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David L. Smith, Editor
February 25, 2007


As of the close on Friday, February 23, 2007

DJIA: 12,647 S&P 500: 1,451 NASDAQ: 2,515
Treasury Yields 2-yr.: 4.808% 10-yr: 4.64 % 30-yr.: 4.78%
¥en: 121.09/$ uro: $ 1.31/ British Pound: $1.96/
Gold: $685/oz. StreetTRACKS Gold (GLD): $67.72 Oil (Nymex): $60.87
PWE: $31.71 CNE: $12.99 FXB: $196.90 FXE: $131.94

EXECUTIVE SUMMARY: The ongoing debate between the “soft-landing”
conventional wisdom and the “hard-landing” contrarians moved in favor of the latter
recently as oil prices rebounded strongly off their year-end lows and “core” inflation
rekindled in December and January. These developments, combined with a surprisingly
thstrong 4 quarter gross domestic product advance report, put to rest any thoughts of
imminent rate cuts, and, indeed, raised the specter of further rate hikes by a Fed clearly
troubled by the “risks of inflation.” Former Fed Chairman Greenspan added some weight
to the “hard landing” argument by acknowledging the “possibility” of a recession in 2007,
something he would never have done while still in office.


4Q 2002-2005
3.5%Average 2.8%

As I have often stated, the Fed is committed, first and foremost, to maintaining price
stability, even at the expense of economic growth and employment. Accordingly, the
central bank will not rest until inflation has been contained, which means bringing the core
CPI and personal consumption expenditures index down from around 2.7% year-over-year
into a 1%-2% range of tolerable inflation. To accomplish this task, the Fed must keep a lid
on economic growth, even to the point of recession, so as to restrain oil demand, thereby
undermining one of the main sources of inflation. I have long been of the opinion that a
recession will be required to contain the inflation inherent in the present third oil shock.
The Fed’s abrupt halt in monetary expansion since the beginning of the year, may be
foreshadowing a recession-inducing hike in fed funds. (See “Monetary Policy.”)
Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 1

In a significant development on the international front, the Treasury reported an $11
billion net outflow of foreign capital from dollar-denominated securities in December
2006. The outflow represents an $81.5 billion swing from the $70.5 billion inflows
recorded in November 2006. The entire outflow of international capital was accounted for
by $11.1 billion in net sales of U.S. equities by foreign private holders. If they keep selling,
U.S. stock prices might suffer. Be forewarned. (See “International.”)

The stock market just keeps rolling along. Stocks extended a strong rally (at an
unsustainable 30% annualized rate) initiated in July 2006, bolstered by the widespread
perception of a “soft landing,” lowered oil prices and the easing of Middle Eastern tensions
accompanying the Israeli withdrawal from Lebanon, plus a generous infusion of private
equity funds, stock buybacks and mega-mergers. However, because stocks are getting
pricey and the odds of an impending recession are growing, I urge you to be ready to exit
the stock market when the major indices break down technically. (See “Stocks.”)

As for the other investment markets, oil and gold bottomed and rebounded strongly,
prompting triggering a technical signal to re-enter gold using StreetTRACKS Gold (GLD)
and a continued hold on the two Canadian oil trusts, Penn West Energy (PWE) and Canetic
Energy (CNE). As might be expected, bonds slumped in response to the foregoing,
extending the bear market in bonds that began 3 years ago. Accordingly, I continue my
longstanding recommendation to avoid bonds.

CURRENT U.S. ECONOMIC SITUATION: The U.S. economy closed out the year
thwith a relatively strong showing in the 4 quarter of 2006 with moderating inflation
and reasonable employment gains, consistent with the “soft landing” scenario. Real
gross domestic product expanded at a respectable 3.5% annual rate, according to the
rdgovernment’s advance estimate, nearly twice the 2% growth experienced in the 3 quarter.
(However, according to consensus estimates, this first look may prove to be overstated by
as much as 1.2 percentage points.) According to the advance estimate, brisk growth in


(Housing, Equipment),

Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 2

consumer spending, net exports and government spending overcame the drag of shrinking
investment – notably in housing, autos and inventories. A significant rebound in non-farm
thproductivity in the 4 quarter contributed to the year-end surge, with annualized
productivity gains of 3%, well above the 2.1% average for the past two years. Robust
st thgrowth in the 1 and 4
quarters offset the
economy’s anemic mid-
year performance to
produce a solid 3.4% rate
of growth for 2006. That’s
a modest increase over the
3.2% rate recorded in 2005,
and comfortably more than
the average annual rate of
growth of 2.8% in the 4
years following last
recession in 2001. Accordingly, the U.S. economy is chugging along fairly close to its real

thSurprises for the 4 quarter included the
acceleration in the annual growth in personal
consumption expenditures from 2.8% in the
rd SPENDING PICKS UP 3 quarter to 4.4% – notably for durable and
thIN 4 QUARTER ‘06 non-durable goods at rates of 6% and 6.9%
respectively. Consumers seem determined to
continue borrowing and dipping into their
meager savings to spend themselves into
oblivion, despite mountainous debt, soft housing
prices, climbing interest rates and costly energy.


