CPI, PPI, Conflicting Data sends the market cautiously downward

Last night, I'm relaxing from a day of arguing with people over how to make admiralty brass tubing, and I flip over to CNBC. They are running a recap show of 2006. Basically, they are lining up one no-name, not important pundit after another who is talking about how great the market is going to be in 2007 and how the PE (price to earnings) ratio of 16 of the combined Dow components is below the 27 PE ratio we saw in 2001 and how the market needs to move higher. They are also playing down the inflationary pressures, energy, and other issues and are calling 2007 another 1995, harkening to an extended boom. They pumped up the idea of continued higher earnings and large corporate profits.

Well, I'm tired of conflicted pundits trying to make a buck by hyping a market that they are already long. There are serious problems in our economy which are coming to bear and such upbeat analyses only confusing people and expections need to be tempered.

First of all, the long term price to earnings ratio for the Standard & Poor's 500, not the Dow Jones Average, is 16 or 17. By saying that the PE Ratio is low, they are implying that the Dow components should trade at a premium to the broader market. This may be the case, although, I would argue that the Dow is not the best predictor of performance, and how much of a premium is a question.

Secondly, the implications that we will see continued high corporate profits is working under several broad and perhaps incorrect assumptions. Most importantly, I believe that there will be wage inflation in a variety of sectors of the economy, reducing corporate profit margins. With unemployment continuing to be low, hitting 4.4% in October, the power, through employee shortgages in certain segments of the economy, will swing back over to labor and corporations will be forced to increase wages and benefits to retain and hire employees.

Third, there is another assumption that these employees and workers in our economy will spend the majority of any potential wage increase which will in turn spell higher revenues and higher profits for the corporation. Unfortunately, this assumption is misguided. The savings rate previously at -0.8%, that's right negative, moved up to -0.2% in October, indicating that people are trying to pay off debts and saving more of their paycheck. Although the holiday season may prove optimistic and consumers will spend, I believe that after the holidays, the pressure to save will return. Due to continued weakness in the housing sector, Americans tolerance for debt will be tempered by their concern over the static value of their main asset.

The United States still has a major debt hangover, funded by overseas banks, a higher dollar due to one of the higher interest rates in the developed world, and a housing and credit boom. The last six months have seen the markets trying to correct and sleep off some of that hangover, but there is still a ways to go and some concerns lurk on the horizon.

If the dollar continues to slide on its own or as a result of a Fed rate cut, the current account defecit doesn't become smaller, and/or commodity prices don't temper in spite of falling US demand, foreign investors will shift their dollars into Euros or other currencies, making it more difficult for Americans to borrow and fund a large current account defecit. Continued high commodity prices may keep inflation high and as a result, keep the Fed from cutting rates which won't alleviate pressures.

After all that doom and gloom, there are couple things that may be in favor of the US economy that may stave off a recession or large correction.

Due to the high corporate profits we may see a pickup in business investment and capital spending. I believe that investments in telecom, energy, commodities and technology are possible, and the continued strength of the commercial real estate market means that corporations in some parts of the country are still investing in or leasing real estate. Several private equity deals focused on Office and Commercial REITs could be an indication of continued strength in that sector. Lastly, the frenzied and continued pace of M&A and private equity buyouts makes the financial sector a good profit source, and potentially means that some of those mergers may produce more value. Further, with profits where they are and cash being so cheap, corporate America may see a drastic restructing. Further, when these Private Equity shops have squeezed the savings out of financial engineering and cost cutting, they will need to invest in order to provide adequate returns that will please their LPs.

We need to proceed into 2007 with caution. We definately don't need to get up on TV about a booming market in 2007 with complete abandon.

Crude Oil Inventories go down, Retail Sales Go up

The Federal Reserve left interest rates unchanged yesterday and the market responded with minimal relief. The Federal Reserve also said that inflation is still higher than they would like and I believe they are concerned about the devaluation of the dollar. Some drop is okay and a gradual slide is fine, if it corrects the trade imbalance a little, but a drastic slide could be problematic.

America is entering a period of confusion in the economy. Although, those individuals in the bottom two quintiles of American net worth, have not felt the good economy of the last two or so years. They haven't had better paying jobs, they haven't been able to cash in on tremendous equity in their homes, and they salaries have not gone up. But they did feel the higher price of oil, the rise in their credit card and other loan payments (maybe even mortgage) and it became more difficult to stretch the dollar.

However, a weaker economy, with less robust growth in housing and autos, may not be so bad for the broad swatch of Americans. Even though the tax cuts and housing boom primarily benefited upper middle and upper classes and has not yet filtered completely through the economy, as corporate profits were distributed to shareholders, and not spent on capital investment or employee raises or hiring. In the past 3-4 months, the labor market has begun to tighten and there has been some wage inflation. This will affect the broader swath of people. Further, although cash rich corporate America has pursued mergers and acquisitions and private equity buyouts, for further return, investment will be required and this will provide a domestic demand stimulus to the economy.

One thing that the Fed and we should worry about is continued inflation due to energy costs and a dramatic drop in the dollar. There is a turning point where Asian economies start trading in their greenbacks for Euros and Yen. But a cheaper dollar and a rising and productive economy in Germany and the Euro region will mean cheaper American exports and a better trade balance.

Cheer up folks, maybe the Fed may begin cutting rates even by the end of the first quarter if inflation stays under control and the dollar doesn't drop too much. I think this choppy environment may be just what we need to bring certain overheated sectors back into check.

Newsflash, the FED is not fighting inflation, its fighting a good economy

Today some bad economic data came out from the housing sector and the dollar continued the slide it started three years ago. This is starting to weigh on the minds of economists and as politicians as they seek to explain or pander to their respective audiences. I believe it means that we are looking at a slowing of growth in the economy and continued weakness in the housing market. There may be a potential of a recession given the overhang of credit and debt, the weakness in the housing market, and a vigilant fed that may continue to hold rates for too long, in order to kill inflation.

Here's what Chicago Fed Chairman Michael Moskow thinks.

Here are the facts on the economics news on December 1st.

Today the Commerce Department came out with the weak housing data we've been expecting and receiving for the past couple months. The housing news is not getting better and is factoring itself into the rest of the economy. In that same article from CBS MarketWatch there was a nice quote from Stephen Stanley at RBS:

"We see this as an unambiguously good thing," he wrote. "The faster builders address their bloated inventories and bring the pace of home construction down, the quicker the housing correction will play out and the economy can return to a more normal footing."

The housing sector has been out of whack for about three years or more. However, the correction that has been needed to bring down the air out of the economy, and some of the air out of inflation, did not start until the fourth quarter of this year and will need to continue to properly adjusted the housing market back to normal levels. This correction should push down inflation enough where the Fed will probably need to begin lowering rates in the first quarter and stop trying to drive us into recession.

This brings me to the point that the Fed may be going to far in their Congress mandated fight against inflation. The housing sector and consumer debt is weighing down on the economy and a significant slowdown is going to happen. The question is whether the Fed will go to far or will it begin cutting rates sooner rather than later.

One thing is for sure, we will see flat to falling housing prices in a variety of markets for several years, some wage inflation, and less demand for inflationary driving commodities such as oil and metals. Our heating bills may be lower, but we won't feel the extra pennies in our pockets as mounting credit and high payments will continue to weigh on consumer spending. Look for some tightness in the economy, and slow growth for the following year and even a potential recession in 2008.