The analogies run rampant – is the economy coming in for a soft landing? Could it be better classified as a tale of two economies (service & manufacturing)? Or maybe better yet have the three bears not yet made it home to surprise goldilocks? To be sure, the economy seems to be actually living up to the hype of a soft landing and judging by the equity market, happy days are indeed here again. However, there are always issues or the flip side (maybe the dark side?) to that argument that the bond market may be following. With home prices declining and equity cash outs not augmenting income, how much longer can the consumer consume? Retail sales last week indicated that the consumer is still willing and able, however the retailers may be selling at cost (and making it up in volume!) to generate the sales. The employment as well as the Supply Management reports both indicated that the service side of the economy remains buoyant and manufacturing is losing jobs (for three months running) and actually contracting. Bond investors are worrying, judging by the higher short rates vs. long (inversion) that has been in place for four months. We believe it is not a matter of if the economy hits the wall, but when.

The cracks are beginning to form in the equity markets, as the OTC market is showing signs of weakness and the transport averages (a gauge of the economy) is not keeping pace. Our daily indicators continue to be buried in the cautious territory, as they have been for the past month. Seasonally, December is a strong month, and this one has been no different. But, we may be seeing the final run before a meaningful correction begins with the New Year (similar to both ’04 and ’05). Whether the correction is but a 2-4 month affair that takes some air out of the market before it regains its’ footing to embark upon new highs remains to be seen. Judging by the high valuations and stretched corporate margins, at some point (likely soon than later) the market will once again put a real scare into investors by declining by something more than 10%, putting sanity back into the markets. Our models don’t lend themselves to answering “when” – but indicate when conditions point to less than average future returns. We have been in that environment for the past six months – even though the markets have gone higher.

The impact of the economic news upon bonds has made it more volatile than stocks – while also flattening the yield curve to its’ “flattest” level in two months. The Fed indicated last week that they remain vigilant against inflation, they did feel the economy is “in transition” – however left out the “to what” part of transitioning. The Fed is caught between wanting to fight still higher than desired inflation while wanting to give the economy a jolt to avoid the hard landing. The CPI report should allow the Fed to breathe a bit easier and the PPI and housing reports this week should provide more color as to the economy’s temperature. For now, our model remains bullish at “3”, indicating rates should still fall in the months ahead.

© 2006 Paul J. Nolte, CFA
Editorial Archive

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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Paul J. Nolte, CFA
Director Investments
Hinsdale Associates
630-325-7100
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