Common sense tells us that these are unsustainable trends. But since they have been
going on for a long time, most pundits tend to forget the eventual dangers they pose to the
economy and financial markets: cascading defaults, sharp cutbacks in consumer spending
spilling over into business investment, undermining employment and stock prices. The
consensus within the National Association for Business Economics sees no such dangers in
its February 2007 forecast, predicting staunch consumer growth will be the mainstay of
continued moderate economic expansion. However, prudent investors should keep these
eventualities in mind and be quick to exit the stock market when debt-laden consumers
start to pull back. In the meantime, until the major stock indices break down technically,
enjoy the ride.
Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 3

Thanks largely to the year-end
downdraft in oil prices and a CONSUMER PRICE INDEX
decelerating mid-year economy,
consumer and producer price
inflation moderated in the second half
of 2006. The monthly headline CPI
plunged into negative territory in
September and October, pulling down
the year-on-year change from above 4% to a tolerable 2.1% by January 2007. The much-
emphasized core rate seemed to be moderating as the year wound down, from monthly
increases of 0.3% mid-year down to zero in November, encouraging the “soft landing”
crowd to expect the Fed to begin cutting rates by mid-
CORE CPI 2007. However, those hopes were dashed when the
core CPI bounced back to a 0.2% increase in December
and an alarming 0.3% jump in January. At 2.7% year-
over-year in January 2007, the core consumer price
index (CPI) remains uncomfortably above the Fed’s
2% threshold of tolerable CORE inflation. This upturn
in the core CPI is consistent with my longstanding
warnings of more inflationary momentum in the
pipeline, given the lag between changes in oil prices
and the core CPI (see graph above). The recent rebound in oil prices from the low $50s to
more than $60 a barrel could add to that
momentum. (See “Petrocycle Update.”)
Likewise, another of the Fed’s key inflation
gauges, the index of Personal Consumption
Expenditures is also hovering uncomfortably
close to 3% on a year-over-year basis, adding
to the Fed’s apprehensions about inflation.

Employers added an average of about 150,000 new jobs a
month in the final quarter of 2006, enough to hold
unemployment at a low 4.5% rate in December.
Longstanding weakness in manufacturing was offset by strength
in education, health and business services. The sub-par addition
of 111,000 new jobs in January produced a slight uptick in
LABOR unemployment to 4.6% -- still tight enough to cause the Fed to
MARKET fret about the inflationary implications of a tight labor market.
STILL TIGHT thNevertheless, the strong 3% rebound in 4 quarter productivity
held the year-over-year increase in unit labor costs to a
moderate 2.8% rate for 2006.

MONETARY POLICY: “Steady as she goes” has remained the hallmark of Fed
monetary policy during the past five meetings of the Federal Open Market
Committee (FOMC). In its January 31, 2007 statement, the FOMC, encouraged by
“modestly improved readings on core inflation in recent months” expected inflation would
“moderate over time” because the economy would “expand at a moderate pace over
coming quarters.” However, the FOMC warned that “some inflation risks remain” given a
Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 4

“high level of resource utilization” combined with “firmer economic growth.” There was
no hint of a rate reduction in the offing, but rather the forewarning that “The extent and
timing of any additional firming that may be needed to address these risks will depend on
the evolution of the outlook for both inflation and economic growth, as implied by
incoming information.” The 0.3% jump in the core CPI announced last week is precisely
the kind of “incoming information” likely to prod the Fed to resort to such “additional

The yield curve has remained steadfastly inverted (with long-term interest rates
below short-term rates) since the Fed reached its plateau in the fed funds rate last
INTEREST RATES June. This inversion, in the face of a mild
uptrend in long-term rates for the past 3
years (see graph above) reveals ambiguity in
the credit markets mirroring the Fed’s own
Inverted yield curve mixed message: on the one hand, the yield
Rising rate trends curve inversion conveys the long-term credit
Source: Federal Reserve Board
market’s expectation of slowing economic
growth, possibly even a recession; on the
other, the overarching uptrends in both long- and short-term rates imply a fear of resurgent
inflation. This ambiguity should not surprise us, inasmuch as the next stage of the
economic cycle is usually stagflation: weak or negative economic growth paired with
troubling inflation. Accordingly, both the credit markets and the Fed sensibly reflect
wariness about the outlook for inflation and growth. The perennial optimists in stock
market, however, remain convinced of the second coming of Goldilocks.

