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The jitter brigade of the bond market might have the right idea because circumstances are far from perfect in either the economy or the stock market.

In the stock market, the replacing of the wall of worry with the tidal wave of a euphoric momentum driven blow off top is creating a textbook setup for the death of a bull market and the ushering in of a bear market with the new millennium as the pendulum of sentiment begins its inevitable swing back towards the historical norm.

The complacent view that the stock market is still in a bull market is also a cause for concern, because as we said several months ago, the current market is no longer in a bull market, rather it is in a bullbear market. What we call a bullbear market, others may call a massive drawn-out end of trend topping formation, but whatever you prefer to call it, it is that period when the market has already begun its journey down the other side of the hill but the crowd has yet to notice the rapid deterioration and reversal of course.

By now, the form of this end of the line epoch in market history is well known: an increasingly narrow strata of stocks exploding to the upside as the crowd piles in late to the show, while the average stock is mired in its own increasingly brutal bear market.  Even during the recent string of new highs by the NASDAQ, the percentage of stocks that were above their 200-day moving average never climbed above 48%--a figure which has since dropped to 44% as the advance/decline line has sunk to its lowest level of the decade.  The oft recited list  of divergences goes on and on: from new 52-week lows in the Dow Transports and Utilities to a sinking bond market.

Perhaps even more than the divergences, it is the current mass euphoria and omnipresence of the stock market in the lives of the average citizen that best signals that there is plenty to worry about.

In the economy, the set of circumstances that momentarily created the Goldilocks economy have ceased to exist.  The deflationary dampening effect of a sinking global economy and falling commodity prices have reversed course and become the inflationary side effects of a rapidly recovering global economy and rising commodity prices.  The list of negatives here also stretches far: from a negative interest rate environment to unsustainable growth, insatiable demand, and a shrinking pool of workers.

This list of worries tied to an overheating economy only grew yesterday with the release of the latest New Home Sales and Initial Jobless Claims numbers.

New home sales grew at a stronger than expected 16.3% in October, and the seasonally adjusted annual rate of home sales hit its highest level of the year (986,000) despite this year's rise in mortgage rates.  The inability of rising interest rates to stem consumer demand remains a problem going forward--a problem which will not escape the eye of the Fed.

Although the number of initial jobless claims came in slightly above expectations at 291,000, the report indicates that labor market conditions remain extremely tight.  The four-week moving average of claims fell to 286,500.

The shrinking pool of qualified available workers is likely to put a damper on growth in the November non-farm payroll numbers. Although we do not expect any surprises from the November employment numbers, we also do not expect to see any signs that labor market conditions have eased to a sufficient extent to prevent further Fed moves.

Euphoria is surging, but so are the warning signs.

Granted, there were other factors at work on Wednesday that also contributed to the market's return to what passes for health these days, with Yahoo and the NAPM survey leading the list of 'factors that uplift'.

The announcement of wonder portal Yahoo!'s induction into the ranks of the S&P500 started the turnaround from the depths of jitterland despair.  Now, while we will reserve comment on S&P's decision to transform the benchmark S&P500 from an index of large companies to one of small companies by giving $3.2 billion in revenues Laidlaw the boot in favor of the $453 million in revenues analyst dream child Yahoo!, and we will reserve comment on whether in the end it will be Laidlaw's school buses that remain standing after today's portal fad fades into the technology dustbin currently occupied by such one-time hot Internet technologies as Gopher, Archie, Veronica, and WAIS, we will opine that S&P's decision to take a ride on a peaking dotcom bubble rather than go shopping in the Benjamin Graham bargain basement is yet one more sign that the top to end all tops could be that much closer.

While a dip from 69.4 to 65.3 in the prices paid component of the NAPM survey also was responsible for today's market turnaround, the market's exuberant reaction to the number was largely a result of a continued misplaced focus on present inflation rather than a focus on the factors which could result in an inflationary spike six months down the road.

Although the prices paid component fell,  the report showed that the manufacturing sector continues to expand.  The order backlog component rose to its highest level in two years and the new orders component rose to 59.9 from 59.5, indicating that manufacturing growth could pick up in coming months.  Any additional expansion of manufacturing activity will put further strains on an already tight labor market.

