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Profit taking was the order of the day on Friday as the Dow and SP500 closed out the week with losing sessions, but complacency remained the word of the month, and oil remained the king of the hill.

The NASDAQ Composite was not the only average to flirt with new highs yesterday.  The XOI (oil index), which had quietly surged 12.5% over the previous 7 seven trading sessions in relative anonymity as all eyes were on the NASDAQ's record run and the FOMC meeting, soared 9.69 to finish the day near its all-time high, a fact which perhaps more than profit taking was responsible for the selloff in the bond and stock markets.

OPEC's resolve to maintain production cuts, and an unexpected sharp drop in gasoline inventories combined to send oil prices soaring, with NYMEX December Crude Oil futures nearing a 3 year high yesterday as they shot up 90 cents to $26.60 a barrel, and Brent crude surging over $25 to an 8 1/2 year high.

In September, we said oil was headed towards $30 later in the year, and it now appears that our estimates were on the low side.  Bullish sentiment towards oil, when combined with falling supplies and the side of the equation we haven't mentioned yet, U.S. demand near its highest level of the decade,  have the potential to push oil prices well over $30 if the weather cooperates this winter--a scenario which will not sit well with the inflation skittish bond market.

The surge in oil prices will also make its presence felt in next month's PPI and CPI reports.  Gasoline and Heating Oil futures also surged yesterday, and these rises will be felt at the consumer level. A 0.1% decline in energy prices was one of the main contributors that helped October's headline CPI figure slow to a benign 0.2%, and we would expect next month's figures to show an upward tick in the headline rate.

While oil induced inflation worries played their part in yesterday's reappearance of the bond market's long running case of the rate hike jitters, signs of a pickup in demand also played their part.  Housing starts rose just 0.1% in October, but building permits jumped 5%, indicating that the housing sector will remain strong in the months ahead.  

The building permit numbers, like the industrial production/ capacity utilization numbers on Tuesday, suggest that the economy's above trend growth rate is likely to continue, increasing the odds that the Fed will be forced to act again early next year in an attempt to slow demand.

Going forward, it is likely to be the demand side of the equation (Retail Sales, Housing) , rather than the price side (CPI, PPI) that determines the Fed's next move.  With the wealth effect an integral part of the demand equation, an acceleration in asset inflation (home prices, stock prices) will be the market's own worst enemy going forward.

Welcome to the latest chapter in the decade's longest running show, The Great Bull Market of the '90's, a chapter which opened as expected with the FOMC raising rates by 25 basis points and moving to a neutral bias, with the added twist of a 25 basis point hike in the discount rate thrown in for good measure.

Welcome to a world where complacency has gone off the top end of the scale, where the wall of worry has evaporated, and where all of the good news is already discounted. In short, welcome to a world where, in the short term, momentum and crowd euphoria are strong enough to carry stocks to new absurdities of valuation, but where, in the longer term, the cheers are likely to be replaced by the ominous hissing sound of air escaping from a bubble as euphoria runs headlong into the unexpected.

The Fed did as expected, and the stock market answered with the expected, a powerful rally borne of relief and complacency that carried the S&P 500 and NASDAQ Composite to new records.  For the NASDAQ, it was but one of a string of recent new highs, for the S&P 500, it was the first new record in nearly 5 months.  The Dow Industrials, while failing to participate in the day's round of record setting closing highs, did manage to break above resistance at 10860, setting the stage for it too to reach for the heavens in the not too distant future.

The current euphoric state of investors could very well set off a broad based short-term rally that carries the market well past its old highs, but the future is unlikely to be nearly as bright for the effervescent U.S. equity market.

Although an equity market valued at more than 1.6 times GDP is more than a concern, valuation levels will not be the pin that pricks the bubble.  While we would have no qualms in placing a bet that the current stratospheric P/E ratios of market darlings Applied Materials (60.6), Cisco Systems (136.2), General Electric (43.6), Home Depot (55.4), Lucent Technologies (70.4), Microsoft (61.4), and Sun Microsystems (99.7), will be significantly lower and perhaps cut in half a year from now, these valuation levels will not be the downfall of euphoria.

No, rather euphoria is likely to die because of a certain incompatibility that has developed in the marketplace: an incompatibility between  the current belief that the Fed's job is done, and soaring stock prices and falling bond yields.  The Fed's job can not be considered to be complete until the economic imbalances that prompted its first rate hike have eased.

Perhaps the key phrase from the FOMC's policy announcement to keep in mind going forward is "the expansion of activity continues in excess of the economy's growth potential". Although the market is celebrating what it believes to be the end of the current rate hike cycle, further rate hikes can not be ruled out as long as the current conditions of unsustainable above capacity growth and labor market tightness continue.

