range of almost 25 basis points intra-day. For a minute there, we thought we were watching a NASDAQ stock. It seems to us that derivatives may be rearing their ugly heads. Under normal circumstances (whatever that means), an inversion in the yield curve is usually signaling a recession or slowdown in the economy. This time around it may just be severe supply-demand forces exacerbated by the dramatic overlay of derivatives. (We're sure you remember us reporting on the $30+ trillion in U.S. banking system notional derivatives exposure, now don't you? Good, because that's what the Thursday discussion will cover - the recent OCC report for 3Q99. Guess what? The number is now $35+ trillion. Stay tuned.)

Happy Anniversary, Mr. Chairman...Today's THE BIG ONE! That's right, officially the longest economic expansion in US financial history. You've got it, in the "new era", financial records just simply fall by the wayside on almost a daily basis. February is economic expansion month number 107 (and counting). The credit rests squarely on the shoulders of the Greenspan regime. We owe him and them a debt of gratitude that continues to expand and expand. We suggest all investors consider sending the Fed a congratulatory bouquet of balloons! You know, when we stop and think about how great things are going, we're just bubbling over. Excessively bubbling, to be honest. (Wink, wink)

Fearless Forecast...It's pretty much a no-brainer to guess that the Fed will fire 25 basis point buckshot ammo tomorrow. The Greenspan gradualist approach. Greenspan and friends probably have all the reasons in the world to step up the plate and knock back 50 beeps, except for one. They haven't telegraphed it. Just like the worst basketball player on your high school team, Greenspan telegraphs his actions. He's prep'ed the markets for every tightening move he has made so far. Quite conceivably, he just may start to prep market participants for a 50 pointer in March. We'll have to see what happens. If the economy continues to accelerate and market speculators refuse to behave themselves, it's a real possibility. We've contended for some time that in the interests of pure politics, Greenspan will need to convince the market he is "done" in relatively short order. We're simply too close to the election to continue the, up until now, laughable (on the part of investors) gradualist approach. The "we dare you" crowd needs a little dose of religion. As you know, virtually every tightening action this go around has been met with a stock market "sigh of relief" rally. In fact the Monday/Tuesday turnaround in the big index stocks was probably the frontrunning anticipation of another such rally for the post FOMC meeting proclamations. This time, just maybe, the frontrunners have come out of the starting blocks a bit too soon. With time-to-election running down, the G-team will never shoot to kill. But watch it. In March, they just may shoot to seriously wound. As we all know, there simply aren't many things more dangerous than a wounded bull.

Rational disappointment?...Forget irrational exuberance. We can't help but show you the recent Advance/Decline Line. The current "new low" level coincides with what we saw in about March of 1995, or roughly 4,500 on the Dow. In essence implying that the broad market is already down significantly. Maybe by 50%.

Remember, opposites attract. Often, "the hard way".

Burning The Candle At Both Ends...Once again, super fine chart work by TH. The near 50% retracement is in. Will Alan spoil the party from here? Are we on the road to a declining series of highs and lows from here?