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I'm not sure how to start as my comments are certain to be contentious but this week's price action once again defies logic. I have offered what I think is the only plausible explanation for why the markets are shrugging off all negatives but to that in a minute.

I started writing this a week ago with a focus on the top line sales and profit growth rates of the Dow stocks. I wanted to see if there was any possible reason for this odd market action in recent months other than the fact that the markets are simply being manipulated. Perhaps I was missing something and if so I wanted to know.

It took a lot longer than normal to pull the data together. It required pulling up 6 years worth of 10-K's on all the Dow stocks to collect the needed data. We will get to that in a minute but for now I want to make a few comments on this week's price action.

Certainly there was nothing noteworthy to suggest that the markets should have shrugged off Monday's slide and move sharply higher on Tuesday and Wednesday.

We did have Bernanke addressing the Senate on Tuesday and the House on Wednesday but his comments were certainly not noteworthy. He didn't announce a new QE initiative and he continued to defend his policies-- same story, different day.

We did get a little bad news on durable goods on Wednesday but the spin on that was predictable and goes like this - even though durable goods orders were lower by 5.2%, if we take out the bad parts like commercial aircraft which was down 34%, we have a pretty good number on durable goods.

Even though the number was severely impacted by particularly dismal commercial aircraft orders, that didn't seem to impact Boeing (BA) which ended up being the 3rd biggest gainer on the Dow moving 2.26% higher on the day.

The only other market mover on Wednesday was the "sequestration cuts." The only game in town on this issue is whether Boehner and the Republicans can shift the blame to Obama and the Democrats. Of course Bernanke told us "sequestration" would have about a .5% negative impact on GDP in 2013 but the outlook for GDP in 2013 doesn't matter apparently.

Maybe I misread the 4th quarter GDP number but I thought it was a minus .1% (now adjusted to plus .1%). It would seem that the "sequester cuts" plus the payroll tax hikes, the recent spike up on unemployment, the recession in the Eurozone, the slowdown in China and the reportedly horrendous sales for February by Wal-Mart (WMT) would outweigh the positives. What positives you ask - well housing data is looking a little better if we ignore the fact that we still have approximately 20% of the nation's mortgages underwater.

I do have an explanation though for why stocks - in particular the Dow stocks - put in new post recession highs. My explanation - any and all sell offs are being back stopped by someone who is willing to spend a lot of money to prevent even a modest sell off in stocks.

My supposition is that the Fed's surrogates are absorbing all selling pressure in the Dow stocks and driving them higher in the face of negative news. I know - that sounds like a conspiracy and no credible analyst puts any stock in conspiracy theories. OK, but at least take a look at the 5 day minute chart below on the major indices before summarily dismissing me as a nut:

(click to enlarge)

The focal point here is the divergence between the other indices and the Dow after Monday's sell off. My assertion in a series of articles dating back to the first part of February is that somebody is defending the Dow - when necessary - and the other indices reluctantly move higher when they see that the Dow doesn't fall back after a sharp surge higher.

As traders and investors we know that the "sequester cuts" or a negative print on durable goods or GDP should cause a sell off but when it doesn't we simply rationalize it away by putting a positive spin on negative data. We say perhaps the market has already priced it in or as we did on Wednesday with durable goods, we simply ignore the negative parts and embrace the positive parts. Of course the only positive I know of right now is the very modest boost in some of the housing metrics but that has been enough in the last 2 ½ months to push stocks higher on the Dow by 1,471 points - a full 12%.

In recent weeks I have started using the following 2 charts to gauge where the market is going. The first is the Dow (DIA) and the second is the Fed's balance sheet. When the Fed isn't expanding the balance sheet the stock market tends to move sideways as reflected in the Dow chart below. When the Fed expands stocks move higher in lock step.

(click to enlarge)

(click to enlarge)

This correlation goes back to the beginning of QE. The chart below shows that the only significant pullback in stocks occurred in the summer of 2011 - a period when the Fed wasn't printing. We had "Twist" but that was a sterilized purchase and left the Fed balance sheet relatively flat for several months. The result was a sharp sell off in stocks precipitated by the debt ceiling debacle and subsequent credit rating downgrade. The point here is that the Fed wasn't providing the needed fuel to back stop the free fall in the summer of 2011.

(click to enlarge)

Series 1 = Fed balance sheet; Series 2 =DJIA; Series 3 = QE1, QE2, QE3 and QE4; and Series 4 = Twist

What's particularly disconcerting is that the correlation - if it continues - will result in a high on the Dow in the neighborhood of 15,800 in 2013 based on the Fed's commitment to expand the balance sheet at the rate of $85 billion a month. What is bothersome about 15,800 is that the economy is starting to falter in spite of the massive deficit spending that is being financed by the Fed.

