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God, 2006 has gone quickly. Currently, there seems to be just a whiff of stagflation in the air for the world economy – just a whiff.

Here’s our first back-to-school math question*:

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"The Big One" being a US recession.

Let’s review some terms. Stagflation : meaning that inflationary tendencies remain in the pipeline while economic growth looks muted to dismal in the major economies. Is this what the VIX is indicating? (see chart below) It’s broken out slightly to the upside. Oil and gold have been taken aback but what are the underlying fundamentals of this action or are we simply seeing a psychological blow-off of pressure as Iran looks to be “negotiable” for the moment and UN Security members China and Russia are not set to discuss sanctions right now – so, in fact, only negotiations remain. US needs oil and Europe as well. The USA stance of going it alone would be a PR nightmare in a key mid-term election year for the Republicans and probably a disaster for the Bush administration both financially and militarily as well as socially, let alone the burned and scorned allies abroad.

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Currently many, including Fed members, are now calling for a “soft landing” in the US economy (housing concerns) along with a mixed-bag of professional opinions on where US interest rates are headed (higher to cap inflation) or lower (to not flabbergast the consumer/US mortgage /debt owners any further).

Let’s look at some puzzle pieces…to get the Big Picture of where we are now and in order to determine what the market is trying to tell us… because : THE MARKETS HATE INDECISION!

But that is seemingly what we have right now.

This is not an easy market to read currently. The 10yr. yield is now at a point we feel may be starting to show where the markets think they are going. A double-top (typically bearish) and since has dropped with support at 4.7% signalling that markets don’t see incredible amounts of inflation just as the VIX has not been “worried” either.

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On the other hand, a broader market indicator could be the Wilshire 5000 index shown here right. It is now in a bearish wedge formation and has failed to stay above its green support/resistance line BUT the higher highs and higher lows is, again, bullish.

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A final indicator is looking at the Dow Industrial average (chart below). It is nearly identical to the Wilshire 5000 in showing both a double bottom (bullish) but yet forming a bearish rising wedge. The key item to point out is that on rising prices the volume has been decreasing. This is divergent behavior and is BEARISH in nature.

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Remember: VOLUME precedes price action. At the moment, volume is weakening.

A note from SG's research department tends to corroborate the foggy US market outlook and how the Fed may need to react:

However, it is the Fed's job to worry about inflation, and developments in compensation trends further complicate the Fed’s decision in the next few meetings. While economic data are confirming slowing growth trends, it is not clear whether the economy will slow enough to bring inflation down on its own. This was the primary concern expressed by the Fed's Lacker who voted against a pause on August 8. In a recent interview, Lacker offered more color on the reasoning behind his decision. His primary concern is that allowing inflation to remain elevated for too long raises the risk that it will become entrenched at these higher levels. If that were to occur, it would require substantially more action on the part of the Fed to bring inflation back toward the desired range.

Here’s another indicator (below), the inflation adjusted (real) oil price verses the consumer expenditures. With the PCE rate currently not decreasing substantially (as it did during the 70s, 80s and late 90s just before recessions hit), the thinking at the FED is that the consumer is now more resilient to rising energy prices, ie he/she continues to spend merrily. But was housing on a ridiculous HIGH during those same past periods thus providing consumers sufficient CASH via equity withdrawals to not deflate the PCE? We think not.

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In fact, it was not so. So much liquidity has never existed before so it is a rather weak argument on the part of the Fed, in our minds, to suggest that because past PCE growth rates fell on higher energy prices they cannot fail now just because the PCE is not currently falling on higher energy prices – there are certainly more than just energy prices which play a role in consumer spending. Morals, savings and liquidity have all changed since the 1970s. In fact, it is seemingly the equivalent of “proving” a theorem true using one premise or one set of data only. What about other data? It could certainly be a “false positive.” As we know, economics (the dismal science) is the one science where the same question can have a multiple of different correct answers.

And finally, here’s another Fed chart. Notice that the interest rate inversions always preceded the recessions (gray bars) by 12 to 24 months. Hence we feel it is patently obvious that all the talk of a recession next year is only partially substantiated by the last 25 years. In fact, we are more worried about 2008. With liquidity (monetary policy is still quite loose) still relatively high and the fact that consumer spending habits (e.g. PCE) die hard even in the face of adverse economic situations, any housing weakness (deflationary tendencies) probably would translate to a weak transitional period (2007) before serious recession starts to show itself. Likewise, remember that the Fed is often, not always, like a misinformed hunter : it goes hunting for wild boar with a BB gun and in turn tries to flush out mice with a shotgun – it’s usually behind the curve with near perfect hindsight because all data they interpret has already happened and any forward projections take time before monetary policy can take effect.

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The analog situation to this way of thinking has to be the US housing market. Back in 2004 many, including we at Der Invest Informant, were screaming that the US housing market was in a bubble and could not be sustained – correct ! – but everybody screaming that in 2004 got the timing wrong. It all happened two years later – ie. now. Now, the housing market is imploding and now consumers may be a bit worried about how to handle the debt and falling prices. Ergo, a recession may still well happen but 2008 looks more probable than 2007 especially if the Fed were to re-loosen monetary policy and start cutting rates in Q1 2007 as we suspect they might.

In conclusion, trick questions take their time to resolve – we’ll be watching this closely in the upcoming weeks.

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