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The inflation-fighting sword of the Fed has two sides. The market has spent much of the last several months focusing on how increasing interest rates and a slowing economy will ease inflation (yippee), but now we are beginning to face the other side of the sword, how a slowing economy will affect business growth (oops).

The Philadelphia Fed Business Survey sent a cannonball over bow on Thursday when it unexpectedly came in at -0.4 well off the anticipated +14. The situation was further exacerbated by the Conference Board’s Leading Economic Indicators, which again came in negative, making it five out of the last eight as negative readings. John Mauldin pointed out last week that when the LEI is down six months there has always been a recession or severe slowdown. What is becoming increasing clear is that we are headed for a sharp reduction in corporate growth. The next earnings season should prove challenging as companies grapple with expressing their uncertainties to nervous investors.

For those not paying attention, all the warning signs are flashing. Yahoo has told us advertising is down, Home Depot has told us consumer spending in the building sector is waning, and Fedex is telling us the shipping is in jeopardy. A translation: Advertising is a sign of corporate confidence, building spending is a sign of consumer strength, and shipping is a sign of overall growth in tangible commerce. Another warning sign is the bond market where we are seeing the yield on the 10 year plummet. This is an indicator that the interest rate sensitive gurus are forecasting slow growth and future rate cuts. Yet another warning sign that has been flashing for weeks is leadership.

The recent market rally has been led by cyclicals and tech, both high beta, and the wrong sectors to benefit from a slowdown, suggesting speculation is driving the rally not fundamentals. The bull market of the last couple years has been driven by building and energy both on the ropes today. For a sustainable rally to take place we need an impetus for new leadership.

Not all is lost. Most economists agree that a severe recession is not a likely case scenario, more likely a mild slowdown accompanied by a modest sell off. My thesis has remained that the market will bottom around a quarter after the last rate hike which coincidently coincides with the Mid-Term Election, also a historical bottoming point. Keep in mind that on average the Fed begins to cut rates six months after the last rate hike. Supporting this, we are now seeing Fed Fund Futures consistently forecasting rate cuts in 2007. In the short-term an onslaught of media pessimism is likely opening the door for contrarians to buy at attractive valuations.

Source: The Economy's Wake-Up Call: Are Investors Listening?