Read This Now

Calculated Risk nails the home inventory issue out of the park.

What Inflation?

From IBD:

Wheat futures surged to new all-time highs Friday, driven by short-covering and concerns about dwindling supplies, especially of the high-protein spring wheat traded in Minneapolis.

The March spring wheat contract at the Minneapolis Grain Exchange closed up the 30-cent limit for a seventh straight session. It reached $15.53 per bushel, the highest-ever price for any U.S. wheat contract. Synthetic trade through options indicated the contract was valued at $20 to $21.

Wheat futures at the larger Chicago Board of Trade and the Kansas City Board of Trade settled limit-up as well, and prices at all three markets set record highs.

Let's take a look at the chart.



-- Prices are in a clear nine-month uptrend.

-- All the simple moving averages are heading higher

-- The shorter SMAs are above the longer SMAs

-- Prices are above all the SMAs

-- Prices consolidated from mid-December to the end of January, and have now broken out to new highs.

And consider this news story from the UK:

U.K. factories raised prices at the fastest annual pace since 1991 in January as gains in raw material costs reached a record, limiting the Bank of England's scope to reduce borrowing costs.

Producer prices for goods including chemicals, textiles and food rose 5.7 percent from a year earlier, the Office for National Statistics said in London today. The cost of raw materials increased an annual 19.1 percent, the most since records began in 1986.

``This is shocking,'' said Matthew Sharratt, an economist at Bank of America Corp. in London. ``It feeds concerns about inflation, and will make the Bank of England cautious about lowering interest rates too rapidly.''

It's Everybody's Fault

There is a group called the Financial Stability Forum, which includes all the big guys from around the world. They recently issued a paper on what is wrong with the credit markets and how financial firms should shore up their balance sheets.

The paper includes this basic synopsis of who is responsible. The answer is, well, everybody involved:

The report said there is plenty of blame to go around for the chaos: The U.S. subprime-mortgage industry was marked by poor underwriting standards and "some fraudulent practices." Investors didn't carry out due diligence when they bought mortgage-backed securities.

Banks and other companies managed their risks poorly and didn't publicly disclose the dangers on and off their balance sheets. Credit-rating companies did an inadequate job of evaluating the risk of complex securities. Financial institutions compensated employees in ways that encouraged excessive risk-taking and gave insufficient regard to long-term risks.

The WSJ had this in one of the last paragraphs:

The forum urged financial firms to be more forthcoming about the underwriting standards used, for instance, in the mortgages that underlie complex securities, and to make their own due-diligence work available to investors and to the credit-rating companies.

Likewise, the credit-rating companies should be more open about the uncertainties in their own models, and should address any conflicts of interest in their work.

Let's tackle this one point at a time.

1.) There were no underwriting standards. There were instead medical requirements -- if you had a pulse, you got a loan. What financial firms really need to disclose is the medical records of borrowers to make sure all borrowers were in fact alive when they got a loan.

2.) All the major players -- mortgage brokers, banks, investment banks, rating agencies and the like -- should instead disclose all internal emails regarding their part in this mess. My guess is there is a contingent within each company that knew damn well each respective company was royally screwing up. The reason I think this is a Congressional investigation into tax evasion plans offered by the big accounting firms uncovered similar emails among the respective firms higher ups. The point all the players had to know -- they are filled with very bright and capable people who were well aware of the financial tsunami they would eventually unleash on the US economy.

How Much of A Correction Can We Expect in Home Prices?

Let me start with this: I don't believe in long-term economic predictions. The possibility of being wrong is so incredibly high that the idea is be definition self-defeating. However, here is a chart of the Case-Schiller home price index



Let's make some observations.

-- During a robust economic expansion in the 1990s home prices weren't that impacted. Of course, the US economy was busy creating another bubble at that time, so maybe the speculative money was entirely invested in stocks. However, there is no reason to think people didn't need houses at that time, or that the population stopped growing or that people didn't get better jobs and therefore wanted a newer or larger home. In other words, there were still fundamental reasons for home prices to increase, yet they didn't do so in an outrageous manner.

