Too Busy Buying the Dip to Fret Over Inflation

If traders wanted to book profits after two days of robust gains, this morning's higher-than-expected consumer price index report provided a ready excuse.

However, early weakness had given way to renewed strength, reflecting the observation of one source that "the tone has changed from a 'sell the rallies' market to a 'buy the dips' market."

The CPI rose 0.5% in April vs. expectations for a 0.4% gain as gasoline prices notched their biggest increase since June 2000. Core CPI, which excludes food and energy, rose 0.3%, also slightly ahead of expectations. On a year-over-year basis, the overall CPI has risen 1.6% vs. its low of 1.1% in February, while core CPI is up 2.5%, within the range of 2.4% to 2.8% intact for two years.

Looking deeper into the data, Peter E. Kretzmer, senior economist at Banc of America Securities, observed the "dichotomy between goods and service price momentum." While goods prices excluding food and energy have fallen 1.0% in the past year, nonenergy service prices have risen 4.0%, medical care prices have risen 4.6%, education costs are up 6.2%, and apartment rental costs are higher by 4.5%.

This dichotomy explains why some insist deflationary pressures are predominant while others are convinced inflation is re-emerging.

Fed Chairman Alan Greenspan doesn't seem terribly concerned about inflation (in fact, he apparently wants some). Therefore, few equity market participants fret about inflation's return, as evinced by major averages' recovery from today's early lows.

Once as low as 10,223.69, the Dow Jones Industrial Average was up 0.4% to 10,330.73 as of 2 p.m. EDT. The S&P 500 was up 0.5% to 1102.71 vs. its earlier low of 1088.94, while the Nasdaq Composite was up 2% to 1753.53 vs. its nadir of 1694.34.

Still, bond guru Bill Gross recently opined at Pimco's Web site that "the secular evidence falls significantly in the reflationary camp," reflecting a view long held by this column.

The return of federal deficits, a rise in protectionism, increased regulation vs. deregulation in the aftermath of Enron's implosion, plus the heightened possibility of more terrorist attacks and/or an invasion of Iraq compel Gross to conclude "almost all of the ... secular cards fall into the reflationary, as opposed to the deflation camp." China's entry into the World Trade Organization being the most notable exception.

Gross also fretted about the potential for a housing bubble, another issue that has seen frequent discussion.

"Although inflation itself should be contained at 3% to 4% levels, new bubbles, particularly in housing, are a distinct possibility," Gross wrote. "Lengthy periods of low short-term interest rates are an inducement to lever and take risk that may or may not bear fruit." He also expressed concern about the "growing dominance" of the government-sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE) in the mortgage market.

Finally, the bond guru sees "the risk of a U.S. current account deficit 'unwind' from near historic levels, which may be precipitated by a more than gradual decline in the dollar," citing yet another long-standing concern.

Notably, few of these issues were reflected in midday trading. Sure, the S&P Homebuilding Index was down 1.6%, and the dollar was weaker vs. the euro and yen, but the movements were modest and followed strength earlier this week. (However, Toll Brothers (TOL) Vice Chairman Bruce Toll has registered to sell 1 million shares of the firm's stock, and that had homebuilding bears in a mild frenzy this morning.)

Meanwhile, the long end of the bond market was modestly higher despite the CPI data. Still, some suggested that was a reflection of bond traders' view that the data would compel the Fed to tighten sooner vs. later to head off inflation, a move that would benefit longer-dated maturities.

Still, "reflationary economies are rarely the bond market's friend," Gross wrote. "Although inflation should stop at 4% at the peak of our next cyclical upturn, current long bond yields do not reflect this risk. We may see 6.5% long Treasury yields or more before we are done."

Notably, this is Pimco's long-term forecast. But those who've disagreed with the concerns raised here about inflation, the dollar and housing should take heed of Gross' warnings, given his track record.

Go, Speed Racer, Go

Major averages were relatively calm at midday, but the recent trend of outperformance by big-cap tech was re-emerging. As of 2 p.m. EDT, the Nasdaq 100 was up 3%, while the S&P SmallCap 600 was up 0.7% and the S&P MidCap 400 by just 0.4%.

Clearly, few observers believe this trend will be long-lasting. But one source declared adamantly yesterday that "the bottom last week is the bottom, [and] now is the time to buy tech aggressively."

The source, who trades for a private firm and "is not looking to drum up business," shall remain anonymous. I have dubbed him "Trader X" because of his somewhat mysterious ways (a la "Racer X" in the old Speed Racer cartoon series) and incredible self-confidence, bordering on hubris: "I have never met anyone as good as me," he deadpanned.

On Friday he observed that the NDX did not make a new low while the Russell 2000 did, suggesting that was further evidence that the dominance of small-caps will give way to resurgent techs.

Trader X believes the June Nasdaq 100 futures' May 7 low of 1144 "will not be seen again," and forecast the NDX will "challenge and easily take out" its December highs" of 1738 by year-end. (NDX June futures were recently up 35.50 to 1348.)

"Everyone is going to look back and feel very foolish that they were not fully invested in technology," he said. "When the [S&P 100] closes above 600 is when the recognition phase will begin." (Of late, the OEX was up 0.5% to 548.22.)

"We are on the cusp of a buying explosion, the rally is real, all pullbacks must be bought," he declared. "Tech is the absolute place to be," with personal favorites being Applied Materials(AMAT) and Jabil Circuits(JBL), while LookSmart (LOOK) is a "wild card."

Notably, Trader X is not jumping on the Applied Materials bandwagon after the firm's better-than-expected quarterly results or the more than 12% gains it registered Monday and Tuesday in anticipation.

Last Thursday, Trader X emailed to say he was "buy[ing] Applied Materials with both hands," an admonition he repeated Friday. The spike in the one-day Arms Index, in conjunction with the NDX testing 1210 and positive readings on the NYSE "tick" -- which measures up vs. down volume pressure -- was "extremely bullish [and] is telling you where the market is going early next week," he wrote late last week.

That prescient call compelled me to avail readers of Trader X's ongoing tech bullishness, which was being confirmed (again) at midday.

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