Saturday, September 10, 2005


Now is the time that it is easy to see both sides of many an argument. The reason is that inflection points are all around.

Greenspan has raised short rates until one person might argue that fed policy is tight enough to slow the economy. While the other person might argue that real interest rates are only slightly positive and indeed are low enough to encourage risk taking.

The unemployment rate has come down to 4.9%. This is at least close to full employment. Full employment is sometimes called the natural rate or the rate at which tight labor markets do not cause excessive inflation. The natural rate, like the appropriate fed funds rate is a moving target. Even if Greenspan were to know precisely the correct fed funds rate today, his action to move the rate to that level would ripple through the economy and bounce back to change the correct rate.

A local plant manager reports that his company is short three supervisors. His company is having a difficult time finding trained, experienced personnel. I like anecdotal evidence. One must be careful not to extrapolate too much from one little story but often the anecdotal evidence is more reliable than government data that is often revised dramatically after it is first reported. The revisions may occur one month later but can occur years later.

Several months ago, I caught some flak over my comments that the increases in Fed Funds Rate were actually an indication that the economy is strong. I reported the market would likely go up in the face of rising rates. One fellow challenged me to look at the long-term history to see that when short rates go up, the market does poorly. The fact is that history only repeats itself until it doesn't. It is true that short rate changes were reasonably good market indicators for decades. However it is also true the relationship has not held for about 15 years. The r square has been very weak for at least 10 years.

The market is more sophisticated now-a-days. For example, the relationship of the long bond rate to the earnings yield was not tight at all until the late 60's. The idea that increasing short rates can lower long rates seems counter intuitive. The reality is pretty straight forward; the fed increases short rates to lower future inflation and the long bond is basically the sum of the economies growth and the future inflation rate. Therefore, if the fed successfully slows inflation, it very well might lower long bond yields.

There has been much talk about the effect Katrina will have on the economy. The answer depends on the ultimate total reaction to the storm. There are many cross currents. For example, the closing of the NO port has increased the cost of steel, rubber, and other shipped goods. Those worried about inflation are horrified. The price of gasoline is another cause for concern but consumers cut consumption 4% during the labor day week end. This means fewer trips were made. Some of the trips cut might have been everything from a vacation to the beach to dinner at a restaurant. The effect has been interesting and powerful. The crude oil price has dropped like a rock. The massive borrowing and spending on reconstruction will like prove ultimately to cause the inflation rate to be a little higher and economic growth to be a little higher. In the short run, output and consumption will be slowed but Americans and indeed people from around the world are digging deep into their pockets to spend for the victims.

The bottom line is that calling turns in the business cycle precisely is nearly impossible. However, prior to Katrina, resource utilization in America was tightening. Yesterday, I reported data provided by Ed Hyman of ISI Group that showed inflation to be under control. I believe the FOMC has been right on the money to raise short rates in small increments for these past many months. The small changes have given the economy the chance to adjust. Indeed, the stock market has gone up and long rates have been flat to down during this period. The bond market and the stock market have projected moderate inflation ahead. PE ratios have contracted even in the face strong earnings growth. The market has gotten cheaper. It has been discounting the risk of higher inflation as the expansion progresses.

In July the YOY% change in the price of personal computers was negative 16.3%! During the same year, a number of new services have been made available on computers that make them far more productive than before. The laws of supply and demand tell us that if we can buy a better product for a lower price, the number of purchases will go up. In the next few years, millions and millions of dual processor computers will be purchased. Many of the wild dreams about the future of computing are going to be realized in the next few years. The adoption of new technologies has historically been a great time to be a stock market investor. It is time to invest because the next leg to the BIG BULL MARKET IS NEAR!