-- From January 2000 to January 2005, home prices doubled at the national level. Let's think about that for a minute and let it sink in. Now -- let's ask ourselves a question: was there a fundamental difference in demand that would warrant that increase in price compared to the previous expansion? Did the population growth rate increase exponentially? Were paychecks that much larger? The answer is -- no. In other words, there was no fundamental demand reason for home prices doubling. It was primarily the result of ultra-cheap money. The reason why this answer is so important is this: a fundamental change would create a cushion for prices, providing a price floor of sorts. But that really doesn't exist. To back up that assertion, consider this point: vacancy rates are now the highest since 1960. And vacancies didn't meaningfully increase until 2005 -- and they really moved higher at the end of 2006.

So -- are there strong fundamental reasons for home prices to remains at current levels? Not at all.

Now for the big question: how much of a decline can we expect? Well, let's eyeball the chart and say home prices are about 210 on the scale. Assuming a 15% correction, that would prices at 178.5 and assuming a 20% correction prices would drop to 168. Here is where those levels are approximately (remember, I'm eyeballing the chart)



Notice how we really haven't done that much meaningful damage to the price increases from the early 2000s? The point is that a large correction -- 20% or so -- wouldn't be that hard to see given there was little reason for the price increase save for record low interest rates.

The Week Ahead

We get retail information on Tuesday and Wednesday -- ICSC and Redbook on Tuesday and Census information on Wednesday. So far, the news out of the retail sector has not been good -- in fact, it's been downright terrible. Considering 2/3 of the US economy is consumer based this should cause some concern for everyone.

International trade data comes out on Thursday.

Friday we get industrial production and the Empire state index.

I'm note sure what I expect from the markets at this point. I'll think about that overnight and tomorrow and let you know.

Last Week's Market Action

The markets dropped last week -- hard:

The S&P 500 fell 64, or 4.6%, to 1331 and is 15% off its October record. The Russell 2000 index of small stocks gave up 32, or 4.3%, to 699.

The tech-sector exodus sent the Nasdaq Composite Index down more than 20% from its Oct. 31 high at one point midweek, before buyers closed that gap to 19.4%. It ended the week down 109, or 4.5%, to 2305. It has fallen in six of the past seven weeks. The Nasdaq 100, meanwhile, is 20.8% off its late-October

If you look at the size of the multi-month drops you'll notice we're at or extremely near a conservative definition of a bear market.



The SPYs had a big drop at the open on Tuesday and continued in that trend for the rest of the week. But there is the possibility for hope, as the market formed triangle consolidation on Thursday and Friday.

Below I note that the QQQQs and IWMs may have formed a head and shoulders pattern, yet don't make the same call for the SPYs. While it is possible the SPYs formed a head and shoulders pattern -- I can see the possibility -- the SPYs simply look more like a downward sloping channel. I think of head and shoulder patterns as being a bit more extreme in their movements. But, that's a judgment call and I certainly wouldn't think calling the SPYs a head and shoulders pattern would be an outlandish call.



With the QQQQs note that Tuesday through Friday formed a pretty clear head and shoulders pattern. If you compare the head of this pattern to the head of the SPYs, you'll see a larger and more pronounced price action.



Also note the QQQQs formed a triangle consolidation pattern on Thursday and Friday.



The IWMs formed a head and shoulder pattern from Tuesday through Friday.



Also note the clear downward sloping channel.

Now that the Federal Reserve has stepped into the debate the bulls have a good friend. Any bad news can now mean there are further rate cuts down the road. This clearly helped the market rally when it was in its oversold position in late January.

But there is also plenty of ammunition for the bears, largely because the economic news for the last month or so has been terrible. The number of economists who are predicting a recession or saying we're already in a recession is increasing.

A head and shoulders pattern is a reversal pattern and could indicate the market is ready for a turnaround. I wouldn't be surprised to see the market trade in a small range for the next week or longer, largely because the shine of Fed action is still out there.

Weekend Weimer and Beagle.

It's been two weeks since this event -- and three if you count the fact that two weeks ago I did weekend Haggis.



Above is Sarge in a pose that demonstrates how long his front legs are.



Above is Scooby in an "extreme close-up"



For some reason, yesterday Kate decided to lie down on top of this footstool. I have no idea why she did that, but I had to get a picture.

