Market Commentary for the week of May 29, 2007

Interest rates are rising. That indisputable truth was brought home more drastically last week when mortgage (lending) rates hit their highest level in 12 months, further dampening the specter of the economy’s lone bright spot, namely the housing industry.

For the last five years, as the stock market dug out of its technology hole, investors have pointed to the explosion in home values, and other tangible assets, as the bulwark of support for speculating in stocks, real estate, and commodities, all the while decrying any data which supported the return of inflation concerns. How the two might not be linked is another story.

Nevertheless, as margin borrowing expense began to eat away at savings, the amount of leverage in the equities market became absurd, despite the fact that some claim the market’s surge was “liquidity-driven”.

But now, as the economy clearly slows in certain areas, employment, wages, borrowing, and production are all being affected. Most retailers, except for the high end, are seeing not just seasonally or weather-related slowdowns in purchasing, but a more persistent lethargy, as well.

Even the technology market has slowed to a crawl as innovation and sales demonstrate anemic growth.

Evidence of a slowdown have been gestating for months. The stock market, which marches to its own drummer, might have been going up, but it does so without full participation amongst its sectors. Financials, Cyclicals, and Tech stocks are languishing behind.

It is true that many companies have shown nominal profit/earnings growth. We all know that those gains have come from “enhancements” such as share buybacks, layoffs, and price increases. I consider this to be artificial manipulation. The classic earnings paradigm should show high demand and nominal production in order to keep pace with order flow. To the contrary, while manufacturing is nominal, demand is slowing in the consumer sectors. At some point, the ability to raise prices or to inflate margins at your expense will cease. The cost of oil, manufacturing, and production will ultimately fall back into the companies who have little wiggle room right now.

These cost pressures are what’s driving interest rates. The monetary models have gone from bullish to bearish. Before the Fed considers lowering interest rates to incentivize demand, they must deal with the spiraling cost pressure that permeates the economy.

Drugs, energy, utilities, transportation, education, agriculture and entertainment are examples of the burden price pressure puts upon the mainstream economy.

While the market has doubled in value since 2002 so too has the rate of inflation. Federal spending is out of control as are the spending habits of the wealthy. Savings in the United States are the lowest percentage of take home pay since statistics were developed on this subject.

Do not anticipate a reduction in punitive borrowing costs any time soon.

History has shown that the market loses relative value as absolute values skyrocket. Right now the excessive spike in equity prices is good for the monthly brokerage statement, but dangerous for a quantitative outlook. Arlington Econometrics shows the highest expanse of price-to-earnings ratios than anytime since 1999. Only this time it’s not Tech stock related.

Our favorite stocks are just too “pricey”. As the market has before, expect that a linear, not parabolic, uptrend will be matched by a capitulation of 10-30%, and nearly identical in linear shape.