This division of opinion is nothing more than a replay of the “hard landing” vs. “soft
landing” debate that has been raging for many months.
If the credit markets are correct, sooner or later we will witness a recession, either
preceded by a resurgence of inflation (to produce stagflation, met by higher interest
rates) or, if inflation moderates, the economy will simply slip into a “hard landing”
as consumers retrench in the wake of continued erosion in housing and autos.
o Stagflation, if it materializes, would initially be bad for bonds and stocks --
as inflation rekindles, driving up interest rates to prompt a recession.
Whether inflation rekindles or not will depend heavily on oil prices.
o An eventual recession would be good for bonds (as inflation abates and
demand for credit slackens pulling down interest rates, pushing up bond
prices) and unabashedly bad for stocks (as recession undermines corporate
If the stock market is correct, inflation will remain “contained,” and the economy
will continue to grow at a moderate pace, producing a “soft landing.”
o A “soft landing” would be good for stocks, producing continued growth in
corporate profits.
o The effect on bonds would probably be neutral, with the downward pressure
on rates from abating inflation being offset by continuing growth in the
demand for credit in a growing economy.

January’s 0.3% pop in the core CPI tilts the scales in favor of the renewed inflation, more
Fed hikes (or at least, no rate reductions) until there is a “hard landing” sufficient to
restrain oil prices and inflation.
Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 5

If we look beyond the Fed’s inaction on interest rates to its action on the money
supply we find what may be the beginnings of a policy shift, as I predicted in my
January 12, 2007 Quarterly Report. You will recall that for the first half of 2006 the Fed,
preoccupied with the possibility of resurgent inflation (as oil prices climbed to around $77
a barrel), held monetary growth to a moderate 5.8% annual rate for the Money Zero
Maturity (MZM) monetary aggregate. Then, as oil prices tumbled into the $50s and growth
slowed during the second half of 2006, the Fed worried about recession, and boosted
MZM’s growth rate to a torrid 8.7% rate – which goes a long way toward explaining the
thstrong 4 quarter finish for the economy and the corresponding stock market rally.

However, as I stated in the last
Report: “The Fed knows it Worried about
inflation cannot keep expanding the money
supply substantially faster than
the economy grows without 8.7% rekindling inflation. Conse-
quently, we should expect a
downshift in monetary growth
soon. Usually the Fed 5.8%
Worried about growth implements such changes around
the beginning of the year.” Right
Worried about inflation on cue, after expressing its
concern about “high resource
utilization” and the risk of
inflation in the face of rebounding oil prices in January, the Fed abruptly ceased expanding
the MZM money supply. This monetary aggregate is critical for financial markets because
it includes large institutional money market accounts that are, in essence, buying reserves.
Therefore, the lack of MZM growth, if sustained could curtail institutional buying of stocks
and/or bonds, thereby undermining rallies in either or both markets.

Bottom line: The Fed’s recent concern about the possibility of rekindled inflation
(strengthened economy, rebounding oil prices, high resource utilization, rising labor costs),
matched by a corresponding curb on monetary growth suggests:
a. The likelihood of an imminent de-escalation of short-term interest rates has
diminished and
b. The probabilities of a longer-than-anticipated fed funds plateau or even further
hikes in interest rates have increased.
Accordingly, the risks to stocks and bond prices have correspondingly risen.

FISCAL POLICY: President Bush submitted his budget to Congress proposing
substantial increases in spending to promote “freedom and democracy” in Iraq while
undermining both at home and curtailing spending on vital domestic needs such as
healthcare, education, infrastructure, the environment. With control of Congress now in the
hands of Democrats pledged to “a new direction,” the budget was duly pronounced “dead
on arrival.” Consequently, I won’t take up your time in these pages with an analysis of this
irrelevant document.

Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 6

INTERNATIONAL: One of my major themes in recent months has been the
expectation of a flight from the dollar by international investors laden with huge
dollar surpluses. The net effects of sustained selling of dollar-denominated securities
would be a decline in the value of U.S. stocks and bonds, with a corresponding increase in
interest rates.