So -- the markets are almost closed. Don't think about economics or the markets until tomorrow.

Now They're Woried About Inflation

From the WSJ:

Federal Reserve officials are acknowledging increasing weakness in the economy, signaling a willingness to cut rates again at their next meeting. But inflation concerns are rising among some officials, indicating the magnitude of their next move may be a matter of contention.

.....

Some officials, however, expect growth to rebound in the second half, and they are wary of cutting rates so low now that they would spur higher inflation as the economy recovers. Monetary policy works with a lag, so interest-rate cuts tend to boost the economy six months to a year after they are implemented.

"The Fed has to be very careful now to add just the right amount of stimulus to the punch bowl without mixing in the potential to juice up inflation once the effect of the new punch kicks in," Richard Fisher, president of the Federal Reserve Bank of Dallas, said in a speech in Mexico City yesterday. Mr. Fisher dissented in the Fed's latest vote, which lowered the interest-rate target half a point.

Charles Plosser, president of the Federal Reserve Bank of Philadelphia who also is on the voting rotation this year, suggested this week that he would need to see a deeper deterioration in the economy -- beyond the weak numbers already expected -- to support further easing.

But Mr. Plosser, who backed the last two rate cuts, said he expects "little progress" in lowering a key inflation measure this year or next, "and I am skeptical that slower economic growth will help," he said. "All you have to do is recall the 1970s when we experienced both high unemployment and high inflation to appreciate that slow economic growth and lower inflation do not necessarily go hand in hand."

This has been one of the main reasons I have argued against the rate cuts over the last few months. The bottom line is inflation is nowhere near a good level.

Here is a chart of the year-over-year change in inflation:



And here is a chart of the year-over-year change in money growth



Inflation looks really tame, doesn't it (end really sarcastic, smart-ass tone)

I first started to become concerned about inflation after my twice weekly shopping trips. I noticed that things I buy regularly -- milk and chicken -- were increasing in price to uncomfortable levels. In Houston Texas, a gallon of milk was roughly $2.99/gallon for the longest time. Over the last 6 months it has increased in price to $3.39/gallon. Bonless skinless chicken has increased from approximately $5.50/package (roughly 4 chicken breasts) to over $7.00 package. Then I started to listen to check-out conversation and it was all centered on prices. I realize the Bonddad's shopping list is hardly exciting reading, but this is where my concern started.

Now we have stories like these about agricultural prices hitting record highs and inflation hedging commodites like gold and sliver doing likewise. Anyone who follows these markets -- wheat, corn and the like -- has seen huge price increases over the last 5-7 years. While the Fed was concerned about "core" inflation -- great if you don't eat or drive anywhere but completely useless for anything else -- non-core inflation was running through the roof.

And it's not as though interest rates were sky high in the first place. Take a look at the following charts from the St. Louis Federal Reserve:

Effective Federal Funds:



10-Year CMT



30-Year CMT



AAA Corporate paper



BBB Corporate paper



Interest rates are cheap beyond belief. It's not as though money is expensive right now. The central problem isn't the cost of money -- it's a poorly managed financial sector. But thanks to 17 years of Alan "cheap money" Greenspan, we're all use to the Fed cutting rates whenever we feel economic pain. Thanks for nothing.

So now we hear the Federal Reserve actually talking about inflation. That's nice. It's what they should have been talking about all along.

Treasury Market Bubble?

From the AP

Investors' raging demand for safe assets over the past six months may have created a bubble in the Treasury market — and some onlookers expect to hear a bursting sound any minute now.

A market bubble exists when asset prices are driven well above their intrinsic value, as occurred with stocks in 1999 and housing prices in many parts of the country in 2006. Often the end of a bubble is marked by disruptively sharp price declines as investors abruptly conclude assets are overvalued.

There are mixed views about whether the recent buying spree in the Treasury market has driven prices up to unjustified bubble levels. The rally, which has also sent bond yields plunging to multiyear lows, was fed first by fallout from the subprime mortgage crisis and then by growing worries about a recession.

"I'm one who believes there is a bubble. Everyone has been focused on Treasurys because they are afraid of the alternatives," said Michael Metz, chief investment officer at Oppenheimer & Co. "It has nothing to do with the value of Treasurys, which are overvalued. The stampede has been because of fear."

