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Yesterday's headlines were dominated by CPI in the morning, and the dollar in the afternoon, but the real story was investor sentiment.  Yesterday's mid-day mood shift, and the inability of the better than expected to spur prices higher, served as a warning shot that the euphoria of summer is dead, that the glass long perceived to be full is on the verge of being seen as half empty.

Although sentiment remains tilted towards the positive side of the road, the slow death that euphoria is experiencing is rapidly taking away the prime support that allowed the major averages to soar to new heights at the same time that the broader market was languishing.  Without "irrational exuberance" to support the Dow Industrials and NASDAQ, we are likely to see an easing of the strong divergences that have held the market captive.  In short, the Dow and NASDAQ could bear the brunt of any market selloff, driven lower as enthusiasm slowly seeps out of the market.

If yesterday's action was ugly, today's action is ominous.

Now, when we say ominous, we are not talking about this morning's stock market selloff--that is merely a continuation of yesterday's ugliness.  No, rather, the ominous action today is taking place away from the stock market floor, and it is occurring on two fronts--two fronts that have the potential to make future CPI reports a little less rosy than yesterday's was.

The first front is rising energy prices.  Oil has surged 65 cents this morning to $24.78 a barrel, a level which is nearing the point where the words oil and inflationary become synonymous, and a level at which the economic effects of this year's crude surge cannot be ignored.  While we expect the price of crude oil to run into serious technical resistance around the $25 level, we do not expect to see it back off seriously from this level, and that spells trouble for an economy which must learn to deal with the knock-on effects of higher prices.

The effects of higher oil prices are already being felt by the airlines, and as today's disappointing numbers by FDX Corp demonstrate, they are having an effect on the profit margins of the companies which transport the goods produced and bought in the New Era economy.  The rise in oil prices also showed up in the recent PPI report, with crude goods registering their first rise in prices in two years.

For the stock market, the rise in oil prices has two likely outcomes, both of which spell trouble.  In scenario one, the crude surge feeds through the economic pipeline, producers raise prices, and the Fed is forced to do that quaint dance known as the Inflation Stomp.  In scenario two, the non-inflationary scenario, the rise in oil prices does not feed through to the consumer, as producers absorb the costs, and profit margins take a hit--click here and here to see the effect that this scenario has on stock prices.

We mentioned that today's action was ominous on two fronts.  The second front, and perhaps the most ominous, is the ever tightening labor market.  While we found today's smaller than expected rise of 288,000 in initial unemployment claims a trifle worrying, it was not ominous. No, rather we are giving today's Ominous Labor Market Award to the DaimlerChrysler/UAW pact, a pact which serves as a warning that wage pressures are beginning to emerge from that bubbling underground pipeline of potential future inflationary pressures to the open air reality of present day problems.

Tuesday's despair was quickly cast aside for Wednesday's glee after a lower than expected Core CPI reading re-kindled the belief (a belief that had been discarded only yesterday morning) that no more rate hikes were on the horizon.

While the numbers continued to reaffirm what both the most dovish and most hawkish already knew: the present environment is virtually inflation free, today's data is unlikely to sway the Fed either way.  As many of you have heard us say following previous CPI releases: the CPI is a snapshot of the inflation picture last month, one which tells us little about potential inflationary pressures six months down the road, and if the Fed were to wait for inflation to show up in the CPI before acting, it would find itself seriously behind the curve.  We continue to believe that the Fed would prefer to pursue a pre-emptive monetary policy, rather than a reactive one.

Today's inflation data, benign as it was, did not negate recent economic data which has continued to indicate that those pesky economic imbalances bubbling just below the surface are strengthening.  Other economic indicators released today were less benign.  Today's release of Business Inventories data continued to point to a pickup in manufacturing activity in the coming months as manufacturers rush to sate consumer demand.  The inventory-to sales ratio remained at a record low reading during July.

Today's CPI painted a nice picture of today, but told us little of tomorrow, and thus told us little about the next move of a central bank which has its eye on the future.

This morning's benign inflation data is not the only story today.  The other stories are less benign, and their effects are likely to put a serious damper on any rally attempts in the coming weeks.

The saga of Oracle, optimistic earnings expectations and a two-week 20% runup in price prior to the release of earnings, and a subsequent wholesale dumping of the stock when expectations were merely met, is a tale that we expect to see repeated many times as earnings season gets underway next month.  As we said on Monday, excessive pre-season earnings optimism is likely to translate into a bad case of sell on the news in the tech sector.

The other story today is the frenzy for yen, with the yen slicing through the 105 level like butter and currently sitting at 104 to the dollar.  The recent surge of the yen continues to be a no-win situation for the stock markets of both the U.S. and Japan.