As we have said before, and as Fed Governor Meyer hinted in his Tuesday speech (see the complete text of speech), it is the continued strength of the demand side of the equation, and its effect on a shrinking pool of available workers that bears watching going forward.

To quote one of the passages of Meyer's speech that sent a tremor through the bond market, "... the key message is that old rules still apply to the new limits. Overheating still eventually results if the growth of demand exceeds the growth of supply for long enough, driving the unemployment rate below the NAIRU (estimate of potential output). Excess demand in labor markets still ultimately puts upward pressure on nominal compensation...Once the unemployment rate falls far enough below your best estimate of the NAIRU, for example, it would be prudent to return to a more normal responsiveness of interest rates to further declines in the unemployment rate. In my judgment, we are already in a range in which such a normal response to further declines in the unemployment rate is warranted.".

The focus thus turns to the release of Friday's unemployment rate number, but a better than expected reading from the number should not be taken as a sign that the dangers of wage pressures bubbling to the surface have passed.  Until the demand side of the equation eases, the danger of upward pressure on wages can not be considered to be over.

The demand side of the equation is unlikely to ease anytime soon.  Tuesday's jump in the Consumer Confidence numbers confirmed one of our oft-stated missives, "there is no escaping the strong correlation between the trend of consumer confidence and the trend of the major stock market averages".  To put it another way, with the wealth effect driving the economy, it is unlikely that rising stock prices and an economic slowdown will occur simultaneously.

Thus, as we have said many times, a necessary precondition for reigning in economic growth will be a fall in stock prices. This decline in the market will also have to go beyond merely effecting short term market sentiment-- it will have to put a dent in the deeply ingrained long term bullish sentiment that has built up during this decade's run if the economy is to be slowed.  Recent declines in the market have only effected short term sentiment, resulting in a v-shaped recovery as the long term sentiment quickly comes to the forefront in the form of buying on the dips.

It should also be remembered that 1998's second quarter market plunge was not of a large enough magnitude to put a dent in the market's underlying safety net of long term optimism--the market quickly regained its composure with a v-shaped recovery, the type of recovery that allows economic activity to quickly return to the pace it enjoyed before the decline.

In order for the economy to slow to a sustainable pace of growth, and for the undercurrent of bubbling economic imbalances to return to equilibrium, it is entirely possible that a decline of 25% or more by the major averages would be required.

While we are not forecasting a decline of this magnitude, a decline of this size or larger within the next year cannot be summarily ruled out.  The conditions that in the past have preceded declines of a similar magnitude are all in place, and the list is long: from rampant speculation in lesser quality issues to mass public participation in the markets, from increasing euphoria to an accelerating pace of margin debt growth, from increasingly narrow breadth focused on a handful of crowd pleasers to a capitulation by the bears, from the trotting out of the phrase "this time its different" to the introduction of new valuation methods used to justify current price levels, from the new economy to a technological revolution, we've seen them all before--and we've seen what follows.

While these conditions can persist for some time, in the past their appearance has always been a sign that the (up)trend has seen its better days.

Finally, a certain large e-commerce stock fell 5 points today after an analyst started coverage with a neutral rating.  The analyst's reasoning: the stock is fairly valued based on projections of year 2009 earnings.  Not that we would want to say anything here, but earlier we mentioned Gopher and Veronica, so we will say something.

Early this decade, before the World Wide Web, the easiest means of finding documents on the web was by using the menu driven Gopher system, and searches were performed using the text based Veronica. Also at this time, anyone who dared mention the words "Internet" and "Commercial Activity" in the same phrase were quickly chased away from the Internet by angry users.

In the early years of this decade no one could have accurately predicted the swift transformation of the Internet from a command-line driven tool of the educational and scientific communities into a mass-market commercial based browser-driven pastime of the general public.

Our point--With the rapid pace of technological change, and the short life cycles of both new technology products and new technology mediums, it is impossible to accurately predict the shape of the Internet, or the patterns of its usage, ten years down the road.