I don't think we have a bubble in the Treasury market but I do believe the Treasury market is a bit "off" right now. First let's look at the multi-year charts of the Treasury market.





The TLTs (20+ year) and IEFs (7-10 year) are at levels not seen for about three years in the case of the TLTs and five years in the case of the IEFs. But while we have seen a big price spike over the last 6 months as a result of the credit crunch, prices aren't at historically at never-before seen levels.





This is a 1-year chart of the TLTs and IEFs. Notice we are in a clear bull market pattern of higher lows and higher highs. These are very strong charts.

When I stated the bond market was a bit off, I was specifically thinking about inflation. As the post below indicates, there are plenty of reasons to think inflation is far from contained right now. Not only are various commodity prices high, money growth is very high. Here is a chart rom the St. Louis Fed of the year over year percentage change in MZM:



In short, Bernanke is earning his nickname "helicopter".

And then there is the year change in inflation:



Clearly inflation is not where the Fed would like it to be. But it's also not where bond market investors want it either. Inflation eats away at the fixed rate of return on fixed income investment. While traders have ignored the higher inflation levels for now, I'm wondering how long that can last.

But it's also important to remember that Treasuries have a yield -- a fixed rate of return. This acts as a natural brake on a Treasury market rally. And it appears we may have reached it:

Treasuries tumbled after the government's $9 billion auction of 30-year bonds at the lowest yields ever chased away investors.

The longest-maturity U.S. debt fell the most since 2004 as bondholders concluded that yields were too low given the Federal Reserve's determination to cut interest rates and keep the economy out of a recession. Before the government's sale, investors expected a 4.41 percent yield, based on pre-auction trading. The bonds were sold at 4.449 percent.

``This is a massive boycott,'' said George Goncalves, chief Treasury and agency debt strategist in New York at Morgan Stanley, one of the 20 primary government securities dealers that are required to bid at Treasury auctions. ``We got a message that enough's enough.''

The yield on the new 30-year bond auctioned today rose to 4.51 percent as of 5 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The yield on the previous benchmark bond due in May 2037 rose 16 basis points, or 0.16 percentage point, to 4.52 percent, the biggest one-day leap on a long bond since April 2004. The 2037 bond fell about 2 3/4, or $27.50 per $1,000 face amount, to 107 3/4.

So, traders have finally realized that after adjusting for inflation they're not getting that much of a return on their investment. That doesn't mean we're going to see a huge plummet in the Treasury market. They are still incredibly safe investments which is very attractive during turbulent times. However, it is possible that we have see a ceiling in bond prices for now.

What Inflation?

From Bloomberg:

Wheat surged to record highs on three U.S. futures exchanges as millers and overseas importers faced shortfalls of spring grain, used to make bread and pasta and other food staples.

Spring wheat harvested in September and October was sold in forward contracts by farmers and grain-elevator operators, triggering a shortage of supplies this year, analysts said. Demand has surged for the high-protein grain, and futures in Minneapolis, where spring wheat is traded, have almost tripled in the past year.

``You have to have it,'' said Jon Marcus, president of Lakefront Futures and Options LLC in Chicago. ``You can't say, `Well, we just didn't make any bread today.' You can't just quit your business because prices are too high, though I'm sure there are some people going out of business. You have to buy it.''

From Bloomberg:

Copper jumped more than 4 percent to a three-month high as falling inventories quelled concern that demand for the metal may slump.

Stockpiles monitored by the London Metal Exchange dropped for a fifth-straight session to 169,475 metric tons. Supplies have slipped 14 percent this year. Copper has gained 14 percent since Dec. 31 partly on concern supplies will lag behind demand.

``We're seeing rather strong demand on the LME as indicated by the drawdown in inventories,'' said Catherine Virga, a metals analyst at CPM Group in New York.

Copper futures for March delivery climbed 14.5 cents, or 4.4 percent, to $3.454 a pound on the Comex division of the New York Mercantile Exchange. The contract settled at the highest price since Oct. 31.