The latest Treasury International Capital (TIC) data released February 15, 2007,
reveal an $11 billion net outflow from U.S. securities in December 2006. (See )This is the first such outflow since June
2005, representing an $81.5 billion swing from the $70.5
TRADE DEFICIT billion inflows recorded in November 2006. Net private
outflows of $42.5 billion in December were partially offset by
net official (government) inflows of $31.5 billion, suggesting
that foreign governments propped up the dollar to preserve the
price advantage for their exports afforded by favorable
exchange rates. The weakness in private demand for dollar-
denominated securities might be attributed to the narrowing of
the U.S. trade gap toward the end of 2006, reducing the dollar
surpluses generated by foreigners available to purchase dollar-
denominated investments.

Whether the December outflow is a harbinger of things to come remains to be seen.
Stock market investors might want to pay particular attention to future TIC reports,
inasmuch as the entire outflow of international capital was accounted for by $11.1 billion
in net sales of U.S. equities by foreign private holders. If they keep selling, U.S. stock
prices might suffer. While the one-month outflow in December did not have a discernible
impact of U.S. stocks, bonds or the dollar, we should remain alert to the possibility of
erosion in these markets produced by a sustained flight from the dollar. Continued
improvement in the U.S. balance of payments deficit could be counterproductive for U.S.
financial and currency markets. Stay tuned.


Strong uro, Strong pound,
Weak dollar Bottom line: We may be witnessing the first signs of a wholesale exodus from the dollar Weak dollar
ambit producing corresponding heightened risks to the dollar (exacerbating a
longstanding weakening dollar trend) and U.S. stock and bond markets.

PETROCYCLE UPDATE: The price of crude oil over the past year has been buffeted by
strong, conflicting currents. During the first seven months of 2006, global crude oil prices
were pushed up to around $77 a barrel as strong demand continued to press the limits of
deliverable supply while speculators piled on a significant risk premium during Israel’s
invasion of southern Lebanon in July. Then, between late July and October, oil prices
retreated down to about $55 a barrel as Israel pulled out of Lebanon and big oil and the
Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 7

Saudis decided to support their Republican friends
with a little “friendly over-production,” creating large
inventory surpluses in advance of the mid-term U.S.
elections. After the November 2006 elections, oil
rebounded to around $65, as I predicted, when
inventory surpluses were drawn down and the Saudis
agreed to a reduction in OPEC’s production ceiling.
Then in December 2006 and January 2007, oil
retreated to the vicinity of $50 a barrel due to weak
heating oil demand occasioned by unseasonably
warm weather, coupled with doubts about OPEC’s
willingness to adhere to its production limits. Finally, oil rebounded to just over $60 a
barrel in recent weeks in response to mounting tensions with Iran and skyrocketing
demand for heating oil as blizzards blanketed the Northeast.

The confrontation with Iran, previously focused on the West’s objections to Iran’s
nuclear program, has become compounded by the Bush administration’s beating of
the tom toms over Iran’s alleged involvement in Iraq. The administration has revived
charges (originally made widely in the press in August 2005 and again before the Senate
Intelligence Committee in February 2006) that Iran is supplying Iraqi insurgents with
professionally made explosive devices (explosively formed penetrators or E.F.P.s)
specifically designed to penetrate the armor which protects American vehicles. In what
could be a prelude to retaliatory air attacks against Iran, a second U.S. carrier group has
been dispatched to the Persian Gulf with a third said to be in readiness. A naval aviator has
been placed in command of CENTCOM, suggesting a possible shift in military emphasis
in the region. Needless to say, if the balloon goes up in Iran, raising the possibility of oil
supply disruptions from the region, a substantial risk premium will be added to the global
price of oil. Mainstream Pollyannas, like Goldman Sach’s Abby Joseph Cohen, assume
there will be no political disruptions of oil supplies, and, therefore, don’t factor such risk
premiums into their forecasts. Given the tensions in the region, I believe it prudent to
assume Murphy is alive and well and living in the Middle East.

Bottom line: In the near term, oil prices will remain volatile, given the unpredictable
nature of the forces – weather, geopolitics, OPEC quotas, speculation – dominating global
oil markets. However, at a time when deliverable surplus oil supplies are tight, demand for
oil keeps growing in an expanding world economy and the risks of political disruptions of
oil supplies are high, the longer-term bias tends to be to the upside, at least until such time
as a serious global recession dampens the demand for oil. An upward bias to oil prices
tends to heighten the risks of rekindled inflation, higher interest rates, lower bond and
stock prices. Eventually, such an outcome can be expected to produce a hard landing with
corresponding risks to stocks and benefits for long-term bonds.

