THE BIG PICTURE IS A MASTERPIECE!

One of the many economic indicators I watch, growth in the Money Supply, has turned negative. In addition, short term sentiment indicators are pretty negative (taking the contrary view). Short term the market may pull back but I'm not worried because the business cycle is playing out just as one should expect. It is typical for the growth in money supply to weaken about half way though the cycle. Money dries up as the Fed switches from stimulating the economy to worrying about future inflation. This cycle is no different. Furthermore, one should expect emotional buying after such strong runs in various stock market sectors. Speculative buying in certain sectors does not imply that there are not good buys available in the market.

The good news is that other big picture indicators are in great shape including the important fact that inflation is not bad. Indeed, the most recent numbers were better than expected. The CPI has actually dropped about 1% in three months--down from roughly 3.5% to 2.5%. The seasonal adjustments skew the numbers a little and the annual number has a couple of hurdles ahead when some large past numbers drop out of the average, but the bottom line is low inflation. The other good news is that the Fed is determined to raise short rates ahead of the projected rise as the expansion phase of the economy heats up. While it is possible that the Fed will tighten a little too much, the concerns of the prognosticators are over-done. The Fed tightened a little too much in 1994 but the market did quite well the following five years.

Another reason for optimism is the deep psychological depression created by rising oil prices. In truth, the rising oil prices work to slow inflation in much the same way that the rise in short rates works to slow inflation. I have not seen the report but a friend tells me that Ed Hyman has posted an average of short interest rate change with oil price change as an indicator of future economic growth. The current combination is getting to the severe level which means there will be an economic recession if the combination continues to rise. Isn't it interesting that increases in short rates work to hold down increase in oil prices and increases in oil prices work to hold down increases in short interest rates and they both work to hold down inflation!

A big part of the confusion about inflation is that increases in short rates and in oil prices are inflationary in the sense of cost-push inflation but disinflationary in the sense of demand-pull inflation. For example, banks must increase their lending rates if short rates go up. Banks struggle to earn a spread because the spread between long rates and short rates goes away. Each investor, financial institution or individual, at some point says why buy a five year note if I can get the same yield on a 90 day bill.

Never-the-less, increases in short rates or in fuel costs as "in your face" increases are actually disinflationary. One may hardly notice an increase in restaurant prices because one may order different meals from different restaurants. Only the fellow who routinely buys a 14 ounce steak at the same place will immediately notice a steak price increase. However, one fills ones tank with the same grade of gasoline time after time week after week. If the price is up you notice and if it starts to pinch the family budget you alter your behavior. If you do not spend the money to fill the tank, you will not be spending big money after driving to your favorite vacation spot!

For the past few years, as houses went up in value, it was tempting to do "cash out" loans. Big money was spent as a result. With higher short rates, the banks are not eager to lend and consumers are not eager to borrow. The house may be worth more and more but the money is not spent.

A few days ago, Larry Kudlow pointed out that Disney has grown its earnings significantly more than has been reflected in the stock in the past few years. This comment caught me by surprise only because it is a true statement about most companies! Look at the earnings of MSFT 5 years ago and the earnings now--about double--but the stock is about the same price! Put another way, the P/E ratio of the S&P 500 has come down sharply from around 35 times to around 15 times. Thirty-five was too high and I for one almost totally avoided stocks but 15 is not bad and is great compared to the available alternative investments.

The bottom line for my optimism about the market is that stocks are under-valued. Indeed the P/E ratio has declined to the point that the 10 year forecast of the market by this one measure is almost 9%! Nine percent is not a huge number until compared to a 4.3% bond rate and a 3.5% t-bill rate. The fact that there are about 5 TRILLON DOLLARS still sitting around in money market instruments means that the FED can soak up dollars and not hurt the stock market.

Do you see the full circle here? Most economic indicators are as pretty as they can be. The one ugly is the slow down in Money Supply growth. However, there is plenty of money around looking for a home. Throw in the fact that real estate investors are at least pausing to think about what they are doing and you only have one place for the excess cash to go--the stock market! BUY THE BULL!

THE BEARS ARE DAZZED! THE OIL PRICE KEEPS RISING WHILE THE INFLATION RATE GOES DOWN AND WHILE STOCKS KEEP RISING. THE BEARS MUST RETHINK THEIR POSITIONS. THE SHORTS ARE GETTING SQUEEZED--IN THE BOND MARKET AND IN THE STOCK MARKET! WHEN THE SHORT CAPTIULATE, THE MARKET WILL SEE A BLOWOFF!

BUY THE BULL BEFORE THE SHORT SQUEEZE BLOWOFF!