From Bloomberg:

Gold futures rose on speculation central banks around the world will follow the U.S. in cutting borrowing costs, boosting the appeal of the precious metal as an alternative to holding currencies. Silver also gained.

The Bank of England today cut its benchmark lending rate for the second time since December, and the European Central Bank signaled it may lower rates later this year. Gold rose 31 percent last year as the Federal Reserve cut borrowing costs to avoid a recession.

``You're going to see central banks start to cut rates,'' said Nick Ruggiero, a trader at Eagle Futures Inc. in New York. ``Gold will stay very strong.''

Gold futures for April delivery rose $5, or 0.6 percent, to $910 an ounce on the Comex division of the New York Mercantile Exchange. The price earlier touched $915.20.

Silver futures for March delivery gained 22.5 cents, or 1.4 percent, to $16.775 an ounce. The metal has climbed 12 percent this year.

Commodity prices look well contained -- where have I heard that before? Hmmmmmm.....

Today's Markets

I will be the first to admit that today's action made no sense to me. Retailers reported terrible sales data:

Retailers led by Wal-Mart Stores Inc. reported January sales figures below already-weak estimates, pushing sales growth to a five-year low by one measure and further fanning concerns the U.S. economy is entering a recession.

Sales at stores open at least a year, a key measure of retailers' performance, rose just 0.3% in January, according to an index compiled by Thomson Financial, below expectations for a 1% gain. Half of all retailers tracked by Thomson turned in disappointing results. (See a sortable retail-sales chart for January.)

The January weakness came on top of a downbeat holiday season, after which nearly a dozen retailers cut their profit forecasts.

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Excluding seasonal fluctuations, sales posted the worst gain since March 2003, when the Thomson Financial index was flat. That same month was the last time before January that an index compiled by the Institute for Supply Management showed a contraction in the U.S. services sector.

Yet the retail ETF rose 2.44% because:

Retailers in the Standard & Poor's 500 Index advanced the most among two dozen industries on the J.C. Penney and Gap forecasts.

Then there was the Treasury auction:

Treasuries tumbled after the government's $9 billion auction of 30-year bonds at the lowest yields ever chased away investors.

The longest-maturity U.S. debt fell the most since 2004 as bondholders concluded that yields were too low given the Federal Reserve's determination to cut interest rates and keep the economy out of a recession. Before the government's sale, investors expected a 4.41 percent yield, based on pre-auction trading. The bonds were sold at 4.449 percent.

This indicates that the government's desire to increase spending may run into some serious problems. But the markets rallied.

Seriously, I am guessing today's action was as much technical as anything else.







The indexes spent most of the day moving higher. They had a small sell-off at the beginning of the afternoon, but recovered.

My guess is there are some traders looking to pull a sell trigger right now, but are looking at the daily charts and have decided to wait for the lower levels or another catalyst. The bottom line is we've been hammered with bad news for he last month or so; maybe traders are just getting numb to the whole thing.

This is a Really Stupid Idea

From the WSJ:

The banks are trying to figure out how to commute, or unwind, their credit default swaps, which are contracts they entered into with FGIC and other bond insurers to guarantee their portfolios of complex debt securities known as collateralized-debt obligations, or CDOs, according to people familiar with the talks.

A consortium of banks working toward a rescue plan for bond-insurer Ambac Financial Group Inc. also is discussing a similar option, according to people familiar with the matter.

In exchange for unwinding the contracts, FGIC and Ambac could give the banks stakes in their companies through warrants, according to these people.

Let me get this straight.

The companies that issue debt would then partially own the company that guarantees the payments of that debt? Am I the only one who sees a mammoth conflict of interest issue here?

Let's play this one out.

Company X issues $100 million in bonds backed by questionable collateral (I don't know -- let's say it's backed by a pool of questionable home equity loans).

Company X would really like to get some cheap insurance for these bonds to get a better rating from the rating agencies -- and increase quarterly profit.

Enter the guarantor the issuer partially owns. For some reason the issuer gets a really good deal on bond insurance.

The ratings agencies disclose this relation,, but in very small print on page 94,892 of a nearly incomprehensible analysis of the bonds. Oh yeah -- the ratings agencies also issue a disclosure/warning with that report that still basically says "buyer beware".

