MARKET OBSERVATIONS

CRACK

MARKET OBSERVATIONS - 5/30

CRACK...Although written almost a decade and one-half ago, one of our favorites reading classics is Cadillac Desert.  Mark Reisner recants the history of water resource development in the Western United States.  In the last 100-plus years, a huge number of dams were built in the west that really allowed the geographic development of areas such as the greater Los Angeles Basin (or more correctly, desert), the greater Phoenix area, etc.  As you would imagine, along the way, there have been a number of catastrophic dam breaks.  In retrospect, many a catastrophe was caused by simple human hubris.  Building a dam is a political endeavor as much as it is an engineering feat.  Once a project was well under way, the discovery of facts contradictory to the momentum in completing the project was not well tolerated by those in charge and in office.  In the last few years, the tolerance of main stream Wall Street and Main Street for the discovery and discussion of facts contradictory to the greatest bull market in history has been minimal at best.  

In June of 1976, the Teton dam burst creating the second largest flood in North America since the Ice Age.  Accomplished by the hand of man.  

    "At about 9:30am, one of the men noticed an odd-looking shadow on the downstream face of the dam, twenty feet or so out from the right abutment.  He looked at the sky.  There was no cloud anywhere.  The shadow was a wet spot.  In a few more minutes it was a spring.  Then it was a creek.  Then it was a sizable torrent washing away the embankment of the dam."   

The damage in human and property costs was incredible as a result of the failure of the Teton dam .  In retrospect, being the political exercise that investigations often become, blame and cause was uncertain.  Some of the best engineers on the investigation inferred that the only plausible cause was poor design.  A faulty premise, if you will.  

By now we are sure you are aware, but most casual observers of the market probably missed hearing a crack last week.  AMG data reported a $7.6 billion outflow from mutual funds for the week ended last Wednesday.  This is one of the biggest absolute dollar outflows we can remember since Bob Adler and the folks at AMG started their fine mutual fund flow tracking service a decade ago.  For now it's just an odd-looking shadow on the downward slope of the dam.  It's a wet spot.  Nothing to be alarmed about if the structural design of the bull market dam is sound.  As you would imagine, we will continue tracking and commenting on the weekly fund flows as we have in the past.  We have been incredibly surprised that flows have been as strong as they have over the past few months as the NASDAQ has melted and the Dow and the S&P have been working hard to go nowhere fast.  Mutual fund investors were piling into tech-net-telecom funds right at the peak.  Is this the beginning of another buy high sell low experience?      

The pressure building up behind the bull market dam has been enormous for years.  The pressure to put money to work.  The pressure for performance.  The pressure to become momentum style investors.  We are now hearing and seeing stress cracks in the equity market as well as the mutual fund complex.  We have long felt that the potential for mutual fund selling on the part of public investors was a ticking time bomb for this market.  Just as buying begat buying in the last 2 to 3 years, the flip side of the coin is a vicious spiral downward as professionals attempt to liquidate ahead of the public investing masses.  We are not there yet, but it remains a possibility.  If we continue to see mutual fund leakage, the potential for a dam burst increases.  Stay tuned.

Long, Hot Summer...We all know that the effect of interest rate increases on the economy can be a lagged effect.  Greenspan and crew are fully aware of the dynamics.  It's the reason that a June interest rate increase may be the last for a while.  Around the edges, we are seeing glimmers that some slowing is becoming a reality.  The real question for Greenspan and the markets is how fast this happens.  In last week's economic stats, income growth in the US actually outstripped spending growth for the second straight month.  This is the first time in two years that we've had back-to-back months of slower spending relative to income growth (certainly some of this may be explainable by rising wage pressures).  Last week also saw a durable goods number that experienced a rather unexpected drop of 6.4%.  The picture is still blurry, but the outline of an economic slowdown is coming into clearer focus each passing month.  The question for investors is "when will this become a mainstream perception?"

