The following article was originally published at The Agile Trader on Sunday, November 26, 2006.

Dear Speculators,

I have spent the Thanksgiving holiday away from the markets in the mountains of New Mexico and Colorado. Normally I find periods in the mountains physically, mentally, and spiritually restorative. There's a kind of quietude that comes over a person (this person, anyway) and a capacity to put our human endeavors into a larger perspective when faced with the vastness and ever-shifting changelessness of the mountains.

But this week I did not find the kind of restorative experience I was seeking. I just felt disturbed and jangled. And my thoughts kept returning to the stock market and to its unresponsiveness to a host of factors that we have been watching for a number of years.

I don't have a particular thesis to put forward. But I would like to do a show-and-tell on some of what's been on my mind.

First of all, part of what's driving the stock market relentlessly higher is the frenzy for mergers and acquisitions, and for private equity investment. Normally this kind of market impetus is a late-cycle phenomenon. But, if our cycle work is correct and a new cyclical bull market is underway, then we are in the early part of a new 4-year cycle. Corporations have loads of cash on hand with which to make acquisitions, which is at least partly a function of there having been no cyclical slow-down in earnings growth (YET) as economic growth has decelerated. With GDP growth clearly slowing, with profit margins already at or near record highs, and with consensus forward earnings projections for the coming year anticipating profit growth of at LEAST 3 times GDP growth, I'm left wondering if the stock market hasn't drunk too much of the magic Kool-Aid for its own good.

As a function of this surfeit of sanguinity, the Volatility Index (VIX), which measures the SPX Options Market's expectations for forward volatility, last week closed at its lowest level since 1994.

In this chart I've plotted the S&P 500 (SPX) against the VIX. And the yellow highlights show up wherever the VIX is below 10.70. This kind of low reading tends to occur AFTER an uptrend of at least 6 weeksand as a change of character (from very trendy to less trendy) is occurring. When the VIX is very low the SPX has trouble making much upside headway and any explosive directionality is likely to be to the downside.

Of course no technical indicator is perfect. In early 1995, for example, the VIX did hit a sub-10.70 level and the SPX continued higher. However, in that case, the normally inverse correlation between the SPX and the VIX was broken and the SPX and VIX both walked higher in tandem. That's a non-normal scenario to keep an eye peeled for. But, as the term "non-normal" suggests, that's the exception rather than the rule.

As for what has been propelling the markets higher, I've read some work lately to the effect that Money Supply has been growing at an outrageous rate. This next chart plots M2, the broadest monetary aggregate still published by the Fed. (They stopped publishing M3 earlier this year.) In the past, great surges in the stock market have often been accompanied by outsized growth in Money Supply.

But in this case, through November 6 we see no great increase in Y/Y M2 growth. Indeed M2 growth has been fairly consistent by historical standards since about February of 2004, hanging around in the 3-6% range. So, the cash being pumped into the stock market doesn't appear on this measure to be riding on the back of outsized Money Supply Growth as it was in late '99 (in anticipation of the imagined Y2K crisis) or in late '01 in the aftermath of 9/11.

Indeed Money Supply appears to be growing roughly in line with Nominal GDP, which could arguably be called a neutral rate.

And on the interest-rate front the Fed remains tight, much tighter than the bond market thinks it will be in the future.

The bond market is so convinced that the Fed will be lowering rates that it has inverted the yield curve by -0.71%. That is, the yield on the 10-Yr Treasury is below the Fed Funds rate by almost ¾ of a percent.

As we can see on this chart, the SPX Price/Earnings Ratio (PE) on the Consensus of Forward 52-Week Operating Earnings has been expanding for 4 months. In our work that suggests that the market has been pricing in a Fed cut for just about that long. But as you can see on this chart, it is unusual for the PE and the Yield Curve to move in opposite directions for very long. And unless the Fed is really going to cut rates SOON (which we doubt will happen before the middle of '07, as Wage pressures, which are a strong correlate to inflation, remain robust), then it should be tough for the market's PE to continue to expand.

OK...3 more disturbing charts.

The US Dollar Index has just broken down hard to a new 19-month low. And the stock market? Almost no reaction whatsoever. Whether the dollar breaking down is bad news for stocks (higher commodity prices, higher inflation) or good news (higher profits for multi-national corporations and greater demand for US exports) is arguable. But the stock market has had almost no reaction at all. And that smacks of complacency to me.

As for Oil, the commodity that has perhaps most been on economists' minds, the stock market's rise on the "Oil is falling" thesis appears to have played itself out in early October.

It was then that Crude broke its downtrend and settled into a trading range. So, the SPX's breakout above its May high of 1326 has NOT particularly had support from a further drop in Crude.

With warm weather in the Northeast having been a depressant for heating oil demand, a surge in prices would appear to be probable as more normal cooler temperatures roll in. (Currently the extended forecast in the NY area is for temperatures to drop from the warmer-than average 50s and 60s into the 30s and 40s in early December.) We're watching for Crude's break out of its "box" between $57.50 and $62.50. (With the US Dollar falling out of bed, we should see upward pressure on both Crude Oil and Gold, both of which will increase inflationary pressures -- again putting pressure on the Fed not to loosen too soon.)

Finally, the decline in the 10-Yr Treasury Yield (TNX), which had been considered supportive of the stock market rally, also appears to have stalled with TNX just above 4.5%.

This "box" in which TNX has been trading is almost exactly concurrent with the box on the Oil chart above.

As with the drop in the US Dollar Index, the decline in TNX is a two-edged sword. On the one hand, lower interest rates suggest that the market is not worried about inflation and that it thinks the Fed will be cutting rates pretty soon. On the other hand, the inversion of the yield curve is historically only insignificant until it isn't insignificant anymore...and it becomes significant, slowing the economy and profit growth to boot.

But what's troubling about this chart, as far as I'm concerned, is that, as with Crude, as with the Dollar, as with PE Expansion in the face of a deepening inversion of the Yield Curve, and as with the too-complacent VIX, the stock market just doesn't seem to notice. It has marched blithely and heedlessly ahead, paying no never-mind to the changing (deteriorating) trends that had been supporting the rally.

Of course if Crude drops out of its "box," if TNX continues to fall because the Fed cuts rates (a bullish dis-inversion), if the US Dollar stabilizes, if earnings continue to grow at a multiple of GDP growth, and if the VIX rises as the SPX continues to rally, then we would have to look back on this letter and say, "Wow, lookee that! Everything worked out just right and the stock market was RIGHT to price in perfection!"

But if some or all of those things don't happen?...then we continue to think that the market would do well to abandon its one-way uptrend and allow for some dialogue between the bulls and the bears, which would show up in the form of diminished "trending-ness" and increased choppiness.

Our cyclical outlook for the stock market remains bullish at least through the summer of '07. However our shorter-term work suggests that the current rally is just too gleeful and heedless for its own good.

Best regards and good trading!