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November 08, 2006

Weekly Wrap-up: The Election and Sticky Inflation
by Adam Oliensis

Dear Speculators,

Since the beginning of November The Dynamic Trading System has taken net profits of +4.5%, +13.5%, and +26.2% in the Index Futures futures markets. The System has accrued 338% in net position gains since its launch in July, 2005 with 77% in net total return in its model portfolio.

If you would like to read more about The Dynamic Trading System or subscribe to The Agile Trader Index Futures Service, please click HERE.

Or if you would like a free 30-day trial to The Agile Trader (in which we trade the less volatile QQQQ/SPY and the Rydex Funds) CLICK HERE.

For those of you who are following the mid-term elections closely, the futures markets are making a clear predictions about which political party will control which house of Congress.

At both the Iowa Electronic Markets and Tradesports.com the collective wisdom of the markets is suggesting that there is about an 80% probability that the Republican Party will cede control of the House of Representatives to the Democratic Party.

By contrast the same markets are suggesting that there is about a 70% probability that the Republican Party will retain control of the Senate.

If we do some simple math, there's about a 60% probability that the Congress will end up split, with one house Republican and the other house Democratic. And that "mix" is, according to the conventional wisdom, somewhat productive for the stock market as it tends to prevent legislators from getting particularly aggressive. (The market likes government gridlock.)

That said, the stock market has retrenched over the past 6 trading days, retracing some of its July-October rally. The extreme persistence of the one-way uptrend has been relieved on a short-term basis. And 2 significant sources of "fuel" for the rally appear to have exhausted themselves.

First, with Friday's upward revisions in the Nonfarm Payrolls data of the past several months it now appears that the Jobs market is significantly stronger than the market had previously been discounting. In response to upward revisions in Payrolls the bond market sold down hard on Friday, driving the Yield on the 10-Yr Treasury (TNX) up from Wednesday's low of 4.57% to 4.72%.

And Friday's 12 basis-point rise in TNX was the largest one-day change in 2 ½ years, representing a significant increase in volatility and, in the process, making a fairly convincing statement to the effect that the near-term low in TNX may have already been seen. (Note the obvious appearance of what looks like the formation of a double bottom in TNX.)

The question, of course, is how will the stock market respond to the end of the decline in long-dated Treasury Yields, if indeed that's what we have just witnessed? And as far as our market forecast goes, the ASKING of the question is precisely the point, probably even more so than answering it. Which is to say that for the character of the market to change from the "one-way uptrend" enjoyed in the July-0ct time frame to a choppy floppy market (which is what we're anticipating for a 6-12 week period) all the market has to do is ASK, "Gee, what does it mean if long-dated interest rates aren't going down anymore?"

Note: If TNX drops below about 4.55% then this last question will be put to bed to let sleep. However a durable move above TNX 4.8% would again raise the specter of TNX flirting with 5%.

The second important factor in what we anticipate will be a change in market character is the stabilization at a high level of Crude Oil prices.

You can see on this chart how productive the drop in the price of Oil was for the stock market. But, like on the TNX chart, some sort of bottom appears to be forming. A durable trip for Crude above $62 should begin to feed fears of rising Headline Inflation again. But a drop down much below $57 could precipitate another rally leg in the stock market.

On the subject of market bubbles, over the weekend I noticed something of interest regarding the Housing market. This next chart shows the Residential Construction sector.

From early 2000 until the summer of '05 this sector rallied by a factor of about 8.6 from a low near 273 to a high near 2173. Since then there has been a pullback of about 50% of the rally, down to 1277 and then a bounce up to 1613 at a height of 62% of the original rally.

Now, look at this chart of the Nasdaq Composite.

From late 1994 until early 2000 the Nasdaq Composite rallied by a factor of 7. That is the Nasdaq's latter-'90s bubble was of duration almost identical to the Residential Construction Sector's '00-'05 bubble and was of slightly SMALLER magnitude.

Why bring this up? Well, I'm not suggesting that the Housing market is AS bubblicious as was the market for Tech stocks in the '90s, but I am thinking that this comparison suggests that former Fed Chairman Greenspan may be premature in suggesting that the worst is over in the Housing market.

In the aftermath of historical bubbles, such as these 2 charts represent, it is unusual for a mere 50% retracement of a lofty bubblicious rally to represent the full extent of the post-bubble popping process. In the Nasdaq's case a 90% retracement of the bubble occurred. And while that is probably more extreme than we'll see in Residential Construction going forward, it does give an indication that a pullback of more than 50% is likely.

And what would contribute to another down-leg in Housing? Inflation and higher-than-currently-discounted interest rates.

This chart plots Average Hourly Earnings (red) against the PCE Price Deflator (blue) and the Core PCE Price Deflator (black).

Most recently we have seen the PCE Deflator, which measures Headline Inflation, drop sharply down from near +4% down to +2% Y/Y. That drop has been a function of the sharp decline in Energy Prices.

However the Core PCE Deflator remains somewhat elevated at +2.4% Y/Y. And Average Hourly Earnings, which has a historically strong correlation to Inflation, remains up near the +4% level. Since 1964, when the Average Hourly Earnings (AHE) series began, trips up to the +4% area have all been at LEAST 17 months long. Which is to say that elevated Y/Y increases in AHE are "sticky." When they go high, they tend to stay high for a while, they don't just spike up and then pull back.

Given the stickiness of elevated AHE growth, we can expect roughly a year and a half of inflationary pressure to come from this data. And with the Fed still vigilant on the inflation front, any uptick in Crude Oil prices will make Fed rate cuts harder to come by than many are currently expecting.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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