We noted last week that the shorter term risk was to the upside. After outlining many of the technical positives of the market, we noted that modestly supportive words from Bernanke & Co. would be all it takes to light the fuse. We suggested a “more hedged stance than a naked short one,” and advised that “nimble traders can get long.”
That turned out to be the correct short term posture. While we like to use variant perception to determine when the crowd is wrong, we know better than to fight the tape. It is always better to step off the tracks than fight a freight train speeding your way. Indeed, that short term shift kept us out of trouble (or at least out of the way) as we waited for locomotive to pass by.
But even that shift in our trading posture underestimated the degree of denial coming from many traders and fund managers. Despite the Fed’s explicit statement that more tightening is sure to come, many market participants are still rationalizing the “One and Done” thesis as possible.
This is roughly analogous to rooting for George Mason in [last nite’s] NCAA final between the Florida Gators and the UCLA Bruins.
For example, Monday’s ISM reading of 55.2, down from February’s 56.7, was hardly proof of a slowing economy (Manufacturing is an increasingly smaller economically). Yet somehow, the markets overlooked the Index of Prices Paid, which climbed to 66.5 in March, up from 62.5 in February and 65 in January. This served to prove us Humans (traders included) selectively perceive only what we want to. On the ISM and prices paid data, equities extended their gains.
In terms of Fed think, the Central Bank is now awash in excuses to keep tightening. The most recent of which was a study by a group of Fed researchers that concluded unemployment rates are not artificially low due to people dropping from the labor market. The study concluded we are at full employment, that strong job growth is likely over the next year, and that wages may rise appreciably. The Fed is likely to view this as an inflationary risk over the coming quarters. That suggests their bias will be to keep tightening, finishing in a range between with 5.5% and 6%.
We think these researchers are incorrect. While inflation has been robust across most sectors of the economy, the one area where is not has been in wages. Globalization – and a lumpy recovery – has kept wage pressures down. Inflation-adjusted Income is negative, hours worked have slipped, and employee mobility is modest.
We reiterate our first half targets of 11,800 on the Dow and 2600 on the Nasdaq. The topping process includes too much enthusiasm taking markets too high. That sentiment is certainly at work in current market conditions.
(emailed April 3, 2006 noon)