First off, any good market hypothesis must include considerations of the opposing viewpoint so let’s get the bullish factors out of the way first. Here they are:

1) As we’ve discussed ad nauseum, the Fed isn’t about to let this market fall much, at least not if they can help it. Big plus for the bulls. Not enough to inspire committed buying, but it’s always nice to know that the “full faith and credit and printing presses” of Uncle Sam are on your side.

2) Interest rates remain exceptionally low and as I’ve speculated for some time in the pages of TSS, they’re likely to remain low even while Uncle Greenscam scratches his head and pretends not to understand the “conundrum.”

(Given that the conundrum is pretty much the only thing holding up this house of cards, G’s confusion doesn’t fly with me. The left hand says “Golly, I’m so conundrummized! Why aren’t rates rising?” while the right hand exchanges high-fives with Bernanke and all the other buffoons hell-bent on bankrupting the country.)

And there you have it. The bullish case. Onward to my favorite part: the bad news. Let’s start with the technical considerations.

As the S&P 500 encroaches upon its bull market high, the Dow and Nasdaq continue to lag by a very fat margin. While the S&P 500 trades slightly over 1% from its cyclical bull market high, the Nasdaq lags by nearly 5% and the Dow by nearly 4%. That’s what I call a glaring divergence and a potential non-confirmation. In a healthy bull market we want to see the major indices moving hand-in-hand. But we’re not. One index lagging is a potential divergence. Two indices lagging seems to imply that the leading index doesn’t really know what the heck it’s doing.

Then there’s that pesky crude oil which simply refuses to cooperate with the assessments of all our high-falootin oil “experts” who only a handful of short weeks ago were splattered all over the media going on and on merrily about “the top.” USA Today rolled out some smug buffoon/expert prattling on about how the panic about high gas prices was a sure sign that the bull market was over. Unfortunately, someone forgot to tell crude oil.

High oil prices are here to stay and cheap oil will be relegated to a charming little chapter in the history of the 20^th century. Corporate and consumer America will continue footing the tab, pulling money from wages and consumer expenditures to account for the difference. Energy isn’t a discretionary expenditure. You buy it or you learn to enjoy your new home under the viaduct. Oil prices are hitting profit margins and it’s only going to get worse.

The yield curve is looking relatively flat these days. Flat is what happens before it inverts, and inversion is an exceptionally reliable indicator of forthcoming economic weakness. That is, recessions. Not so good for cyclical bull markets.

Not to mention that the narrowing spread between short and longer-term interest rates continues to make the so-called carry trade less profitable and risky. Today’s “service” economy depends so much upon shuffling money around from one party to the next in order to generate “profits” and far less on producing anything of real value. The fallout of an unwinding carry trade says “goodbye” to fat profits for the financial firms and banks.

Real estate is looking rather frothy. Although admittedly, there’s so much press these days about the “real estate bubble” that I suspect we’re nowhere near a top. The day the mainstream press calls a market top accurately is the day I head to my underground bunker to hole up in preparation for the Martian invasion. (And to hide from yet another Tom Cruise film.)

For those who argue that Time magazine has signaled a top with its recent “Why We're Going Gaga Over Real Estate” cover, I submit that our new lightning quick information age and its attendant technology has simply allowed the folks at Time to get stupid faster than usual. Time might be going gaga, but the top may not be in just yet.

But dangers abound nonetheless. According to the Economist, 40% of all jobs created since 2001 are directly related to housing, including construction, mortgages and brokerage. The fallout from a slump in real estate could be a huge damper on the economy. That’s in addition to the fact that declining real estate prices would withdraw one of the primary sources of “income” from American consumers: borrowing against the value of the home.

But the costs of a pricked real estate bubble extend far beyond that. When everyone stops trading up Mini-McMansion for McMansion Deluxe or Biggie McMansion with Fries they also stop buying new appliances, new carpeting, new furniture, etc. Not so good for a cyclical bull market struggling to do much of anything.

Still more subtle signs of danger lurk. Take a look at recent strength in gold. This, despite healthy gains for the dollar. Are we finally seeing a sustained decoupling of gold the dollar? Thus far during most of the current bull market in gold, the dollar has called the shots. But now gold appears to be developing its own momentum and is even beginning to look strong against the euro.

Why is that important? Because gold is the ultimate barometer of the financial system. (When it isn’t being successfully manipulated by the criminals at the Fed, that is.) When gold rallies relative to other currencies it serves as a warning that paper is in trouble. The latest action suggests that gold is no longer simply moving in knee-jerk reaction to the dollar but is in fact climbing on its own merits. Hard to imagine stocks doing very well in an environment where investors are worried enough to buy gold.

Does this mean that stocks are about to crater? Hardly. I maintain my hypothesis that for the time being the Fed and their cronies will continue to support the market and prevent any significant declines. We’ve been in one iteration of a trading range or another since early 2004 and I see no reason for that to change until the market is shocked by a major exogenous event.

Or until Greenspan walks away leaving the next sorry sap to deal with his mess...Along with the rest of us, of course.

© 2005 Mark M. Rostenko
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