In the early 90's, buying a stake in a company that made products designed to help users utilize the resources of Gopher and Veronica would have seemed like a sure fire bet.  At the end of this decade, it's apparent that the sure fire bet was a dud--and at the end of the next decade many of today's seemingly sure fire bets will also be duds.

The news that the average citizen had spent their weekend furiously mouse clicking at e-commerce web sites and stuck in traffic jams at the shopping mall gave a lift to retail stocks in Monday's trading, but it sent the bond market into a tailspin and already nervous traders took flight and ran for cover as the odds of a February rate hike grew.

The sight of bond yields at 6.30% sent a shiver through the stock market as even the most complacent of NASDAQ and DotCom speculators were forced to confront the fact that perhaps three was not the magic number that signaled the end of the current Fed rate hike cycle.

While we have been saying for several months that three rate hikes would not do the trick, and we still believe that a February rate hike is inevitable, we question the wisdom of a continuation of the Fed's current policy of staggered quarter-point moves, which to date has been an abject failure.

Although the Fed's current policy has followed the classic textbook example of 'how to slow an overheating economy' to a q, it has failed to adequately take into account the new landscape: a place where nearly 50% of the population is involved in the stock market to some degree, a place where the average investor believes that annual returns of 20%-30% are a fact of life, and a place where sentiment borders on the edge of perpetual euphoria.

A quarter point move in interest rates has little effect on the psychology of an investor who believes that their assets will grow by at least 20% a year.  The sentiment boosting effects of 5 year's of outsized gains in the equity markets allows the investor to look upon each quarter point move by the Fed as a mere pin prick that will do little to stop the market front moving higher. 

Combine the sentiment boosting effects of parabolic stock market moves, the confidence instilled by the best jobs market in decades, and the Fed's habit of preparing the markets for each rate hike, and the net result of each Fed increase rate increase becomes a pin prick that missed by a mile.

A continuation of the Fed's current policy of carefully preparing the market for each move will only lead to more of the same: a momentary case of the jitters, followed by a rebuilding of euphoria that allows the economy to continue powering ahead at an unsustainable pace none the worse for the wear.

If the Fed truly hopes to slow the economy and ease tight labor market conditions, it must do more than it has done, and it must do it in such a way that euphoria and the wealth effect will not be given the chance to quickly negate the effects of the Fed's moves.

The best way to do this is by introducing the unexpected, the element of surprise.  There are several ways in which this could be accomplished.  Although we rate the odds of a move by the FOMC before the February meeting as slim to none, a rate hike at the December meeting would send a powerful message that the Fed is serious about slowing the economy to a sustainable pace and is prepared to accept some short term downdrafts in the equity markets as a necessary cost of implementing its policy.

The Fed's other possible course of action, a raising of margin requirements for equity investors, is an unpopular one with many, including ourselves, but would curb the rampant speculation that has created a bubble in U.S. equities which threatens the global economy.

While a raising of margin requirements would have the desired effect of curbing speculation, the question remains whether it is too late in the game for this solution to be practical--euphoria has been allowed to build to such an extent that the Fed would be walking on a tightrope as it made this move, with no way of knowing beforehand whether the move would have the desired effect of putting the brakes on the wealth effect and slowing the economy, or whether it would precipitate a crash that would snowball into a deep recession as investors leveraged to the gills were forced to severely cut back their spending.

Going forward, the Fed will be forced to make one of two choices: short term pain now but long term prosperity as the economic imbalances ease, or a continuation of its current policy which will eventually lead to the Fed falling behind the curve and the economy enduring a New Era of a different sort: the second coming of 1990's Japan.

Finally, in an unrelated note from our short term/long term sector watch department, 3 ideas to kick off the holiday season.

In the short term gain, long term pain category: online brokers and retailers.  While November's surge in trading volumes and this holiday season's surge in shopping volumes will benefit online brokers and retailers, respectively, in the short term, neither trend is likely to be sustainable, and both groups are likely to give up their recent gains over the intermediate to long term.