Insights & Advice

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Back to the Future

It was a “Back to the Future” week on Wall Street. Reminiscent of this winter’s wild swings in the averages, investors were running first for their foxholes and then a day or even a moment later buying at the market in an effort to get in on the upside. On the surface, there were many reasons for the volatility–oil, the dollar, the unemployment data, European interest rates and the Federal Reserve’s worries about the economy. But to me it all comes down to one word: stagflation.

On one side you have worries about the economy exemplified by Friday’s unemployment number, 5.5% versus 5% last month, the largest monthly increase in 22 years. Then there were more bad numbers, credit downgrades and other problems within the financials led by Lehman Brothers, this month’s poster child for possible insolvency.

On the other side are inflation concerns voiced simultaneously by Federal Reserve Chairman Ben Bernanke who acknowledged that “longer-term inflation expectations have risen in recent months” while across the pond the head of Europe’s ECB, Jean-Claude Trichet, warned that he may tighten interest rates as early as next month for the same reason. Higher rates in Europe would mean a lower U.S. dollar. Their combined comments produced an immediate rise in commodity prices, led by oil as the world’s two most powerful central bankers acknowledged that inflation was real and climbing.

At the same time, Bernanke said he would do whatever it takes to insure that “the dollar remains a strong and stable currency.” And just in case we missed it, he repeated the message twice in two separate speeches this week. Investors know that there are only two ways of strengthening one’s currency: central bank intervention or a rise in interest rates. Neither prospect seems possible right now.

Investors do not believe that the Fed would risk raising rates and sending the economy into a deeper recession. Nor do they believe that there is a coordinated global Central Bank plan afoot to support the dollar. Remember global food is priced in dollars. Given the riots and protests in many foreign capitals as a result of rising commodity prices, no foreign government is anxious to see those prices rise even higher.

So given the prospect of higher European rates, the greenback dropped against the Euro sending commodities skyrocketing. Oil spiked over 13% in two days to $139/bbl., helped along by tensions in the Middle East and a Wall Street analyst’s prediction that oil could reach $150/bbl. by July 4th.

If all this sounds familiar, I would urge you to re-read my March column “Is Stagflation Worst than Recession” for more insight into this conundrum. It seems to me we are caught between a rock and a hard place right now. Inflation is climbing, the economy is slowing and the on-going credit crisis among the banks and brokers is just a bit too dicey to risk taking any concrete action (raising rates) against inflation right now.

So what’s a reader to do? Don’t panic and stay put for now. The S&P 500 closed at 1360 a little over 4% from my first downside support of 1300. The markets are still in a trading range. If commodities, especially oil, continue to march higher the stocks will go lower. My bet is that oil is in a classic speculative blow-off. Sit back and watch the fireworks. I expect we will re-test the lows but maybe at a higher level than 1285-1300. So far this is looking like a classic third leg down in a market bottoming process. If so, I would be prepared to start buying on the way down because I think the rest of the year will be up.

Posted in A Few Dollars More, At the Market