Comment February25 2007

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• Publié par: Uproi
• Nombre de lectures: 49
• Langue: English

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CYCLICAL INVESTING COMMENT

David L. Smith, Editor
February 25, 2007


ODDS OF A ‘HARD LANDING’ INCREASE

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.


CORE CPI


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 [phone] [e-mail] 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







STRONG
CONSUMPTION,
NET EXPORTS,
GOVERNMENT

WEAK
INVESTMENT
(Housing, Equipment),
INVENTORIES




Cyclical Investing Comment February 25, 2007 © D. L. Smith [phone] [e-mail] 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
potential.

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.


DIPPING INTO SAVINGS HOUSEHOLDS KEEP BORROWING.
TO SUSTAIN SPENDING
DEBT SERVICE PAYMENTS CLIMB.






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 [phone] [e-mail] 3



Thanks largely to the year-end
HEADLINE AND CORE
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
UNEMPLOYMENT RATE
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