With the wealth effect still very much alive and closely correlated to the direction of stock prices and to a lesser degree interest rates, as the recent  rises in consumer sentiment and mortgage applications that occurred simultaneously with a sharp stock market rally and a steep drop in long term interest rates shows, it is unlikely that a scenario of "no more rate hikes" will be able to coexist with a continuation of the recent rallies in the stock and bond markets.

In order for the prevailing wisdom that "3 did the trick" to translate into reality, it will be necessary for consumer demand to ease, a scenario which will likely only occur if the wealth effect is thrown into reverse: i.e. a rise in bond yields and a fall in stock prices puts a strong enough damper on consumer confidence that the consumer is forced to think twice before pulling out the pocketbook.

In order for a drop in consumer confidence to erase the possibility of further rate hikes, the drop in domestic consumer demand must be of a large enough magnitude that it negates the growth spurring effects of accelerating global economic growth.  Not until the net demand for goods and services eases from its current blistering pace and translates into a lower demand for new workers will the danger of wage pressures developing be erased, and as long as the threat of an acceleration in wage pressures remains, the potential for further rate hikes will exist.

While the Fed has made its last rate hike of the year, it has more than likely not made its last rate hike of the current cycle.  After the Fed takes a momentary respite in deference to potential Y2K related problems, we expect further rate hikes to follow next year--a scenario which is not at all discounted by the stock market.

On the eve of the FOMC meeting the celebration is in full force, tech stocks, Internets, and financials at the front of the line, and not a cloud of worry in the sky.

In the technology sector, the glass is no longer half full, it is brimming over the top, and the market is able to pick itself up from any arrow that may be shot its way, whether that arrow be in the form of Microsoft's anti-trust woes, a less than sparkling earnings report from Dell, or an analyst downgrade of Intel. Buying on the dip, and a record inflow of funds into technology funds during the last week provide the NASDAQ with a solid safety cushion to seemingly weather all storms.

The financial stocks, too, are benefiting from a blast of euphoria as financial reform takes center stage and interest rate fears take a back seat.

All across the land, investors are once again driven by a need to get in on the only game in town, to hitch a ride on the road to endless 30% annual returns, and wherever one goes, the refrain is the same, "the sun will always come up tomorrow, happy days are here again".

Even the once despondent bond market has gotten in the act, with rates tumbling from 6.40% to 6.03% on the long bond as traders become convinced that the storm will have passed after tomorrow's expected third and final rate hike.  True, there are some who fret that the Fed might suddenly find itself behind the curve if it succumbs to the temptation to hold rates steady, but even here the fear is but mild, as market participants one and all believe that whether the rate hike comes tomorrow or early next year, three will do the trick.

The current economy, for its part, has played a starring role in reigniting the stampede into the crowd 's favorite issues.  The economy continues to steam ahead at full force as increases in productivity smooth the way, with productivity surging 4.2% in the third quarter, while unit labor costs inched up a measly 0.6%--the final proof needed by an eager public that inflation has been put to bed.

Rising productivity, wage pressures seemingly stopped dead in their tracks, and signs of a slowing economy--enough evidence to stop the current rate hike cycle at three many would say, or perhaps to even prevent a third rate hike from ever materializing, others would say.

As the Goldilocks economy struts its stuff for all to see, there is not a cloud in the sky, and not a frown among the onlookers--a condition the cynical might describe as complacency on steroids, and a condition that will likely cause the Fed to give a quarter point nudge tomorrow, although even that expected nudge will do little to dampen spirits.

The only thing with the power to darken the skies, to put the brakes to euphoria, is the possibility that perhaps three will not do the trick, a possibility that becomes closer with each passing day as euphoria erases the effects of each Fed rate hike.

The underlying pressures will not suddenly ease with tomorrow's expected Fed move--blame it on the wealth effect.  The recent surge in stock prices and drop in bond yields is likely to quickly reverse any temporary economic slowing that occurred as stock prices briefly slid down a wall of rate induced worry to their recent brief date with the 10,000 mark. Already signs of a reversal are gathering: mortgage applications picked up after the recent drop in rates, and then there is consumer sentiment, which after a brief dip is on the rise again.

The outlook for today is bright and inflation free, but the outlook six months down the road remains clouded--a condition that is unlikely to ease until consumer spending is dampened and the threat of inflation is erased.

 Pressures bubbling beneath the surface suggest that the threat of inflation picking up remains very real.  From rising prices in intermediate goods to continuing signs that wage pressures could be about to make their presence felt, the threat of pricing pressures working their way through the pipeline remains.