Consumer spending accelerated in August, rising a greater than expected 1.2%, its fastest pace in six months.  Ex-autos, spending rose 0.7%, compared to expectations of a 0.4% rise.  The report sent the bond market reeling, with yields on the long bond rising to 6.12%.  The long bond has now given up virtually all of the ground it gained on the backs of the recent benign Employment and PPI reports.

The consumer's resiliency in the face of two rate hikes, along with recent signs of a pickup in the long downtrodden manufacturing sector, points to a pickup in third quarter growth.  More growth, of course, means that more good will have to be produced to satisfy demand, and more workers will have to be hired to produce those goods--a set of circumstances that only adds to the already developing underlying inflationary pressures that have been quietly developing under today's low inflation environment.

While today's numbers alone are not enough to force the Fed's hand at its next meeting (just as the employment report and PPI were not enough to stay the Fed's hand), they do highlight the fact that the Fed's job is far from done.  Until the consumer, driver of two thirds of the great ship Goldilocks economy, feels compelled to reign in the pocketbook, the economy will continue to grow at a pace that is incompatible with the sustainable maintenance of the present low inflation environment.

We continue to believe that consumer spending will only be slowed by either a drop in the stock market, or a rise in the unemployment rate.  With the major averages still sporting gains that are substantially above the long term annual trend, and the continued strength of the labor market, rates will likely have to go much higher before their rise will begin to have the desired effect of reigning in the consumer's urge to splurge.

Tomorrow, CPI will be reported, with a benign figure likely to once again instill a false sense of confidence that all is well.  We continue to caution against regarding any piece of economic data, including today's retail sales figures, in a vacuum, instead the data must be regarded in the context of the accumulated data that has preceded it.  At this point, that accumulated body of data points to the need for further action on the interest rate front, but the data has yet to rule out a taking of that action later rather than sooner.

Thus, while all signs point to an economy going at full steam, the possibility still exists that no rate hike will be forthcoming at the October FOMC, and instead the Fed will choose to adopt a tighter bias, with a rate hike lurking around the corner if a change in bias fails to instill a little fear in the markets.

Will the cat still be grinning as the week draws to a close, or will this week's full slate of economic reports sandblast the grin from the market's outer facade?  A cursory judgment made with the aid of prevailing market wisdom says the smile and the good times will last, but a more reflective voice whispers that things are not as bright as they seem.

The picture on the tech front is bright, with demand high and an upcoming earnings season sure to please, the joys produced by solid fundamentals in the sector swiftly replacing the late summer interest rate induced blues.  Optimism has begun to bubble-eth over, the analysts who only dare venture an opinion when a rising tide will drown their faults have reemerged from exile, and it is here, that the picture becomes less bright, and the prospect for a continuation of the march to new record highs begins to waver.

The recent upsurge in excessive optimism over the prospects for technology stocks is likely to prove its undoing when the much awaited batch of third quarter earnings begins to poke forth.  As in the runup to July's slate of earnings releases, excessive preseason optimism is setting the market up for a letdown, with a repeat of July's earnings season experience in store, as a mere meeting of top end expectations proves to be not enough to rally the troops yet higher, for a market with all believers on board is a market that suffers from a lack of necessary fresh recruits willing to jump on board.

The end result for the broader market of this cycle of "everyone buys on the expected news, no one is left to buy on the actual news" is likely to be a lack of leadership, a market left at the mercy of its rapidly deteriorating internal divergences without the saving prop of a surging crowd pleaser. 

With the ranks of the in favor becoming increasingly narrower as the year progresses, with the inflows from the individual displaying a corresponding narrowness of focus (inflows into large cap funds hit an 18 week high last week), and with the advance/decline line in a tailspin for 16 months now, the fallout from this seasons bout of buy on the rumor, sell on the news, is likely to turn ugly.

Outside of the tech sector, here to, attention paid to a gleaming exterior is acting as a sedative on investors, masking an ugly underbelly.  Two straight bang-up Friday bond market rallies have helped to calm interest rate fears among many stock market investors, but they have masked and overshadowed the weekly declines that the long bond has endured each of the past two weeks.

On the economic front, a pair of crowd pleasing reports have blinded many to the less than benign data releases that these reports have been sandwiched between.

For the market, the end result of operating with a focus on the exterior and an unawareness of the interior has been a dangerous buildup in complacency, and an accompanying unpreparedness for the unexpected.

While the stock market still has a bit longer to run on the fuel provided by excessive preseason optimism, this week could provide a real test for that faith, with a full set of economic releases potentially acting as the catalyst to inflict further blows to a weakened long bond and dollar, blows which would have a knock-on effect on the complacency now wafting through the stock market.

During the digestion of this week's latest round of economic data overfeed, we would pay closest attention to tomorrow's Retail Sales figures, and Friday's U. of M. Consumer Confidence figures, for it is not until these figures begin to weaken that the battle against higher rates will be won.