U.S. ECONOMIC OUTLOOK: In today’s economy we can rule out sustained fast
growth as a plausible forecast primarily because a) fast growth accompanied by
unacceptably high inflation would be quickly stymied by an inflation-averse Fed and,
alternatively, b) fast growth accompanied by low inflation would not only require
sustained, improbably rapid growth in productivity but also an equally improbable
willingness by corporate America to generously share the wealth with the workers so as to
enable them to continue spending while paying down debt – the key to sustained growth.
Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 8

However, the improved gains in productivity we have seen to date have been
overwhelmingly bestowed on corporate shareholders and top executives, leaving workers
only meager gains in real earnings and mounting debt. Consequently, absent substantial
pay raises for the working classes, the robust growth in aggregate spending required to
sustain a rapidly growing economy will not materialize because of the slow growth in
earnings and mounting deadweight of record debt borne by working-class households. (See
graph on page 3 above.)

If sustained rapid growth is either impossible or, at best, implausible, that leaves
moderate or negative growth as the remaining plausible near-term outcomes – in
other words, the “soft” or “hard” landings. A “soft landing” may be possible for a
while, near-term, as long as households are willing and able to continue borrowing and
spending, accompanied by a commensurate willingness and ability of banks to continue
lending. However, as has been often pointed out, living beyond our means through
continued borrowing and use of savings to sustain consumption cannot continue
indefinitely. Therefore, it is merely a matter of time before the soft landing becomes hard,
when consumers are forced to pare spending in order to pay back debt and rebuild savings.
The greater the accrued debt burden, the more severe the ensuing crash. Consequently, the
Fed’s attempt to extend the current expansion at a moderate pace will eventually prove
counterproductive inasmuch as it will only add more debt to household balance sheets.
Seen in this light, the “soft landing” is merely an extended version of the inevitable “hard

The main remaining question is “When?” The answer is “I don’t know,” (and nobody
else does for sure either). I should have thought the retrenchment of consumer spending
would have happened already. But it has not, largely because of the insatiable appetite for
goods and services by American consumers, fueled primarily with low-cost credit from
foreigners eager to sustain their economies through exports. It remains to be seen whether
consumers will come to their senses and begin paring expenses, paying back debt and
rebuilding their savings, or whether lenders will force the issue by either refusing to lend
more money to over-extended consumers, or demand repayment of outstanding debt,
creating a domino-effect of cascading defaults.

The timing of these decisions is essentially unknowable. The best we can do is to
monitor the indicators of aggregate demand such as retail sales, consumer spending,
consumer debt. We must also monitor leading indicators relating to future consumer
Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 9

spending including: foreign lending (as the fuel for domestic spending), housing prices (as
the primary collateral for such lending) and interest rates (as the cost of such lending).
Interest rates, in turn, depend on oil prices and related inflation. Recently these indicators
have been faltering, suggesting to me that a “hard landing” may be imminent.
The recent collapse of the housing
market is likely to foreshadow
consumer retrenchment. Not only has
housing activity plunged, reducing
employment in the housing sector, but
also housing prices have begun to
retreat, undermining the collateral
value of homes for future borrowing.
The $81.5 billion swing in international
capital flow, from the $70.5 billion inflows recorded in November 2006 to the $11
billion outflow in December may be a harbinger of future reluctance of foreigners
to continue underwriting America’s spending habit.
The rebound in oil prices in recent weeks to the vicinity of $60 a barrel has
doubtlessly contributed to the Fed’s concern that “inflation risks remain,” (together
with “high resource utilization.” The recent plateau in the MZM monetary
aggregate could be setting the stage for further rate increases which would put the
nail in the coffin of the “soft landing.” One of the key questions to be resolved is
whether the U.S. economy will experience a resurgence of inflation prompting a
Fed counter in the form of additional rate hikes, dampening growth (i.e. a period of
stagflation). The direction of oil prices is likely to be the key to resolving this
uncertainty, which, in turn, will depend on the resolution of tensions between the
U.S. and foreign oil suppliers, like Venezuela, Nigeria, Iraq and Iran.
The unsustainable growth in debt and debt service as a percentage of disposable
income along with continued negative savings (see graphs on page 3 above), are
also harbingers of an eventual consumer retrenchment. However, they give no clue
as to when such retrenchment will occur.
Retail sales, dragged down by flagging auto
GROWTH IN RETAIL SALES sales, flattened in January 2007, showing no
gains over the previous month. It is too early
0to tell whether this is the beginning of a
retrenchment, but is, nonetheless, an ominous
sign. We won’t have the figures for personal Source: U.S. Department of Commerce
income and outlays for January until early
The growth in total consumer
debt has abated fairly steadily
in recent years, however, as of
December, continued to
expand at about 4.5% year-
over-year. So far this indicator
is not signaling an end to the
All-American consumption Source: Federal Reserve Bank of St. Louis

Cyclical Investing Comment February 25, 2007 © D. L. Smith (713) 532-6090 10

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