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Bear Market Rally is Over

If you have nothing intelligent to say it is better to say nothing at all… a thought that crossed my mind as I was muting the news channel last night.

Dow Jones Industrial Average
Dow Jones Industrial Average - 3 Years
Put/Call ratio
Put/Call Ratio- 6 Months

The next 2,000 points is now down,
That would be the Dow Jones Industrial Average that we are talking about, and we will certainly show you why we see that outcome, but also, we would like to offer up a little bit of truth about the "economy."

Fed fuels consumption as inflation risks accelerate:
Consumption is our economy and credit money drives it, but what backs it? A mountain of paper denominated assets? A strong dollar "policy?" Productivity? Economic growth? How about none of the above. We've seen how well paper assets hold up, but that was nothing. Wait until this year is through. As for policies, few are assembled without fault. The strong dollar policy can only work so long as the inflation is containable - in other words, so long as it still works to inflate paper rather than to devalue the purchasing power of the currency - and only so long as there is cooperation among the major currency partners, which is often the outcome of shared interests. We discussed this in the last issue (Dollar/Yen = Dollar/Gold).

What of productivity? There have been some highly intelligent thoughts on the validity of the Fed's productivity argument. Dr. Frank Shostak posted a thorough overview of the delusion behind much of the data (The Labor Productivity Myth), as have others, and we've already covered the subject ourselves in the summer time. Please refer to A Nation of Storytellers.

The delusion begins with a fundamental misunderstanding between money supply and economic growth, as measured by the GDP, GNP, or what have you. The fact is that the statistic that we are familiar with as Gross Domestic Product is in reality, only a measure of the money supply. Please refer to Dr. Shostak's case as our reference for this, and for the sake of brevity here. It is really important to understand that what we qualify as economic growth is effectively a credit induced expansion in the money supply, which tends to expand only when the horses still choose to (or can) drink the generously supplied water.

At the core, productivity is total output per hour of labor, which goes into producing the output. But by using our national income statistics, this number simply divulges the total amount of money spent per hour of work. And although that number has been rising, it has taken ever more credit money to influence each dollar of actual expenditure (consumption). I guess that the rest goes to servicing our rising "aggregate" debt levels, or to other non-productive wealth redistributing activities.

I am indeed suggesting that money, which is not somehow spent "efficiently," is less likely to show up in the final output number, which "leak" must be either the symptom of an overzealous credit expansion or an impotent monetary policy. Another way to say that is that there are patterns of consumption that work well to maximize that output number, and there are patterns of consumption that work against it, specifically the kind that result in an immediate decline in the purchasing power of the currency. Additionally, the potency of monetary policy can in many cases influence these patterns of consumption as easily as any other deliberate program.

Nevertheless, our increasing leak should continue to erode the effectiveness of monetary policy at the Fed, and as the effectiveness of monetary policy erodes, so too, will the (above) productivity number ultimately decline. But it doesn't stop there, our ignorance that is.

It has understandably become important for us to understand how much real money it costs to produce a level of real output in an hour. So, perhaps in order to acknowledge that total output measured in dollars (the unit of account in this case) is only a monetary output statistic, the concept of nominal and real GDP is introduced into the argument. Yet the adjustment is arbitrary, because it is only a government estimate of how much purchasing power the money has lost. Still, this arbitrary number helps them arrive at what is a more generally acceptable measure of real economic performance.

Anyhow, the whole idea that the measure of productivity imparts what many "experts" say it does is nonsense. Our hope is that we can help explain why it doesn't.

So, if productivity = real hourly output / hourly unit labor costs, then…
Having considered the numerator, let us also assure you that the denominator, the unit cost of labor per hour, is also a mish mash (sum) of mutually exclusive variables… like adding apples to oranges and saying that you have got two apples. But, does that mean that the equation (above) is meaningless? It is arbitrary in its most common interpretation, but not entirely meaningless. Then what does it tell us and who is it most useful to?

Calculated this way, the productivity data tells us how much (arbitrarily adjusted) money we can create per hour of work, and if we can do it profitably, thus efficiently. Then we can compare the data to last week, last month, or last year, in order to determine if our country is printing and spending this money with greater "efficiency" or not. In other words, if this number is high, then inflationist monetary policies can still work - as opposed to break down.

Thus, productivity (calculated this way) is simply a measure of the productivity of inflation. Obviously, this is a meaningful statistic for a central banker to have.

