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Still on the Payroll?

by Dominic and Joe

A consolidation period would seem natural and beneficial after the record-breaking run like the stock markets have just made from this past summer. Instead, consecutive down days on the major indices in the wake of unexpectedly negative economic data over the course of the last two weeks now have investors debating whether or not markets have, in fact, topped out.

Since August, we've been watching a critical Fibonacci level on the SPX at 1360. As the chart above shows, this was not only the upside target of the recent rally, it is now preparing to become important support or resistance for the next big move.

The rally out of August is largely the result of a data-dependent Fed policy that seemed to give everyone what they wanted to hear. Tomorrow's payroll numbers will play a large part in determining which direction that will be. Ben Bernanke has had to walk a fine line since his first day on the job, between rising inflation expectations and a slowing economy. The current stall is a return to that stagflation "conundrum" that has dogged the markets all year.

Last time, the Fed talked down inflation fears with the idea that a slowing economy would moderate inflation pressures. For a while, at least, everything played out perfectly and the Fed was able to look credible against inflation while keeping interest rates level. Stocks rallied on the pause while the bond yield curve gradually flattened. But now that the data prove the economy has slowed significantly, but inflation is still at uncomfortable levels, economic uncertainty again abounds.

The October FOMC statement cited lower energy costs as a catalyst for a moderately expanding economy. Traders have shrugged off OPEC production threats and kept oil under $60, which has helped stave off a significant decline in equities. Higher wage inflation and lower productivity, though, have boosted inflation fears and kept potential dip-buyers mostly on the sidelines. Attention has also been directed toward gold as it retook the $600 level. Language in the Fed's last statement, however, seems to suggest that higher commodity prices in a stable oil environment would not be the obstacle to rate-cuts that economic data could be.

And so, under the reign of a data-dependent Federal Reserve, it's no surprise that all eyes are on the latest economic data to see who will win the tug of war playing out in stocks and bonds between the bulls and bears. There's no consensus on exactly what number will be released Friday morning, but it will probably the largest single factor shaping macroeconomic outlook even if it can easily be revised in either direction a few weeks later. Strong payroll growth will continue to support the "soft-landing" hypothesis and stem the tide of red ink. Some might argue this would be a neutral outcome as higher payrolls could be inflationary to the Fed and hence an obstacle to the rate-cuts currently anticipated in early 2007. A sharply lower than expected payroll growth number will look like a hard-landing, but could make the case for rate-cuts easier to swallow.

Overall, there is compelling evidence to suggest we are in a midst of a healthy consolidation and there is plenty of upside left for this rally. What's needed is some clarity on which direction we're headed next. Now that inflation is getting headlines again, it may be important to note that none of the major indices, including the DJI, are anywhere near their all-time highs in inflation adjusted terms. Returning to the SPX, the chart above shows the consolidation just above an important Fibonacci pivot at 1360. A break below this level would be required to suggest a significant reversal of the recent rally. We will continue to monitor this unfolding situation and offer actionable analysis in our regular weekend updates.

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