Collateral goes belly up (I know that would never happen because the issuer would use stringent underwriting standards too prevent it from happening). But let's say it goes belly up anyway -- just for the sake of argument.

Insurer gets hit with a bill they can't pay. But who cares? The issuer -- who partially owns the insurer -- got a great deal on bond insurance which lowered their compliance and issuance costs and increased their profit for a quarter. The insurer goes belly up or takes a major hit to its earnings, but upper-level management still gets a sweetheart post-dismissal compensation package (or they have been dumping stock for the last 6 months because they see the writing on the wall).

Let's just repeat the problems we've had for the last 6 months - 9 months again, shall we? They have been so much fun the first time around after all.

Market Breadth Is Looking Weak

Market Breadth is a measure of how the market is doing as a whole. It looks at two things. The first is the number of issues increasing in price verses the number of issues decreasing in price. This is called the advance/decline line. The second measures the number of stocks making new highs versus the number of stocks making new lows. This is called the "new high/new low" index.

Thankfully, stockcharts.com keeps a running total of these numbers for the NYSE and NASDAQ. Here are those charts.



The NY advance/decline line is in a downward sloping range. It's been decreasing for about a 8 months now which is not a good development. It indicates the number of stocks declining in value is larger than then number of stocks increasing in value. Also note this number has climbed a lot over the last two years, so we have a long way to go down.



The NYSE new high/new low number has the exact same analysis as the NYSE advance/decline line.



The NASDAQ new high/new low has been dropping hard since October, indicating there are some areas of the market that are taking very large hits.



The NASDAQ advance/decline line has been a disaster for two years. I have to wonder if this index is still feeling the mathematical effects of the 1990s bubble (remember we saw some extreme distortions during that run). However, if not, this chart makes me wonder why anyone thought NASDAQ would be the markets saving grace.

The point of the above charts is this: the technical underpinnings of the market are deteriorating. In addition, it also means that fewer and fewer stocks are doing well.

Enter the IBD 100, which is a list of stocks picked by IBD's ratings system. In general, this list is a group of industry and market leading growth companies. IBD's method of picking stocks is pretty solid. In addition, a lot of people let IBD do the work for them, relying on this list as a pre-screened group of winners. So we should pay attention to what this group is doing.

From IBD:

Nowhere is there better evidence of a poor market than in the IBD 100. This list of the market's best names is chock-full of problems.

First off, for the most part we're seeing the same old names that led the market before this correction began.

With every new market uptrend, new leadership emerges. So far there's little in the way of new components with solid fundamentals and institutional sponsorship.

The next problem is related to the first: These "leaders" are much damaged. In many cases their corrections are deep, and many broke badly in high-volume sell-offs.

So, the IBD 100 isn't doing that well either.

Let's tie all of this together.

Market Breadth is deteriorating.

The stocks that were doing well -- the stocks that were propping up the deteriorating market conditions -- aren't doing well either.

Overall, this is not a good development for the market as a whole.

What Inflation?

From IBD:

U.S. steel makers have the added benefit of favorable exchange rates, which have tamped down imports and stirred sales overseas.

"High shipping rates and the weak dollar are giving producers here a lot of leverage, particularly in the spot markets," said Bob Richard, senior research analyst at Longbow Research.

Hot-rolled coil sold at $670 a ton on Jan. 25, according to a recent report from Citigroup. That was up from $543 during last year's fourth quarter and well above the 2007 peak of $580.

Cold-rolled coil fetched $750 a ton on Jan. 25 vs. $640 in the fourth quarter and $680 for the 2007 peak. Gains were reported across most product categories.

No Slowdown Seen

Most analysts see prices remaining strong this year, even amid U.S. recession worries.

No worries here -- prices are contained -- it's all OK -- just lower rates again and all will be fine.....

Cicso's Warning And the Economy as a Whole

From IBD:

"We are seeing our U.S and European customers becoming increasingly cautious," Chambers said on a conference call with analysts. "We did see the slowdown occur pretty rapidly between December and January."

He also said that India and China remain strong and that "if the market does continue to slow, we do not believe this will dramatically change our long-term opportunities."

