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The Stock Market: Warning Shots and Spin

Below is a slightly-modified extract from a commentary originally posted at www.speculative-investor.com on 3rd December 2006.

Warning Shots

We don't think an important top is yet in place in the US stock market because the NDX/Dow ratio (a reliable leading indicator) hit new multi-month highs as recently as the past two weeks and because sentiment is yet to reach the sort of optimistic extreme that typically coincides with a major top. However, we do think there's a good chance of a major top being put in place within the next 3 months, in which case we should already be seeing a few early warning shots.

The evidence at this time isn't substantive but we are, in fact, seeing a few signs that a topping process is underway. Here are some examples:

1. The financial sector was a leader to the upside between the second half of June and the first half of October, but over the past 6 weeks this sector has been relatively weak. Take a look, for instance, at the way JP Morgan Chase (JPM) appears to be rolling over.

2. The major European stock markets were relatively strong until around mid November, but have since been relatively weak. This could be indicative of an impending trend change.

3. During the first half of this year the stock markets of the Middle East were leaders to the downside, typically peaking about 3 months ahead of the G7 stock markets.

After stabilising between May and October the Middle Eastern markets have resumed their declines. In particular, the following weekly Fullermoney.com chart shows that Saudi Arabia's Tadawul Index has broken sharply to the downside over the past several weeks. As was the case during the first half of this year, the Tadawul's breakdown could be a warning shot for other stock markets.

4. Gold has been strengthening relative to base metals since late October, a possible sign that the sea of liquidity upon which stock markets have floated upward is about to dry-up.

Like the man with a hammer who sees everything as a nail, perhaps we are guilty of seeing topping signs simply because we are going out of our way to look for them. This is a risk, but note that during a secular bear market the potential cost of being too cautious is a lot less than the potential cost of being too bullish.

Spinning the housing downturn as a stock market positive

The downturn in the US housing market is being spun as a stock market positive on the basis that it will force the Fed to begin a rate-cutting program and, as everyone knows, Fed rate cuts are bullish for the stock market. Well, it's often the case that what everyone knows is not worth knowing and that certainly applies here because Fed rate cuts are often NOT bullish for the stock market.

When it comes to the setting of the Fed Funds Rate target the Fed will usually just follow the market in that some time after the market begins to lower short-term interest rates the Fed will start doing the same. However, lower short-term interest rates definitely wouldn't be a significant positive for a stock market priced in anticipation of strong earnings growth if the downward move in interest rates was a response to a sharp deterioration in the economic outlook.

In any case, the whole idea that the Fed's next move will be to lower the official interest rate deserves to be seriously questioned because it is based on the assumption that inflation expectations will remain low. There are, however, conditions that have a reasonable chance of arising over the coming months that would invalidate this assumption. Before we mention what these conditions are it's important to understand the Fed's greatest fear.

It is often said that the Fed fears deflation. This is true, but the Fed's fear of deflation can be likened to your editor's fear of swimming with Great White sharks. Your editor would be very fearful of jumping into the water if he suspected that a Great White was lurking below, but sharing a patch of water with a Great White is not something he spends any time worrying about because it is something he can easily avoid. It's the same story with the Fed and deflation. Deflation would be a nightmare for the Fed, but Ben Bernanke will never spend much time worrying about it because he knows he can easily avoid it.

What the Fed regularly does have to worry about is an out-of-control surge in inflation expectations. The Fed can create money in unlimited quantities at practically zero cost, but today's money continues to have value because most people TRUST that it is going to do no worse than lose its purchasing power at the rate of a few percent per year. Or, to put it another way, the money is essentially worthless but as long as most people BELIEVE that the money will decline toward ultimate worthlessness at a slow pace it can continue to be a useful medium of exchange.

The Fed and all other central banks would face a problem, though, if a critical mass of people began to anticipate a rapid acceleration along the road toward eventual worthlessness. If this happened then the Fed would be at risk of losing its ability to keep the world's greatest confidence game going, and it is this risk, not the risk of deflation, that has the potential to keep a central banker awake at night.

We'll now return to our original discussion. There is a significant chance that additional weakness in the housing market WILL prompt the Fed to begin reducing the official short-term interest rate target within the next few months, BUT ONLY IF inflation expectations remain under control. On the other hand, if it looks like the gold price is about to breakout to new multi-year highs then cutting interest rates will probably be the last thing on the collective mind of the Fed, regardless of how weak the housing market happens to be.


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