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US Economy - Smoke and Mirrors

Economics / US Economy Jun 18, 2007 - 12:28 PM GMT

By: Paul_J_Nolte

Economics It is nice to be able to take a bit of a vacation, come back and see that everything is just as you left it. Including the SP500. OK, so there was a bit of volatility while on the trip, with markets rising and falling by 70+ points in all but three trading days for the month of June. Everything from China to inflation to interest rates has been blamed or credited with the daily changes in the markets, however it just may be that investors are struggling with still high valuations and a likely slowing to the economy.

However, what made the week interesting is the overall economic analysis of the various reports and what is likely making the market go. Let's start with interest rates – they are going up, as the economy seems to be regaining momentum and the first quarter was the only rest the economy was going to get. It was also argued that stocks could rise further as bond yields were low enough to support higher valuations. And then there is the consumer, counted out when gas was above $2 at the pump, then $2.50 (and so on), yet according to recent data; the consumer has barely slowed their consumption of gasoline. What makes this all very interesting is that interest rates are rising (and fairly quickly), companies continue to slow expansion plans and as long as you don't eat or drive your car, inflation is not a problem!

After a preponderance of selling the prior week, last week the market turned tail and put in a smart rally, although not quite back to the old highs. The market internals were mixed at best, with volume still rising on declines and falling on the rallies. For the first time in two months, total declining volume (for a five week period) actually matched that of volume in stocks that are advancing. Save for some brief moments in late '06, the advancing volume has consistently been above that of declining volume. Each subsequent rally attempt at the old highs has come with a smaller and quicker decline as well as poorer internals with each attempt.

By our way of looking at the world, the markets are slowing making a top that could lead to something more than just a 5% correction. To be fair, however, the markets too have weathered nearly everything that could be thrown at it – from higher interest rates to China to rising gasoline prices. The market decline is not likely to come from a “conventional” place, like interest rates rising above a certain number or even if employment gains somehow vanish – it is likely to come from a political event – issues with China (trade barriers) or melt down of a large hedge fund. It will be a hot summer – both outside the office and on Wall Street.

Interest rates continue to move higher, although they had a mild reaction to the inflation figures. The yield curve, for the first time in over a year is actually “normal”, with higher rates for each maturity out to ten years. Our model remains negative and has done so for four weeks. On average (and this is dangerous!) the model is negative for 6-8 weeks, while positive for 13-15 weeks. However, the model has remained negative for 36 consecutive weeks (ending ominously 3/31/00), while it twice managed to be positive for at least 46 weeks. If we are embarking upon a new era for interest rates (one that is generally higher) then we would expect to see many more weeks of negative than positive readings on our models – stay tuned.

By Paul J. Nolte CFA

Copyright © 2007 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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