Against the fuzzy outline of a potential slowdown, we continue to digest conceptually conflicting signals.  The diaper companies raise prices.  We have a friend who runs a Pepsi bottling plant who relates to us that every bottling cost that is a derivative of petroleum is rising.  Packing film.  Labeling wrappers.  PET bottles, etc., to say nothing of transportation costs.  The earnings bombshell lobbed by Costco last week is a straw in the wind of a macro spending slowdown.  Despite these anecdotes, the immediate summer has brought strength on oil, gasoline and natural gas prices.

Clearly the above chart does not update the price of crude's recent return engagement with the $30 price level.

Last week's San Francisco Chronicle ran a story about existing home sales being down 20% last month (relative to the like year ago period).  The beginning of the end for fantasy real estate prices?  Far from it.  The reality is that there is simply no supply.

Despite the West being completely unrepresentative of the country as a whole, the price of living everyday is accelerating.  Oil, natural gas, housing, commodity food products, services, etc.  

Quite possibly, the perception or reality of an economic slowdown may come to coexist with accelerating inflation as we move into the summer.  Not only does an economic slowdown lag interest rate hikes, but inflationary pressures often subside after an economic slowdown has already begun.  Most visible recently is the pressure on wage inflation.  Railroad labor negotiations.  Janitors striking in the Bay Area.  Teachers vocal about being unable to earn a living wage.  If this scenario indeed plays out ahead, we have to believe the Fed remains in tightening mode until prices and wage pressures back off.  Just think, a slowing in economic growth (and potentially in corporate earnings) coupled with an acceleration in inflationary pricing pressures.  Just what the bull market doctor ordered, right?  CRACK.

Perceptions and reality are oftentimes two different animals.  You do not need us to relay this message.  The stock market has been a case study in cognitive dissonance over the past few years.  Despite consumer confidence hitting a near record number, actual consumer spending in April posted the weakest gain in nine months.  This infers that actual consumer behavior may be closely linked to near term movements in the stock market, but perceptions of the macro economic environment can still burn brightly in spite of real world evidence and behavioral response.  Bubble bull markets and bubble bull market economies do not come to an end without a perceptual fight.

Maybe it is different this time in that so much credit is being created outside of the traditional banking system.  Greenspan can effect the "price" of money and credit, but maybe he's lost a good amount of control over its "supply".  We remember all too well that one of Paul Volker's toughest tasks twenty years ago was to effect a change in perceptions, not just in the price of money.

Put'em Up...It used to be that quarter end's were institutional window dressing extravaganzas.  Now it's month end periods.  Today's little ramp job was no disappointment.  Relatively light volume, gaps in pricing, mark-up's of the big cap institutional favorites.  The institutional "fever" was helped by multiple cheerleading routines.  Breathless Maria.  (We'll soon be setting up an oxygen tank for her right on the trading floor for those special days when MU opens higher.)  The trotting out of "broken clock" Joey B. on CNBC.  Tom Galvin calling for a super rally (for the ninth attempt in a row).  Ralph Bloch declaring that the summer rally will have "officially" started if the indices closed on or near their highs today.  (Whew! We can stop wondering as it's now official.)  Claim-jumper Dan Niles spouting from his new $6-7 million perch at Lehman on the wonders of semiconductor stocks.  (We know there is inflation when we see the rates for shoveling garbage being raised for Lehman.)  Over the weekend, even Bearish Bob Brinker called for a quick 20% upward move in the NASDAQ.  If today is any example, Bob's has about two more days left.  He's already half right for the NDX.  Just remember, most of these are the same folks who have been calling for a bottom about every 200 points over the last 2000 point drop for the NAZ.

Eight percent one-day moves in the NASDAQ are not healthy for the bulls or the bears.  In either direction.  Plain and simple, this is the type of volatility that characterizes bear markets.  We've said it before and we'll say it again.  How does one make thoughtful investment decisions in this type of price volatility environment?  Simple, one doesn't.

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