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January 11, 2006

Lucky Seven

U.S equities are now seven-for-seven in 2006 with every index sitting at fresh highs. Although I've been saying since late December that we are on the precipice of disaster, my money, quite fortunately, is not where my mouth is. I have not yet seen the type of action I want to see to trigger bets on the disaster scenario, but I have not reduced my expectations that it will occur.

The market's action so far this year reminds me of a comment I made to a friend, a high-roller on Wall Street, several years ago. In early 2002, the Nasdaq Composite had just cracked below 2000, and I told him the index would see 1000 before it saw 2000 again. He thought I was nuts. Turned out he was right. The index only made it down to 1160 before turning up and surging back to 2000. I have a feeling of making a similar error in judgment about the powers that be. It is very dangerous to underestimate the propensity of the Federal Reserve to print money.

In 2002, Alan Greenspan was printing money like crazy to try to stem the effect of the tech bubble bursting. Today, he is printing money like crazy to smooth over the transition to a new Chairman, and the words "like crazy" do not do justice to the pace of monetization. Over the passed several weeks M-3 growth has been nearly 30% on an annualized basis! The increase is phenomenal and is no doubt helping fuel the current market rally. This pace of printing can also help explain why the dollar has been falling so sharply.

The question for traders must be whether we are in a 2002 scenario where money printing will remain out of control, pushing stock prices much higher nominally (but not in real terms) or whether we are in a 1999/2000 situation where money printing will be scaled back once the "event" has passed, resulting in a major market roll-over. Considering that the Fed will cease publishing M-3 two months from now, we will have to rely on any other information we can gather to make judgments.

Today's action saw strength across the board, especially in financials. Financial institutions are the primary beneficiaries of Fed liquidity, so it's not surprising to see them leading the pack. Perhaps this group will gives us some clues as we move along. Energy also caught some bids as oil tacked on about a percent. Oil's chart looks very compelling to bulls at the moment with two gap-up moves recently. At the risk of stating the obvious, it seems oil will do anything but go sideways from here. I would expect that either the gaps will be followed by a sharp move to new highs or for they will prove to be a sucker's rally followed by a sharp move downward. If I had to guess, I would say we're going to new highs, but I don't have enough conviction to trade it right now.

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