An example
For instance, imagine an economy where the top number (total adjusted money supply spent per hour) divided by the bottom number (hourly monetary compensation) results in a number, which ultimately defines your nation's economic standing and therefore, economic purchasing power. Assume that you, being a powerful world leader, want to maximize that number.

All you would need to do is encourage consumption (sort of like persuading the horse to drink water from the trough) and therefore credit, thereby increasing the supply of money.

Now, the trick is to ensure that the money is not spent on real things, all at once. Rather that the bulk of the excess money supply is poured into the asset markets, preferably the paper asset markets, so that more credit can be created. This way there is a positive drag on the reported inflation rate, which then influences (discovers) a maximum value for the numerator. And in such an economy, where the asset markets can generally inflate at will, foreign investors are attracted to this "productive" inflation, are willing to finance its perpetuation, and effectively encourage the cycle of consumption by inflating our global economic purchasing power (by bidding up the value of dollars).

Now, in such an economy, what employee would turn down the lure of the stock option to cash? Remember, in this economy, stocks go up at will. Anyhow, if enough participants (people) do choose this method of remuneration, conceivably, the effect would be to depress the denominator in our equation. Thus, the productivity rates in our hypothetical economy would surely rise.

But what if one day, stocks do not go up anymore? What employee is going to prefer a stock option plan to cash? And if wages begin to rise as a result (of many things really), will not the denominator in our equation be forced higher?

Hourly Wage earnings
Hourly Wage Earnings

That is where we are. The future of our economic delusion rests with the effectiveness of monetary policy. But total stock market capitalization has not been able to expand for well over a year, even though the Fed has allowed, and encouraged, the monetary aggregates to grow wildly throughout this period. So if people are not buying stocks with this new money (liquidity), and they continue to lose confidence in the increasingly abundant paper, what might happen in our simple economy?

S & P 5500 Large Cap Index
S & P 500 - 3 Years
M3 Money Stock
M3 - 3 Years

Participants may stop saving altogether and spend all of this never-ending supply of credit money on real things, rather than on stocks. So, the top number becomes smaller now, well, as soon as the lag in the government statistic (the price deflator / CPI) is washed out, that is. And if the process continues to be fueled by a cowboy Fed policy, it will prompt accelerations in the reversion to an objective valuation for the dollar.

Light Crude Oil Futures
Light Crude Oil Futures - 3 Years
M3 Money Stock
M3 - 3 Years

Thus, taking all of this into account, we too will join the growing chorus of analysts "predicting" that the US productivity data will begin to decline, except that we think the number will decline for some time. The reason is because we fully suspect that the inflationist policies of the Fed have been breaking down, terminally. Therefore, we also predict that the purchasing power of the dollar will continue to erode, against most things, and until the foundations of excess are purged. So you see, the number does mean something to us, but it also means something to the Fed Chairman.

Mr. Greenspan's productivity edict is intended to mean that he assures us, and believes, that the inflation can still work. That monetary policy is still effective. As long as productivity rates rise, the inflation can still work, and so, every time Mr. Greenspan lowers the interest rate, stocks will rise on command!

So, what are they buying, besides oil?
Since the last rate cut early this month, investors have been piling into the high yield, high risk securities markets, allowing some of the liquidity starved financial houses to reduce their risk, and perhaps walk the stock markets up a little bit more. Survival of the fittest my ass; this type of socialist monetary system can only reward the biggest and dumbest fools. Accordingly, it is doomed.

An economic slowdown, or an "inflation" warning?

30-Year US Treasury Yield
30-Year US Treasury Yield - 6 Months
 US Short Term Yields
US Short Term Yield - 6 Months

What these two charts mean is that long-term interest rates are going up and short-term interest rates are going down. Simple, huh? Whether the analyst interprets this chart as a sign that a short recession may be behind us now (and that the yield curve is thus simply normalizing), or that inflation expectations are on the rise, will depend on his or her understanding of what inflation actually is.

If inflation is (interpreted as) the result, on the general "price level," of some form of aggregate economic demand exceeding some contrived concept of total economic capacity, then the analyst will tell you that the normalizing yield curve is the result of a slackening in demand, and further, that it (the curve) is predicting the end of the economic weakness, and ultimately setting up for a turnaround. But this form of analysis overlooks the real possibility that prices may rise even as "aggregate" demand (consumption) weakens. That is because the analysis refuses to take into account the influence of individual preferences on the purchasing power of the money used in any given transaction, at any specific moment in time.

