NOLTE NOTES - Waiting for the Fireworks

By: Paul_J_Nolte

Halfway home and we may have learned a few things about the first half of the year that may actually help with the second half. First, the consumer – left for dead when gas prices crossed $2/gal at the pump, then $2.50, then $3 – and much to everyone's surprise, the consumer is still spending.

Thanks to ethanol, corn prices have shot higher along with related items like milk and meat prices, but those don't get counted (along with oil) in the core inflation rates that have remained very subdued for much of the year. The housing market was going to bottom with the coming of spring and the buyers would be moving in on the lowered prices – so far there have been a few nibblers, but no biters at current prices.

The Fed has remained on the sidelines, watching and waiting for either the economy to move out of the goldilocks “happy place” or for inflation to kick in gear before they either raise or cut rates. However, the bond market has already done some of the work for the Fed as rates on the 10-year bond are now north of 5% vs. 4.75% at yearend. After a bit of a swoon late in February, stock prices took flight through May, under the impression that as long as nothing happens prices should rise. However, the rumblings of the first half may turn to all out shouting in the second. Sit back and watch the fireworks.

For those that sold in May and went away – you haven't missed much, as the markets are about where they were at the end of April. The volatility has picked up, as the daily moves are habitually around 100 points.

The trading range that has existed over the past two months has been a boon to traders, however investors have been frustrated by the “treadmill” activity (running fast, but going nowhere). The market internals have been deteriorating for a while, however so far, the ultimate arbiter of breaking down – prices - has not done so yet. A break of the 1490 to 1540 range in the SP500 will determine the next direction for the markets, but most of the indicators so far are pointing to a break below 1490, with the next likely stop 1460, which markets the February peak and the top of the trading channel the SP500 has been contained within since 2004. The bottom of that channel is roughly 1325, a 12% correction that would, if reached by yearend, put the market at a 3% annualized gain for the past two years – well below bond returns. Earnings season will begin in two weeks, and outside of the energy complex, growth has been very hard to come by. We believe that more normal valuations are likely somewhere around the 1325 range discussed above.

The Fed has decided to leave rates alone, yet again. For the past year, the Fed has met and indicated that the best thing to do is nothing. We also got a bit of a scare from the sub-prime markets as a hedge fund by Bear Sterns was looking for salvation. The ensuing flight to quality did push yields down during the week, but also moved the market back toward the inversion that has market the bond market for the past year.

The bond model continues to point to generally higher rates and remains negative at a “1” reading. This week brings the usual surfeit of economic data – unemployment and ISM reports that have historically been big bond moving reports. We expect some further deterioration in the employment report and gauging the regional reports, the ISM data may remain fairly strong, but the component that will be watched closely will be prices for any hint of inflationary pressures building.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

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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