That has brought me to the point of giving careful consideration to how far out of kilter we may be at these levels. The question I needed an answer too was whether or not corporate profits could justify a 15,800 level on the Dow in 2013.

The chart below shows the average of top line sales on all the Dow stocks going back to 2007. Sales are reflected as a percentage of 2007 as a base year and also reflected as a year on year rate of growth. The total sales trajectory explains why stocks have recovered so nicely since the end of the recession but the rate of growth from year to year turned down in 2012 and tends to explain why GDP printed negative in the 4th quarter of 2012.

(click to enlarge)

The next chart looks at profits in the same context. After peaking in 2011, the year on year growth rate on profits turned lower dropping by 14% from the 2011 peak. More telling are profits as a percent of the 2007 base year. After climbing in 2010 and 2011, the average profits of the Dow stocks flat lined in 2012 despite the fact that sales as a percent of the 2007 base year actually climbed by 4.74%.

(click to enlarge)

The fact that profits are still below their 2007 peak year by 7.08% even though the Dow has climbed to within .7% of the 2007 highs suggests that maybe the Dow has overdone it a little in the last few months. Just using this metric the Dow should probably be trading about 7% below the 2007 peak which would put the Dow at 13,172.

We were at that price level on the Dow the first week of December 2012. Since that date we have climbed significantly in spite of a long litany of headwinds. You are free to draw your own conclusions as to how we have managed this feat but from my vantage point the implications are that someone has managed to distort reality by vigorously defending the Dow stocks and that implies a pretty big player is absorbing the sell side volume.

More important to investors though is where we are going from here. An argument I have made in recent months is that profit margins are being compressed as companies struggle to reduce costs. The implication is that these companies are about as lean as they can be and the likelihood of further expense cuts in an attempt to maintain an upward trajectory on bottom line profits is suffering from the law of diminishing returns. In other words, there just isn't a lot of fat left to cut and therefore, if top line sales begin to shrink profits will contract sharply.

Operating on that assumption I built a pro-forma composite of the Dow stocks to see what the possible impact would be based on a 5% and a 10% contraction in top line sales:

2012 average

2012 average - 5%

2012 average - 10%

Gross sales

106,956,708

101,608,873

96,528,429

Cost of sales

58,383,056

55,463,903

52,690,708

Expense

39,424,903

69,424,903

39,424,903

Net profit

9,148,750

6,720,067

4,412,819

Profit reduction

100%

26%

52%

Note: last three 0's are dropped in table above

The table above starts with the average for 2012 of all 30 Dow stocks in the 3 relevant categories - top line sales, cost of sales and fixed expenses. The assumption is that cost of sales is variable and will fall with a decline in sales but expenses are more rigid and won't decline despite a drop in top line sales. As you can see in the table above a 5% drop in top line sales under these assumptions ends up shrinking profits by 26% and a 10% drop in top line sales reduces profits by 52%.

The key variable here is top line sales and the relevant question one must ask is whether or not a 5% or 10% drop in top line sales could occur. The answer of course is that it certainly could occur and did occur in 2009. In fact, top line sales dropped by 9.6% in the aggregate in 2009.

In 2009 we had a massive sentiment shift precipitated by a systemic crisis in the banking system. Top line sales dropped in large part because of consumer fear and anxiety. The likelihood of another systemic crisis in 2013 is very remote but the idea that a sentiment shift can't occur without a systemic crisis is a little naive.

What are some of the factors that could impact top line sales? Perhaps the single biggest factor is a reduction in discretionary income. A second consideration are sentiment shifts that work to curb spending and drive individuals and companies to save more and spend less and a third factor is inflation. Let's look at each of these separately.

Reduction in discretionary income

We don't have to guess on this one - we know discretionary income will fall in 2013. Specifically, we will have approximately 2% less in net after tax income due to the expiration of the payroll tax holiday.

Another factor that is more relevant than many think is the sequester. The amount of spending cuts projected to kick in this year is $85 billion. That only represents .05% of GDP assuming the cuts produce a 1:1 impact on GDP. It is not unreasonable to consider the possibility that these cuts could impact GDP by a much larger multiplier effect though.

One way the sequester multiplier could exceed the 1:1 ratio is through furloughs. It is not unreasonable to assume that as many as 8 million workers could be impacted by a 10% to 20% pay cut resulting from the sequester. Here's my math: $85 billion / $50,000 (average annual income) = 1,700,000 in direct lay offs or a 1 day per week unpaid furlough which would be a 20% reduction in pay on 5 times as many workers or 8,500,000 total workers.