If the analyst is driven by the truth, however, he (or she) will understand that the concept of a price level means adding apples to oranges to a pair of jeans to an automobile in order to arrive at an average that is representative of something too meaningless to qualify as abstract, in the first place. This analyst should then also realize that the one thing, which these very different things do have in common, is the money in which they are priced (exchanged for). Thus, the quantity of money combined with an individual's unique preferences, at any given moment, will determine the value of that money, and thus the price of a specific good.

Furthermore, the analyst will know that the lower short-term interest rate is not only an artificial policy induced rate, but that it will ultimately fuel the inflation. Unfortunately, this is a result that comes nowhere near describing an economic trough, but rather a continuing crisis. Let's keep it simple, shall we?

When this is happening, it is a really bad idea to lower interest rates!

Commodity Research Bureau
Commodity Research Bureau - 3 Years
Goldman Sachs Commodity Index
Goldman Sachs Commodity Index - 3 Years

Why? Because when people become confused about the value of things, which they so often do, and their central bank keeps throwing new (credit) money at them, they will in turn throw it in the direction that suits their economic interests. Thus, the meaning of the phrase, liquidity seeks inflation. And if the system arrives at the point where everybody is cashing in his or her chips because nothing else is inflating anymore, the inflation that has been so well managed and organized, will become disorganized. Government policies will beget bad ones, as they have no choice but to defend the value of the (overly issued) currency with everything that they have got, which never is enough when it comes to a war over real things, and the entire economy implodes.

Not even higher interest rates can stop this process when it gains momentum. Only the hoarders will make money. But so be it… the social consequences of dishonest money. Again, we post these two charts as we did in late December, and we ask Mr. Greenspan to please lower interest rates again…

US Dollar Index
US Dollar Index - 2 Years
Gold Futures
Gold Futures - 2 Years

We did ask nicely, didn't we?

Mr. Greenspan has now had two different occasions to reflect on the Greenspan-Put. The first being just before Christmas time when he made the original promise. The stock market yawned. The second when he tried to catch the market entirely by surprise, and did, on January 3rd, with a half point credit sale. The move has worked to alleviate some credit market stress, but otherwise, has not done much for the stock or government bond market. What if the next one doesn't work either? Well, that is one basis for our stock market call, for the next one is already priced into the Fed Funds market - the rumor having already been floated during Tuesday morning's trading session.

Dollar confidence will then have to rest with a leaky (leaking inflation everywhere except in the government figures) dollar and fiscal policy? Yikes. So, get this, and I hope you are sitting down for this.

We are so insolent…
Mr. Greenspan's upcoming testimony is going to have to hint at a reverse course in monetary policy. He is going to have to reflect on the risks to inflation of engaging a monetary policy that is perceived to be the cure for our economic problems, when it is actually the cause. He will have to, sooner or later, admit that monetary policy, while effective under conditions in the past, is no longer effective. Of course he will. For, if every time that interest rates are lowered, the new liquidity increasingly fuels the prices of real things (read: accelerates the point of recognition), then it will also accelerate the rate of deterioration in the purchasing power of the dollar.

Who am I kidding? Yet, this kind of talk is the only way to make US monetary policy effective again. Here is why: First, because it would unquestionably knock the heck out a stock market, which is expecting lower interest rates. And then, maybe then, a 50 basis point rate cut can work to re inflate the stock market… maybe. For the record, Mr. Greenspan already made his first mistake by not listening to us when we suggested (in December) that he shouldn't lower interest rates until after the stock market sells off.

Anyhow, even if he were to talk the talk, I know it cannot possibly sound quite as honest as written above, but the point is only incidental anyways… not a serious prediction, more like a guess, a gut guess. But consider some of our more logical support for the stock market call.

The Sensitivity Index
Oil prices, on the other hand, have indeed acted on command. They have risen 15% since the rumor of an OPEC cut was first floated. This is an important observation for any trader because just by comparing the stock market response to an interest rate cut with the response of oil prices to an OPEC cut announcement, you have found your real bull market! If this doesn't make sense, consider it this way.

If two public companies concurrently announce better than expected earnings, assuming all else being equal, and one's shares react (rise) stronger than the other, in the market, you could make dumber mistakes than to assume that it was the right one to buy.

What else we do not like about this "stock" market…
The blue chip averages, Dow Industrials and NYSE composite, look poised for another crack at support. Both spent the short week bumping up against their 200 day moving averages, but in the end, couldn't cut it, closing Friday's session in disappointment, near the low end of the trading week. The action so far this week has changed nothing.

