Barry Ritholtz
Market Challenged by Macro Concerns
 By Barry Ritholtz
RealMoney.com Contributor

9/22/2004 3:37 PM EDT
URL: http://www.thestreet.com/p/rmoney/barryritholtz/10184276.html
 Market Overview BEARISH
  • The FOMC is viewing the economy through rose-colored glasses.
  • The Fed got it wrong in its assessment of both growth and inflation.
  • Already faced with technical resistance, the stock market will struggle here.
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    Last week we declared that the rally was facing a challenge, as reflected in Wednesday's market action.

    Given all of the fundamental and macro events which have occurred since our (mostly) technical assessment a week ago, perhaps it's time to take a closer look at what is now ailing the markets.

    The Fed

    The Federal Open Market Committee met Tuesday to discuss its inflation expectations and the gradual end of its accommodative policy. Since what it did -- a 25-basis-point rake hike was essentially fait accompli -- mattered less than what it said, it is important to read the tea leaves correctly.

    The FOMC's comments reflect the somewhat contradictory nature of the economic expansion. It re-emphasized the gradual removal of its accommodative monetary stance to a more neutral policy, while at the same time it stated that "monetary policy remains accommodative."

    The Fed stated that the recent "soft patch" is showing signs of abating, though its language -- "output growth appears to have regained some traction" -- hardly suggests robust expansion. Further, the statement "robust underlying growth in productivity is providing ongoing support to economic activity" is contradicted by the slowdown in productivity gains and the weakening in GDP. Even the Fed's inflation statement is self-contradictory: "Despite the rise in energy prices, inflation and inflation expectations have eased in recent months."

    Hey FOMC, thanks for clearing things up.

    I believe that the Fed's statements about both growth and inflation are leading examples of the "clap louder" school of economic cheering. The central bank asserts that inflation is benign, but in order to keep it that way, it must move towards a neutral policy. As we shall see, inflation is alive and well and more malignant than benign. As far as growth is concerned, I believe the Fed's enthusiasm is misplaced.

    Wrong on Inflation and Growth

    In each of these instances, I fear the Fed got it wrong. Let's look at inflation first: Although the fed funds rate is now higher than core inflation (as measured by the CPI or PCE deflator), Alan Greenspan's favorite inflation gauges woefully underestimate real-world price pressures. That point was made clear by several household names in the consumer non-durable sector. General Mills (GIS:NYSE) , Coca Cola (KO:NYSE) , Colgate Palmolive (UL:NYSE) , and Unilever (UL:NYSE) each preannounced disappointing earnings, citing increased prices of raw materials, including sugar and cardboard, along with transportation costs.

    Some people -- they used to be called economists -- call rising commodity prices inflation. That these firms find themselves increasingly unable to pass along these production cost increases to their customers is why they are suffering from a margin squeeze. At the same time, their consumers are facing oil prices in the mid-to-upper $40s per barrel. Gasoline prices have risen considerably this year, and home heating expenses are likely to rise dramatically this winter. Hence, consumers will feel a further bite, leading to pressure on gross sales.

    It's a commodity-based double squeeze: While manufacturers' costs go higher, their clients have less discretionary cash.

    At the same time, we continue to see evidence that the U.S. "soft patch" is anything but. I cannot find any reason for GDP to do anything other than muddle along at the 2.5%-3.5% level -- at least until some new positive catalyst comes along. Corporate hiring and capital expenditures are not showing signs of picking up; unless and until that happens, growth is going to be on the anemic side. To paraphrase one of my favorite commentators: For the first time in three years, there are no government tax cuts, no rebate checks, no other one-off items to spur the economy forward. The refinance afterburner has flamed out, and the Fed is raising rates.

    In other words, the pig is through the python.

    As for energy, I simply do not believe there is a $15 terror premium built into a barrel of oil. That thesis is simply contradicted by the way oil traded after the attacks on Sept. 11, 2001. Initially, there was a selloff and bounce back in crude. After that, oil went sideways until the run-up of the Iraq invasion in March 2003. That is hardly what one would call evidence of a terror premium.

    Terror Premium? What Terror Premium?
    Oil's moves since 9/11 belie the conventional wisdom
    Source: Stockcharts.com

    Nor is speculation the explanation. The Wall Street Journal recently reported that hedge fund activity in oil futures is a very small portion of total oil trading. Instead, consider the fundamentals: For the first time in over a decade, Japan is seeing economic growth; the U.S. military is a big consumer of petroleum; and, finally, China's economy has slowed to a mere 15% annual growth -- their demand for imported oil is up 37% on a year-over-year basis.

    Between a Rock and a Hard Place

    This is the quandary for the Fed: It is trapped between inflationary pressures which we all must acknowledge exist, and growth which can only described as anemic -- with most of 2003's stimulus far behind us. It is between a rock and a hard place.

    The best-looking sectors of the economy have been very much tied to low interest rates: The homebuilders, and transports moving their raw material. If the Fed were to raise rates very much further, the central bank risks killing one of the few geese still left laying golden eggs.

    Last week I mentioned becoming cautious about getting aggressively long, saying: "I suspect there will be better entry points over the next few weeks, perhaps even fresh lows in October. Core positions can be hedged via covered calls or the outright trimming of names that have had good runs." I see no reason to change that view at present.

    The indices are working off their overbought conditions, retreating in the face of overhead resistance, while looking for the next positive catalyst. We are not quite yet at a point of denouement, but we are starting to move in that direction. Thus, we continue to advise caution here, waiting for better entry points -- long or short.
    Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to barry.ritholtz@thestreet.com.