But investors have grown increasingly worried that the U.S. economy might slip into a recession, on reports of higher unemployment and a sharp decline in the services sector. Some fear the economic slowdown is spreading to other parts of the globe. Cisco said its orders rose just 8% in Europe last quarter vs. 20% in the previous quarter.

EDS Also Disappoints

On the conference call, Chambers forecast revenue of about $9.7 billion to $9.8 billion for the current quarter ending in April. Analysts were expecting $10.2 billion. Tech services company EDS, (EDS) also reporting results after the close of regular trading Wednesday, issued tepid guidance. Its shares were down about 5% after hours.

24/7 Wall Street puts the above information in perspective.

Cisco (NASD: CSCO) and EDS (NYSE: EDS) have businesses which point different directions on a compass. But, it is the same compass. In one day, Cisco was able to show that large capex tech spending was slowing while EDS said that the consulting business aimed at data center out-sourcing was in the dumps.

To put a point on it, the whirlpool of falling tech earnings is pulling in almost every company in the sector. Reason did not prevail among those who hoped that large companies would continue to put money into next-generation upgrades of existing hardware and software. That puts the need for consulting services well out of consideration for most firms.

Why listen to Cisco? According to Yahoo finance, they are the largest player in the networking and communication devices by a wide margin. Their market cap is $140 billion with the next largest being Juniper Networks at $16 billion. And there is also this nugget (from IBD):

Investors look to Cisco for a fresh take on the economy. It's the first major tech company to give results for fiscal quarters that end in January.

But more importantly, this gives us an opportunity to look at a part of GDP we haven't talked about at all -- equipment and software investment and national GDP.

According to the Bureau of Economic Analysis, E&S investment totaled $1.026 trillion in the 4th quarter of 2007, which total national GDP was $14.080 trillion, making E&S investment about 7.28% of the overall economy. E&S investment is twice the size of non-residential construction investment, meaning technology investment is pretty important.



Above is a chart of the total dollar value of E&S investment from the BEA. Notice the real gains for this area of the economy occurred between the second quarter of 2004 and the second quarter of 2006 when the total dollar investment increased from about $800 billion to $1 trillion. Also note that from 2Q03 to 2Q04 there was also an increase, but not as strong as the following two year period.



Above is the percent change from the previous quarter in E&S investment. What this chart shows is it appears the really strong investment in E&S occurred earlier in this expansion, from roughly 2003 - 2005. That's when we see big month over month percent change increases. Since then, we've see growth but not as strong as earlier in the expansion.

Cisco's warnings indicate that on the percentage change from the previous month we may be looking at another down month.

Translating "Fedspeak"

There have been two Fed speeches over the last few days. The first was from Jeff Lacker of the Richmond Fed, and he second was from Charles Plosser of the Philadelphia Fed. While I am not sure how to interpret the implications of these speeches for future policy, there is no doubt that Fed speeches are usually decent sources of overall macro-economic information. It's also important to try and see the economy as the Fed sees it. Finally, these speeches often provide an excellent way to look at the macro economy. So, here goes. I will deal with Plosser's speech this morning and Lacker's speech this afternoon.

Plosser's Speech

By last September, we had already seen a cumulative deterioration in the housing sector during the earlier part of 2007. In addition, the disruptions in financial markets in August caused by the problems in the subprime mortgage market raised the risk of potential adverse effects on the broader economy from a further tightening of credit conditions. As a result, I lowered my projection of economic growth for the fourth quarter of 2007 and the first half of 2008. In particular, the adjustment to my forecast involved pushing back the turnaround in residential construction, as low demand for homes meant it would take longer than expected for the economy to work off the inventories of new and existing homes for sale. The continuing high prices of oil and other commodities also suggested the potential for some slowing in the pace of economic activity, as well as hinting at increasing inflationary pressures — a point I will return to later. As the outlook changed, the FOMC lowered the fed funds rate target by 50 basis points in September, and then by another 25 basis points in both October and early December.

