ROCKS IN THE ROAD, SO WHAT?!

When I wrote that Big Ben is about ready to fire the starters pistol, a reader asked how I can believe the "race is ready to start" when there are so many problems. He mentioned the union negotiations, the failure of congress to pass the budget and of course, the housing "collapse".

My reply is: What is new about financial stress at market turns?


Indeed, one of the most positive indicators I have that the market is ready to turn is the fact that there is financial stress.

As I have said many times, the ideal environment for stocks includes a low inflation rate. When does the inflation rate fall? During times of economic stress.

We must remember that one man's pain is another man's gain. The slow down in the housing market is largely the result of the 17 increases in the Fed Funds Rate starting in June of 2004. The increases were brought on by the strong world wide economy. If one area of the economy is super strong, another area needs to be weak in order to avoid over heating and high inflation rates.

INFLATION RATES ARE FALLING AND ARE PROJECTED TO FALL SOME MORE!

China just hit a 10 year inflation peak; inflation in the rest of the world has started rolling over. Please remember that listening to the talking heads in regard to inflation is only confusing. You have people on the TV such as Barry Ritholz who has been whining about inflation for several years. When gas prices were going up, he had a point, but after two years of flat or moderating gas prices, he still yaks about how the FOMC is between a rock and a hard place. The best inflation forecast is available in the blink of an eye. All one has to do is observe the 10 year treasury bond rate. The rate on the treasury bond is always a combination of projected real economic growth and inflation. Don Hayes moves the bond plot forward 2 months and gets an inflation forecast that has an r square of 88! Did you notice the huge drop in 10 year rates over the past several weeks? INFLATION RATES ARE READY TO FALL SOME MORE!

My friend Lamar, who was a broker at Merrill Lynch in the early 1980's, will remember our old 1.9 indicator. We plotted the t-bill over the dividend rate of the S&P. In the summer of 1982, in October of 1984 and in September of 1990 this indicator gave a BUY signal, just as it did two weeks ago. Again, this is nothing but a fall in short term interest rates.

Fed Funds have been trading day after day well below the target rate of 5.25%. In other words, the FOMC has been keeping enough reserves in the banking system to hold rates well below their own published target. The rate has bounced around the 4.7%. The FOMC has already cut rates but is waiting for the "appropriate" time to make the announcement.

YES, I DID SAY...

I said that stocks would take off after commodity prices have moved down the "third hump". I also said that the stock market discounts or moves 6 to 12 months ahead of the economy. Each cycle is a little different. In 1996, the CPI adjusted CRB index peaked in February of 1996, the big gains were made by those who "got in" to the new market leaders even before the peak. The CPI adjusted CRB peaked in January of 2007. The NASDAQ 100 is already busting out. The DOW JONES is making headlines by jumping up and down by 200 points or more but all the while the NASDAQ is performing well. Yes, it jumps up and down but it jumps three steps and only retreats a couple.

ROCKS IN THE ROAD

The auto unions and the congress are holding out as long as they can. They would love to see a big turn in the economy. The unions want auto sales to take off. The car companies have produced enough "extra" such that they might even enjoy reducing inventories during a strike. The congress wants to spend a lot of money. To spend the money they need to raise a lot of taxes. They would love for the economy to be strong. Unfortunately for them, the economic weakness will continue until well after the budget needs to be passed. The idea of raising taxes, while the economy is in the tank, cuts against the wisdom of all the major economic theories. Keynes nor Friedman would have advocated raising taxes during a "slowdown".

Because the stock market leads the economy by 6 to 12 months, there are always "rocks in the road" before it takes off. Sure, the battle between Bush and the Democratic Congressional Leaders will likely drag on for several more weeks. By law, the 13 budget bills are to be passed and signed by October 1 but continuing resolutions are not uncommon. Bush is likely to veto some spending and the congress is not likely to "close the government down". The state of the housing market is going to encourage Democrats to advocate all the more spending. They will want quasi government agencies such as Fannie Mae to "bail out" the mortgage market. The argument will be made that this will be done to protect the poor homeowner, who never had equity to start with, but the effect would be to bail out the lenders who stretched to make an extra buck.

Bush has asked for reformation of FHA. The odds are that some of the reforms he wants will be passed along with a few additions that he will not like. My guess is that by mid October compromise budgets will be passed. The actual speed will depend on the perceived advantage or disadvantage in regard to the coming elections. With many primaries just around the corner, the candidates will want to be back on the campaign road as soon as they can.

WILL THEY CUT AND IF SO BY HOW MUCH?

Keeping the market guessing serves a purpose. The longer the FOMC can keep the question in doubt, the more inflation they can squeeze out of the sponge. As noted, their strategy has worked. TIP spreads and regular 10 year bond rates show that inflation is dead. China will be the last to feel the slowdown but some big economic waves are already headed across the ocean. The weakness of the Yen and of the dollar are each having the expected effects. Industrial machine orders in Japan just jumped by 17%! The super efficient Japanese are ready to go head to head with the Chinese who have low cost labor as their comparative advantage.

I continue to believe that the odds of a recession are less than 50/50 even though the highly accurate TradeSports betting site now has the odds at around 55%.

YES, RATES WILL MAKE A DIFFERENCE

It has been fun to listen to various pundits suggest that it is "too late" for lower rates to make a difference. OH COME ON! Have the pundits forgotten the law of supply and demand? If the price of money is cut, the demand for it will go up. A cut in one of the cost of doing business will mean there will be more business done. It is true that the effect of lower rates is a process for the economy the effect will be much more immediate for the stock market. EACH CYCLE IS A LITTLE DIFFERENT. WE DO NOT KNOW IF THIS ONE WILL JUMP EARLY OR LATE. THE BEST STRATEGY IS TO JUMP ON THIS BUCKING BRONCO AND HOLD ON FOR DEAR LIFE. ADD ALL THE FUNDS YOU CAN BECAUSE ONCE THE STAMPEDE STARTS THE TEMPTATION WILL BE TO WAIT FOR A "PULL BACK" TO JUMP. IT IS SIMPLY HARD TO GET ON A MOVING TRAIN. GET ON NOW AND SIT FOR A WHILE! YOU MAY BE SCARED BUT NOT TRYING TO JUMP ON BOARD AFTER THE TRAIN IS MOVING IS EVEN MORE SCARY. BUY BUY BUY!