Sunday, December 16, 2007

Inflation adds another yoke to the market

- Inflation numbers add extra weight on a weary market as stocks slide lower to end a down week.
- CPI adds inflation worries to Fed woes as some energy pass-through shows up.
- Dollar has its best week against the euro in over 3 years.
- Market's near term fortunes dependent upon successful Fed auctions starting Monday as well as continued improvements in Fed targeted areas.

Inflation adds another yoke to the market.

The stock market was moving higher on the second leg of its holiday rally, rallying right up to the Tuesday afternoon FOMC monetary policy announcement. The Fed disappointed with a 25BP Fed Funds rate cut (25 on the discount rate as well) and a muddled, repetitive statement that dropped a reference to 'forestalling' an economic slowdown and still harped about inflation. Then the next morning it confused and indeed infuriated many, particularly the financial market traders, with a second day announcement that looked, based on the timing, as if it was a reaction to the market's sell off in response to the size of the rate cut. It could not have been; you cannot coordinate that many central banks in a few hours. Still, the rambling statement and the clumsy chronology of the 2-step action plan lost the financial markets' confidence.

On top of that, the second action sent the market into a temper tantrum. The Fed's second phase actions had an immediate and positive impact (LIBOR spreads narrowed and rates fell, the dollar surged, and US interest rates reversed their deflationary path). The key for the next market move is whether the Monday auction (the first of four) will show enough success to start convincing the market the Fed, despite its left-handed bungling of the action that hurt a lot of investors, at least knows what is necessary to fix the problem and only has to learn better timing.

Obviously Friday the market was not over its tantrum. Indeed, it was not going to get over it as the CPI was much hotter both in the core and overall and with the unknowns regarding the Fed auction next week. With fears that the Fed was failing to forestall, or as its statement indicated, maybe giving up attempts to forestall a slowing economy, the higher inflation reading raised the unspoken worry over stagflation. That CPI number showed why the Fed kept language about inflation worries in its monetary policy statement, but just because the Fed was right ironically provided no comfort to the market. The market is worried the Fed doesn't have a clue, yet Bernanke's tenure to this point has for the most part shown he understand economic cycles and their history. As with Alan Greenspan in his early tenure (when many called for his ouster as well), implementation of the knowledge is the shortcoming that time will help alleviate. Unfortunately, we have to live through the seasoning of another Fed chairman. You can study history all you want as Bernanke has, but the transition from theory to reality is inherently sticky.

There were positives with respect to the issues that are worries to the economy and thus the market. As noted, LIBOR rates continue lower and spreads are narrowing. The dollar surged. It was not enough to offset CPI, earnings issues (BDK reported a shortfall in its guidance), and Greenspan started talking about recession again after a 3-month hiatus (inflation chances are "clearly rising" and "economic growth is close to the stall speed"). As the market balanced out the pros and cons, the cons won again. Most everything was down: gold, oil (91.33, -0.92), financials, metals, energy - - it was widespread to the downside. But, as noted below, while down, many stocks such as the leaders we have positions again held up quite well. That shows there is an undercurrent of strength after the FOMC decision, and that shows there is some recognition out there of the positives developing despite all of the angst over what the Fed did or failed to do.

Technically the action was mixed again, but of course the overall bias was to the downside. The market started lower as the futures tanked after the CPI data came in hot. The market spent the first hour and one-half recovering, and NASDAQ actually turned positive while DJ30 and SP500 missed the green by a couple of points. Unfortunately the bids died out midmorning and stocks slid to close at the session lows. NASDAQ squandered 37 points from its high, DJ30 dumped 145 points, and SP500 frittered away 18 points off the high. There was no Wednesday or Thursday rebound off the session lows as the more bearish intraday action returned.

Internals: Breadth was pretty rotten at -3.6:1 on NYSE and -2.8:1 on NASDAQ. Of course, that included a lot of stocks that lost fractional amounts on the session as they held their near support and performed just fine despite all of the market gloom. Volume was again lower, coming in well below average ahead of the weekend. Though the market dropped to close at session lows, the volume shows the sellers were not rushing in to push it lower. It was a lack of any buyers willing to step in following the FOMC's decision and the subsequent selling Tuesday and the failed rally attempt Wednesday. If the sellers are not pushing when they have every reason and opportunity to do so, you look around to see what else is going on. The leadership as discussed below becomes very interesting in this scenario.

Charts: The week shows a lot for the indices. They rallied up to resistance into the FOMC decision and failed right there when the Fed disappointed. They tried to hold up to finish the week what with the two rebounds off the lows on Wednesday and Thursday, but after the Friday close they are teetering on the edge of another downside leg after the dump on the FOMC decision. DJ30 will try to make a higher low at the 200 day SMA or 13,250, but the patterns for the US indices are again more bearish than bullish after failing at resistance on the FOMC decision.

