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September 25, 2006

Sweet Spot

Doom & gloomers are having a rough time these days. Commodities are getting beat into the ground, and stocks keep bobbing up like a fishing float in an unstocked pond. The cruelest part of this action is that stocks may be going up because commodities are going down. Perhaps it is partly a soft-landing mentality, but more importantly, all the money fleeing commodities has to go someplace, and right now it's going into stocks and bonds. The S&P 500 rose 1% in today's session to set a new, three-year high before pulling back slightly into the close, while 10-year Treasuries achieved yet another gain to drop rates to near 4.5%... quite a rally from the 5.25% being offered in early summer.

In one of the more absurd statements to emanate from a Fed official in recent times, the Dallas President, Richard Fisher, said that the economy remains "healthy and robust" despite a "serious correction" in the housing market. Those two situations are incompatible. Housing is too important to the U.S. economy, especially in this decade, for it to seriously correct without adversely affecting the economy. We are simply drifting through the sweet spot between the fall of housing and its ultimate affects on the economy. Once this sweet spot passes... or at least when more traders become cognizant of what is happening... stocks will react in a manner more conducive to the expectations of doom & gloomers.

I, for one, certainly thought the sweet spot was behind us... or close to being so... but recent action in equities says otherwise. Traders remain in denial despite the 1.7% drop in year-over-year median home prices reported by the NAR this morning, the first year-over-year decline in 11 years. The information we can gleen from the market's reaction is that traders remain primarily focused on interest rates rather than earnings. With housing continuing to show signs of rapid deceleration, seeing a stock market rally only makes sense when viewed within the framework of expectations for interest rate cuts. This explanation fits well with the sweet-spot scenario: it is a brief interim during which the soft-landing fantasy can prevail.

One may quickly challenge this assertion and ask why commodity prices continue to fall if there are expectations for rate cuts. The simple answer is that the price slump has momentum that must be burned out. I wrote during the summer of expectations that we would see another down draft in commodities to wash out weak hands before moving higher. I believe that process has just about run its course, and I am remaining alert for signs that it is time to jump back into the fray.

Disclosure: None


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