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Thursday, March 22, 2007

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Going "STAGflation" to the party? 3-22-07

So that was it? The end of the correction… Not! Corrections only end when people stop referring to them as corrections. When market participants are convinced that something much more hideous is underway, a correction can truly find a bottom. Unfortunately, the past few weeks never offered such a scenario, even though there were a few scary moments.

However, the market will likely continue to suck in the underinvested bulls and nervous bears before it continues the downtrend that started a few weeks ago. The “end of the correction” is being celebrated as dip buyers resume their dip buying activity that worked so well since last July with only a minor recent interruption. Ultimately, market participants will be faced with a critical decision as to whether or not the market is forming a double top or threatening an upside breakout. This pivotal moment may be approaching fast. So start choosing sides.

The dip buyers will have you believe that yesterday’s Fed language painted a rosy scenario. These stubborn bulls will preach that the power of a rate cut in the not too distant future will be the juice that is needed to cause the market to break out to the upside. The bearish camp will tell you that although a Fed cut seems likely sometime in 2007; real economic pain must be felt before the Fed actually acts. Remember, the Fed is always more concerned about fighting inflation then preventing recession. Therefore, although they may have slightly greased the wheels for a cut, the fed will certainly be waiting for the economy to cry uncle before a rate cut is actually delivered.

Unfortunately for the Fed, they are at a very tricky juncture. Their statement yesterday describes an economy that is showing signs of cooling with elevated signs of inflation… STAGFLATION anyone? Most market professionals who have been around long enough understand the dangers of being too heavily long a market in which the Fed is fighting stagflation. Evidence of the Feds quandary can be found by looking at their actual words compared to the January statement. The January Fed statement described “Somewhat firmer economic growth and stabilization in the housing market”. This has been replaced with “recent indicators have been mixed and the adjustment in the housing sector is ongoing.” Clearly the fed has taken notice of the cooling economy with this change in language.

More alarming is how the central bank altered the inflation paragraph. The new language reads “Recent readings on core inflation have been somewhat elevated”, as opposed to January’s statement which states: “Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time”. Kcap is not surprised by these changes in language since recent economic data points have demonstrated elevated inflation (Hot PPI report) in conjunction with sub prime woes.

If You Held a Taser to Our Head:
Did anyone notice how the complacency dropped like a rock with the collapse in the Vix? Market Participates are once again getting all lathered up over an immanent Fed cut. Most seasoned traders on Wall Street should have learned by now that the economy must suffer MUCH more before the Fed actually delivers. Only when inflation is well behaved due to accelerating productivity can the Fed cut rates when the economy is just showing preliminary indications of cooling. Most of the time, the Fed cuts rates when ugliness in one sector of the economy has already spilled over into other sectors. We are not at that point …yet! However, don’t fret… earnings season should provide a window of opportunity for the doves. Have you ever seen a Bear eat a dove? It’s not pretty! Patience and lots of cash is the way to play. Another way to think about the market and rate cuts and in keeping with the season, “you have to sit through the Seder before you get to the meal.”

Hope you’re being careful out there.

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