7-7-06 The Rules Have Changed.

Good Evening.

Just when the market was able to throw egg on the face of ADP with their outlandish 368,000 job increase prediction the mood of investors changed. Suddenly the weaker than expected payroll numbers of 121,000 new jobs and high wage component created a whole new set of fears. Until this morning, any economic weakness was more than welcome due to the fact that the Fed may be more inclined to pause. With today's weaker than expected Nonfarm Payroll number in conjunction with a sharp increase with average hourly wages the word STAGFLATION is suddenly on the tip of everyone's tongue.

We mentioned in a recent post how even the threat of stagflation is enough to send money scrambling to the sidelines. Today is clear evidence of that emerging pattern. The market is now faced with something that they were wishing for (slower growth) but still need the other shoe to drop (lower inflation). Those who have confidence in the Fed will take comfort in knowing that Big Ben Bernanke has made it clear that inflation acts with a lag and should abate now that cooling in the economy seems to be evident. However, you have to look under many rocks to find anyone who trusts the Fed specifically Big Ben at this point in time so early in his tenure. Should Ben ultimately prove to be correct about inflation (and we believe he will), his credibility will not be questioned for "many moons…Kimosabe". The problem is that until we get to that point every piece of data will be scrutinized for signs of decelerating inflation.

Basically all economic reports over the next 3-4 weeks will have profound market effects causing significant volatility on a one to three day time frame. Reports that show stronger than expected growth with high inflation will likely cause a selling reaction in the equity markets due to Fed hike fears. Furthermore, reports that show slowing growth with still elevated inflation will likely lead to SEVERE selling in the equity markets due to fears of stagflation. On the flip side, reports that show low inflation and tepid economic growth will likely be met with market rallies at this juncture. Finally economic reports that show high growth and low inflation is the stuff that wet dreams are made of!!! Unfortunately the market will likely have to wait until the October/November time frame for those pleasant dreams.

If You Held a Taser to Our Head:
Your friendly neighborhood Kcap Team went into today's report heavily long and we were caught off guard with the sudden reversal in market psychology. Around midday we sold a tremendous amount of our positions once it became clear that there was a psychological shift. We are currently carrying approximately 50% cash and will look to get further long as today's sell off exhausts itself sometime early to mid next week. We are proud of ourselves for not being scared off by the erroneous ADP report. However, we are even more proud for having the courage to quickly act once we recognized that a potential major turn in market behavior might be developing.

Have a good weekend.

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