MASTERING
THE TRADE
ORIGINAL, INTERACTIVE SEMINAR ON TRADING USING
TECHNICAL ANALYSIS 

 SEC FILINGS

A tide of relief swept throughout the bond pits as uncertainty gave way to clarity.  Yields sliced like a knife beneath the 6% level, settling at 5.95%, the 50% retracement level of their April 1997-October 1998 decline, with the next downside yield targets at 5.86% and 5.81% if the rebound were to gather steam, an event which is unlikely until after the FOMC meets.

The fall in yields below the valuation consciousness inducing level of 6% stirred a ray of hope for a return to the glory days amongst traders of the market's fallen heroes: the Internet stocks. While many analysts and fund managers have proclaimed a bottom in the Internet stocks, we haven't.  The Internet stocks current rally is merely the expected, and normal, dead cat bounce that occurs after an industry group has suffered a swift 50% decline.  We expect the current .com bounce to retrace 38% of its recent decline before sputtering out.  If you're holding the 2 biggies of the .com world: AOL and Yahoo, this means look for the rally in the two stocks to run out of gas around 125 and 170 respectively.

While bond traders, Internet devotees, and the Market Guru Supreme of Goldman Sachs are now confident the worst is over and one rate hike will be the extent of the damage, we're not so sure.  The one rate hike take on yesterday's testimony is nice in theory, but not likely in practice.  Greenspan left the door open for further rate hikes, and the odds favor the door being pushed further ajar in the coming months.  A 1/4 point cut is more flash than substance, it produces an acknowledgement of action from the crowd, but its ability to pre-empt lurking evils is severely lacking.  The Fed will likely have to take back all 3 of last year's rate cuts in the coming months if it hopes to "pre-empt forces of imbalance".

Nowhere was the buying frenzy more intense than in the Internet stocks, where the Goldman Sachs Internet Index soared 14% as investors with a nose for a bargain snapped up shares after the sector's recent 50% plunge.  Forgotten in the day's buying spree were words only recently learned such as valuation levels, P/E ratios, and 6% interest rates.

We mention 6% because even with yesterday morning's bond market rally, interest rates remain above 6%, a level which only last week triggered an awakening of the concept that bond yields and P/E ratios tend to move in opposite directions.  Even if the members of the FOMC had been magically transformed into gentle doves upon seeing the CPI data, as many believed yesterday,the fact remains that stock market valuations have yet to adjust to the rise in interest rates since January. Since we do not see bond yields dropping back to their January levels of 5.17% even if the Fed were to leave rates unchanged, and the relationship between P/E ratios and bond yields has yet to be rescinded, the likely result will be a contraction in the market's P/E ratio which now stands at 34.5 for the S&P 500.

8:30 dawned, a pair of figures flashed by, CPI unchanged, core up 0.1%, smiles grew wider, traders rushed to place buy orders: the NUMBER was below expectations.  The world was safe from the Fed Bull Wrecking Crew.  The long bond's yield sank to 6.04%, S&P Futures rallied 14 points.

A trading rally had begun...

...And only a trading rally.

Today's lower than expected core CPI provides the market with the ammunition for a short term rally, but not with the fuel for a sustainable long term advance to new highs.  The numbers provided relief to many traders, they'll provide the major averages with a pop to the upside, but they will do little to avert a rate hike.

We've said it before, but we'll repeat it again: The Fed's job is to be preemptive in the war on inflation.  The door to the reemergence of inflation remains wide open.  The strong rebound in Asian economies and the surprising growth figures out of Germany and Japan have removed the lid from the inflationary pot. The global economic turmoil which was the primary weapon against inflationary bottlenecks developing is now on the mend, and with the healing process will come an increase in demand and more importantly, an increase in pricing power.

The Fed is well aware that the Goldilocks economy's secret defense, the global inflation damper, has been removed and that the pieces are now in place for inflation to develop.  The Fed's recent slew of warnings points to a Fed that is ready to be preemptive, which means acting before inflation has a chance to work all the way through the system and show up as a string of worse than expected CPI numbers.

We would pay close attention to Greenspan's speech tomorrow, and remain prepared for a rate hike at the next FOMC regardless of the speech.   We would also remain prepared in the coming months for the Fed to take back last Fall's 3 rate cuts.  In order to slow the economy sufficiently to keep inflation at bay, the Fed will have to slow the prime component of recent economic growth: the consumer, and to slow the consumer's desire to spend the Fed is going to have to slow the stock market which will take more than one rate cut.

In an age when keeping up with the Joneses means staying fully invested in the only sure hit money maker in town, money has to go somewhere and yesterday it went into the perennial laggards turned leaders: aluminum, oil, paper, and steel.  Yesterday's money spent may well turn out to be a case of fund managers counting their chickens before they're hatched, of premature hopes based on a story that never unfolds.

Resigned to the inevitability of a Fed move, investors have begun to focus on the future, and what they see is more of the same, but with a global kicker thrown in for good measure. The prevailing wisdom is that the unstoppable U.S. economic expansion will keep chugging along after the Fed moves, and the global economy will join in the party, with the end result being a United Nations of Goldilocks.   We, of course, beg to differ with this scenario.

The Goldilocks economy in all likelihood is nearing its end. The much lauded New Paradigm continues to be an economic expansion built on a house of cards, in this case the self feeding virtual merry-go-round of an  indebted consumer feeding the economy through a belief in a unidirectional stock market.  With the interest rate environment now acting as a damper to "irrational exuberance", the stock market has likely seen its better days.   Without a continued surge in market valuations, the ability of the New Era to continue as an ongoing entity is called into question.  A consumer spending beyond his means whose financial health is possible only with a continued rise in share valuations will swiftly be forced to apply the breaks to spending if the market heads south, and with the demise of the free spending consumer will come an end to the wealth effect which is now helping to feed economic recoveries from Kuala Lumpur to Frankfurt .

The use of leverage to achieve the bull market dream only adds to the dangers, as we saw yesterday when many a gunslinging Internet stock trader heard the ring of  that most dreaded of unwanted calls: the margin call.  As the market continues to work off the excesses which have been allowed to build, we are likely to see a pick up in the pace of the market's reversion to historical norms of valuation as the margin squeeze induced rout becomes only too common place.

In a parallel universe, in a place where the land of good and plenty is seen as the precursor of  impending gloom, spirits are not so bright and fear permeates the air.  This forsaken place, the land where good is bad, where each sunrise brings a chill and jitters have replaced smiles, is the U.S. bond market.

The bond market greeted the release of Friday's as expected PPI and stronger than expected retail sales numbers with an initial sigh of relief which was swiftly replaced by a sigh of resignation to the inevitable.  The resulting selloff was not born of fear, but rather of capitulation.  Inflation doves, with their backs against the wall, surrendered to the prevailing winds of change and headed for the exits, sending the yield on the long bond to 6.15%. Where there is capitulation, there is usually a short term rebound.  We look for yields to retrace their steps to support at 6.11%, and on a break of support 5.97%, as trader's await the Big Events: CPI and Greenspan on the Hill.

While awaiting the release of CPI, we would spend some time contemplating the Fed's role in fighting inflation, for it is in the Fed's methods that you will receive your answers to the all consuming question, "Will They, or Won't They".  To refresh the memory, the Fed's desire is to act before the onslaught, to be preemptive.  The Fed as a matter of policy does not seek to act after the fact. The Fed attempts to act before the arrival of the Ghost of Inflation Present (the CPI), preferring to throw its preventative darts at the Ghost of Inflation Yet to Come ( the future  effects of a pickup in the global economy).