According to the BLS there are 134,825,000 people in the US with jobs as of January 2013 and 8,500,000 represents 6% of that total. The question that requires an answer here is how much impact will a 20% cut in gross income have on the purchasing habits of that 6% that could be impacted by furloughs? In broad general terms a rough estimate of discretionary income for those in this income category is about $20,000. Assuming a 20% cut in gross income, the impact to discretionary income would be a reduction of 50%.

I will leave it to the reader to extrapolate the numbers but suffice it to say that the impact to total GDP will be significantly more than .5% resulting from the sequester. Additionally, the 2% payroll tax - although not as large an impact to discretionary income in percentage terms - impacts the entire workforce, not just 6% of the workforce.

In summary, it seems reasonable to expect a best case scenario of a 2.5% contraction to GDP from the payroll tax hike and the sequestration cuts combined. Assuming a multiplier effect of 3:1 on the sequester that number could move as high as 3.5% of GDP.

Sentiment shifts

Sentiment is a bit of a wildcard in that a downturn in confidence will work to constrict spending and could do so in a very big way. We all like to look at consumer sentiment surveys to gauge the consumer's propensity to spend but I think the best consumer sentiment gauge is the savings rate. The following chart has had more influence on my bearish forecasts than any other metric and it is one very few pay any attention too.

(click to enlarge)

The chart above plots total M2 growth, the savings component of M2 and the difference between total M2 and savings. It is a big deal and here is why. If money is being saved it isn't being spent and if it isn't being spent it isn't doing anything to increase GDP. It also explains why money velocity is at 60 year lows.

So many fail to look at this metric and simply assume the Fed's monetary policy is expanding the total money supply and therefore GDP should be rising at a greater rate than it is but if the M2 increase is simply sitting in savings it is doing nothing to drive GDP. That has been the case since the onset of the recession and explains why inflation is contained, why GDP growth is anemic and why unemployment hasn't responded to massive stimulus.

M2 using January of 2007 as a base value has increased 147%. The savings component of M2 has increased to 181% of January 2007 levels and the difference between the two has only increased to 110% of January 2007 levels.

The amount of M2 that is circulating in the economy - the net difference between M2 and savings - has only increased by $364 billion since January of 2007. Dating from the start of QE, M2 less the savings component has actually fallen by $57 billion.

The impact of inflation

Inflation has been well contained despite the unprecedented expansion in the Fed's balance sheet. The reason is simple enough - there has been almost no private sector M2 growth created through the private sector fractional banking multiplier effect and the impact of the M2 increase has been diminished by the even greater increase in the savings component of M2.

The chart below indicates that inflation has not only been subdued but trending lower in the last few months:

(click to enlarge)

Despite opinions to the contrary there is a real possibility that disinflation and even deflation could occur in coming months. Such an occurrence is rare as monetary policy is designed to create modest inflation. The problem today is a simple one - the Fed has used all the tools at its disposal to create inflation and to no avail.

The law of diminishing returns is in full play here. What is particularly disconcerting is that we remain at very high levels of unemployment and it is indeed rare to enter recession at these unemployment levels. What makes the situation even more untenable is the fact that the Fed has used extraordinary measures to prevent deflation and one must wonder what they could possibly do in the event we do enter recession in the first or second quarter of 2013.

I have been arguing that the Fed's policies have not been inflationary and will not be inflationary in coming months. I have also made the point that the US dollar would actually gain in value if we do enter recession as the deleveraging that will occur in a recession will work as a contracting force on M2 expansion.

Some may want to argue that point but the truth is the Dollar index has been climbing in recent weeks and additionally, gold has been falling. That makes sense for the reasons I have set forth above. Specifically, M2 after accounting for the cash hoarding reflected in the savings component of M2 has produced an extremely low money velocity and that is decidedly negative as far as inflation is concerned.

Concluding thoughts

I think there is a very valid case to be made for entering recession in early 2013. The truth is nothing is working to create GDP growth or improve unemployment. What makes a recession at this point particularly disturbing is the fact that we are already at very high levels of unemployment and there are few - if any - monetary policy tools left to combat recession.

Compounding the problem is the fact that GDP absent deficit spending would be in the negative 7% to 8% range. The truth is we simply cannot stand any spending cuts or tax hikes and remain in positive territory on GDP. On the other hand, the consensus amongst almost everyone is that we can no longer ignore the massive levels of deficit spending. In other words, we are going to tackle the debt and deficit - at least a little bit - and if we do we are guaranteeing recession.

Will top line sales and profit margins turn lower in coming months? I think so. Those on the other side of the argument will point to the positive signs that the economy is finally recovering. When pressed on the matter they will point out that housing is improving. There is really no other positive to point too and one must ask if that is going to be enough.

Source: Top Line Sales And Profit Growth Falter As The Dow Approaches All Time Highs

Additional disclosure: I am long TZA, FAZ, TECS and UVXY.