Don't Fight Inflation

by: Financial Sense

By Tom Smith

In the first decade of this century the enormous growth seen in China had a profound impact on our markets. When better-than-expected growth was reported in China it did have a positive impact on certain companies and sectors. Clearly, as China built out their infrastructure heavy equipment sales, for example, surged. The impact from growth in China led to a decade long advance in commodities across the board.

A negative aspect to this spike in growth was the higher input costs for consumers and businesses. Higher input costs hurt cash flows for companies and families. As profit margins come under pressure earnings growth slows and P/E multiples contract. All these factor lead to struggling markets. This put the market under pressure for several years without even getting into the mortgage meltdown.

I have cautioned many times this year about not trying to win the last battle. The past five years are not necessarily the prologue for the future. After the inflationary battles of the 70's many investors got trapped in their thinking and missed out on the great markets of the 80's and 90's. On the flipside, after it was clear that tech stocks discounted decades of accelerating earnings into their Y2k stock prices, many investors held on to their former tech darlings for far too long.

Now many are still fretting over inflation. There are no signs of inflation in the system right now. With inflation subdued and growth slowly but surely improving the major tailwinds for commodities simply are not present right now.

The name of my piece should actually be don't fight lower inflation. When inflation is subdued it is easier for companies to expand profit margins and exceed earnings expectations. With mortgage rates as well as food and fuel costs lower than a year ago the consumer is in better shape than at any time in recent years. Remember what is good for the consumer is good for the market. As employment continues to improve, consumer spending will improve.

CEOs have been very aggressive in managing analyst expectations and have constantly fought to "keep the bar low". In the second quarter of this year we had the highest ratio of negative to positive pre-announcements. As the condition of the consumer continues to improve, management teams will be more willing to raise forward earnings guidance projections.

As management teams increase forward guidance, analysts will feel more confident in increasing their earnings estimates for the companies they follow. As they increase earnings growth projections they are more willing to place higher P/E multiples on the stocks they cover. Higher earnings projections multiplied by higher P/E multiples lead to higher price projections.

Last week I gave you the number 1124 as the key level for the Russell 2000 average. That was the only major average that I use that had not gone above its near-term resistance level. Last Friday the Russell closed just above that level. Prior to the close on Friday the pullbacks we have seen recently in the market have remained controlled and orderly.

The Dow (NYSEARCA:DIA) and S&P 500 (NYSEARCA:SPY) are above the levels I gave last week. I am focusing on the Russell and Nasdaq. In order for the advance to continue we need to see the Russell move comfortably above 1124 and for the Nasdaq to trade above 3996.

If the two smaller cap averages fail to take out those levels we will likely see a correction. Based on the strength of the market, corrections should remain controlled and orderly. Here are the short-term support levels for the S&P 500/Dow/Nasdaq/Russell 2000: 1775/15,860/1095/3910.

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