Leadership: There were not a lot of surges higher on such a down session, but going down the list of plays and stocks that we are watching for opportunities to buy, there are a lot of stocks that are in surprisingly spry shape after the negative four sessions (both in price and in sentiment) in the US indices. That was a continuing theme this week that we discussed every session. May have seemed as if we were beating a dead horse, but their action in the face of the negative sentiment is very important. The leaders showed rubber band action, i.e. stretching down to near support but not breaking. As noted earlier in the week, if you did not hear all of the negative stories about the market and the Fed or see the action in the major indices, you would be pretty excited about the opportunity to move into some great stocks.

Of course you can never forget about or disregard the overall market if it is struggling. But with the split in the global economies, opportunities remain, and quite a few as we can see from the list of strong leaders in good position to move higher. To us that indicates there is a continuing undercurrent of support for these stocks, and if there is improvement in the areas the Fed's second phase approach targets, an oversold market can make a bounce, and these stocks are primed to jump back up, e.g. AAPL, BIDU, CMED, FCX, SNDA, VIP, etc.


CPI heats up, injects stagflation fears.

Consumer prices popped 0.8% (0.6% expected), and the core topped expectations as well (0.3% versus 0.2%). Year over year prices surged 4.3%, 2.3% on the core. That growth rate doubles that in August (2%) before energy prices spiked. This is the highest annual core rate since the 2.9% reading in September 2006.

Gasoline/energy was the biggest component with a 5.7% gain, up 21% year over year. Ouch. Food rose 0.3%, up 5% over last year. Thank you ethanol for pushing up corn prices, the very basis of our diet here in the US. Drugs rose 0.8% for the month, same with apparel. Airline fares spiked 2.6%, and some are saying that is the long-awaited pass through from energy prices.

That looks to be a real problem ahead. Energy prices are up 21% over last year, and they have remained very high for a very long time. As noted earlier last week, the impact of energy prices is cumulative. If they remain high they keep banging into prices and eventually they break through in areas. Airlines have tried to pass on price hikes for several years but have failed miserably. If this one sticks that marks a turning point for prices.

What can the Fed do about that? Can it lower energy prices? No, at least not directly. It can slow the US economy until we all cut back on fuel so much we are living as we did pre-1940's. That may impact the price of oil, but frankly with China, Brazil, India, etc. growing so ravenously, it would not be enough to push oil back into the 40's or 50's. The Fed definitely doesn't want to lower our standard of living in such a manner, but it is torn by the inflation it was worried about on Tuesday in its statement where it emphasized the slowing economy but could not let go of the inflation worries. Then you throw in food inflation on top of that, something driven by the Executive's side of the government thanks to its energy initiative, and the Fed is sweating it out.

Problem is, the Fed cannot accomplish anything if it tries to play both sides of the fence. It has to either attack inflation or attack the slowdown. As we have written over the past year, and as many economic heavyweights such as Bob McTeer are saying, the slowdown and credit issues are the primary concern. You keep inflation in mind, but you solve the credit problems first to get the economy expanding again as that will help alleviate the inflation issues: growth does act as a cure all in most cases.

That takes us back to the disappointment with the Fed action this past week. It has something of this two-faced approach and its statement on Tuesday only underscored the appearance of indecision as to what to attack. That more than anything in our opinion is what really rattled the market. The Fed holds much too much power over our economy and our lives, and thus any appearance of confusion or uncertainty is devastating to investors.

Dollar enjoys a big week.

The dollar advanced the most against the euro since August 2004 on Friday. Indeed, it gained against 14 of the 16 most actively traded currencies. That is on top of a strong week overall that saw the dollar gain 1.6% versus the euro, the largest weekly increase since June 2006. The move got underway in earnest as the dollar broke the $1.4650 resistance level against the euro. The dollar is now down 8.5% versus the euro for the year.

The drivers are two-fold. First, the dollar was down too far, too fast as it moved to the $1.50 level versus the euro. It had to snap back. Moreover, the dollar has been trending lower for an extended period, and we all know that leads to relief moves or even a key reversal that changes the game.

That leads to the second driver: the Fed action. The Fed's rate cut didn't hurt the dollar as many currency traders feared a 50BP move and thus the dollar actually started strengthening on the Fed action. Then the announcement of the swaps and auctions jumped the currency higher as it enjoyed its strongest session in weeks. Then the CPI reduced, at least in currency traders' minds, the likelihood of further Fed rate cuts. That combination of events started by the Fed directly targeting the credit logjam really turned the currency. Add to that the long downtrend and you see a spring that was wound pretty tight.

As a result we could see the dollar at sub-$1.40 by year end. The rally could be just getting started there, however, as the dollar has been underwater a long time and when these moves start to reverse the recovery can be lengthy. If the Fed auction on Monday is a success, then we will see the dollar continue higher and even increase the speed of its gains. Already we are hearing stories of European visitors wondering if they need to think about cutting their stays here in the US shorter. That is how dramatic a move this was in the currency this week. Cannot complain about that, and frankly, despite the market angst over the Fed's actions, this is some pretty excellent news.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at

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