In December, we suggested that the Nasdaq was ripe for a bounce, but we also concluded that the bounce would presage a crash in the blue chip averages, as it would crowd out the remaining liquidity. The Fed responded by slashing interest rates in order to provide additional liquidity, thus delaying the move. Early last week, we thought the bulls had enough time to gather momentum and concluded that if they didn't demonstrate any meaningful territory, the bear would reassert its position shortly thereafter. On Tuesday morning, rumors that Mr. Greenspan was going to hint at a minimum 25 basis point cut at his testimony, on Thursday, sent the equity markets on what may have been their last gasp.

A glance at yesterday's Dow leadership was revealing. The top quartile of performers included General Electric, American Express, Boeing, Coca Cola, Home Depot, Intel, and International Paper. Below is a brief overview of the technical (chart) condition of each stock.

General Electric
Recently broke down from a 10 month Head and Shoulder top, which has been tested twice now, and thus implies a $12 drop to $34 from here, give or take. The objective is roughly a 25% decline. Today's pop may have been its last test of resistance at $47.

American Express
AXP has seen an enormous amount of selling pressure impressed upon a long in the making sagging top of various persuasions (multiple bearish technical patterns) almost on the very same day that the Fed slashed interest rates. Volumes almost classically accelerated into the decline. On Tuesday, AXP exhibited climactic behavior, but prices traded mostly an inside day. The market is only half way to its more obviously immediate objective at $40, another $6.50 from here (12% lower). This move is not over, and besides, volume climaxes often precede a turn around in price, sometimes by a week or two.

This stock may be in the process of topping out right now. Money flows have turned decidedly against the bulls here (since early December), and prices may have conceivably fallen out of a small two-month rising wedge. But while the stock price has not yet clearly broken down, in my opinion, it has yet to establish an intermediate higher low, also, in what may become a primary bull trend. What that means is that it has yet to test trend support at $54, and then that has yet to prove that that was trend support. In other words, there is plenty of nearby downside.

Coca Cola
Money flows have turned bearish now (meaning that over the past twenty days, on average, the higher volume days are down days - typically a sign of distribution) after three discernibly noble attempts (?) to turn the primary trend around, which remains bearish, at the $64 handle. This chart had the potential for a turn around, but the bears have visibly demonstrated primary trend control and arguably, now appear ready to test the $50 low, $7 (12%) lower.

Home Depot
HD is simply a terrible looking chart. The bears have a lot of unfinished business here. The October break down confirmed a double top, which straddled the beginning of last year (2000), while December's rally filled a gap, retested the validity of that same top, and established a potential downtrend. Thus, the stock appears ready to test the $34 level again, in the short term (almost a 24% decline).

The stock has room to move higher, but unquestionably, only within a primary down trend. After testing the low $30 handle for bullish support, repeatedly, over the course of January, the bulls moved the stock back up to the $35 mark. A run at the bearish outpost somewhere near the $40 level is not out of the question, but confidence is paramount.

International Paper
IP is a stock where the money flows have turned decidedly in the bulls favor. December's accumulation was so heavy that it established a powerful correction to the bearish primary trend. But that is all. The primary bear trend is still intact. Thus, if that is correct then there is room for new lows, but the relatively strong signs of accumulation may also foretell of the kind of leadership this market may get in the next cycle, perhaps late this year. Yet, even if that is true, a successful retest of October's lows may still be in the cards if only to establish a long term bottom. Still, that is about 30% lower.

Except for Intel, Tuesday's interest rate rumor did little to alter the bearish bias in any of the above leadership. If anything, it set up the next down leg.

The Nasdaq indexes spent the short week (last week) rising in countertrend, but bumped up against the bearish stronghold just a little too hard and ended up gasping for more air by the time they got there. It was a 150-point rally on the week, at best. Volumes weren't bad at all for the week.

We could hear the bulls snorting away and aching to go all week long, still in denial of the forces, which have already turned the primary trend against them. Can they make it to 3000 (another couple of hundred points or more)? Possibly, but can they make it to 3500? That is what they will have to do to turn this market around.

But, you might ask, that's a pretty good rally... up 25% from here? It is, but for a market (index at that) to rise by 25%, it has to "look" like it can rise a lot further than that. That said, they (bulls) did manage to leave behind a 500 point one month diamond (a popular pattern this month) and push through the faster 50 day moving average, raising the odds for a short spurt to the 3000 handle on a day when the bears aren't looking. The move, in fact, may be just what the doctor ordered to create the next liquidity crisis for the Fed.

Thus, the stock market is a sell.

Dow Jones Industrial Average
Dow Jones Industrial Average - 2 Years
NASDAQ Composite
NASDAQ Composite Index - 2 Years

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