Since the Committee’s meeting in early December, the economic data have indicated that the deterioration in the housing market has continued unabated. Although that by itself was discouraging, other economic indicators also showed signs of an economy that was weakening. The renewed widening of some credit spreads in financial markets, along with weaker figures for retail sales, manufacturing activity, and job growth in December, led many forecasters in early January to further mark down their forecasts for 2008. The sharp rise in December’s unemployment rate, which was released in early January, also heightened many economists’ concerns about the economy’s health. What’s more, the Philadelphia Reserve Bank’s closely watched manufacturing survey recorded a surprisingly steep decline in industrial activity in January, to a level not seen since the last recession.

Let's take this information one piece at a time.

By last September, we had already seen a cumulative deterioration in the housing sector during the earlier part of 2007.

The housing market has been falling apart for some time. First, the problem was "contained", then the problem was only a "small section of the economy". Now economists are realizing how important housing was to the last expansion.

Here is a chart of total existing homes for sale:



While the total inventory dropped last month, December is typically a month when people pull their homes off the market. Also note we're just shy of 4 million homes on the market, which is a ton of home.

Here is a chart of the months of supply at the current sales pace:



Again this number dropped last month, but December is not the hottest month for real estate. If we continue to see a drop over the next few months then we'll be in better shape. In addition, with the credit market tightening a strong rebound seems unlikely.

The continuing high prices of oil and other commodities also suggested the potential for some slowing in the pace of economic activity, as well as hinting at increasing inflationary pressures — a point I will return to later.

The Fed is in a classic pickle right now. On one had they are looking at the possibility of a recession. On the other hand, commodity prices aren't looking like they want to come down anytime soon.

Here is a chart of agricultural prices:



And here is a chart of oil prices



While the agricultural price chart is in a clear multi-year bull market, oil may be topping right now. We could be looking at a double top forming in late 2007 and early 2008. However -- we'll have to wait an see how that plays out. On the bearish side, a slowing economy does mean less oil demand from the US. But on the bullish side there is India and China and their increased demand for oil caused by their respective growth levels. In other words, barring a major change in the demand side of the equation, I wouldn't expect oil to see a major price drop.

The renewed widening of some credit spreads in financial markets, along with weaker figures for retail sales, manufacturing activity, and job growth in December, led many forecasters in early January to further mark down their forecasts for 2008.

For a discussion of the tightening credit markets, see this article

Here is a chart of total retail sales from the St. Louis Fed:



Notice that while sales are still increasing, we've seen somewhat of a leveling off over all of 2007.

Here is a chart of the year-over-year percentage change



Notice that 2007 results were considerable weaker than 2006 and 2005. While sales spent more of the year around the 1.8% level, they dropped near the end of the year when there should have been a nice holiday push.

Here is a chart from Martin Capital Advisers of manufacturing data:



Note that the overall change in industrial production has been about 2% over 2007. That's a decent reading, but is clearly off its highs. Also note that ISM manufacturing index has been dropping since about mid-2007, indicating manufacturing is weakening.

Here is a graph from the WSJ:



I've blocked off 2007 and added a darker line to the 100,000 level for job creation. Notice the following.

-- There were only 5 times in 2007 that monthly payroll growth exceeded 100,000.

-- One of those times was a "just barely" number

-- Four of those times occurred in the first half of the year.

-- For five months, job growth came in at 50,000 - 100,000.

-- Two times after a big number, the following month's number was really low (as in barely positive). Two other times, the number came in between 50,000 - 100,000.

In short, the last year's employment numbers have been terrible.

Follow That Lemming.....

Angry Bear had a link to this report on housing prices from 2004.



Let's remember an important trading fundamental: Economic numbers (like prices) usually revert to the mean.

Today's Markets

SPY -.97%
QQQQ -1.97%
IWM -1.42%









All the markets tried to rally today, but just couldn't keep the momentum going. Once all of the averages broke support it was look out below. The QQQQs led the way, but the SPYs and IWMs were quick to make up for lost time. The bottom line is charts like those above indicate the market is now -- once again -- looking for a bottom somewhere and not finding a convincing level.



Last week's rally is gone.



The QQQQs really didn't have much of a rally last week. But they are still hurting pretty badly.



Last week's rally is nearly gone.

The luster of the Fed's rate cuts is definitely gone. The markets are realizing the underlying reason the Fed made its rate cuts -- a terrible underlying economy.