Judging from the last two days of trading in October, the US equity market has returned to solid footing. According to Bloomberg news, as Monday was drawing to a close the headline read: the biggest two day rally in almost a year. It has been hard to find a bearish view since last Friday’s 170 plus point rise in the Dow. CNBC proclaimed almost without exception, the underlying strength in the American economy and the resiliency of the US consumer. We have weathered hurricanes, displacements, rising interest rates and soaring energy costs with barely a whimper.

The S&P has just broken to the upside from an important technical level. Point & figure charts of the DOW have also crossed an important point to suggest we move higher. We would be cautious, and consider selling into strength, and perhaps even put some shorts on. The vast majority of reported earnings for companies will be over by the middle of the month. Volume should begin to pullback.

Now we are not bullish or bearish. We simply attempt to remove ourselves from the emotion of investing. I am an optimist by nature. Energy spending in the US was up $53.8 billion in September and above the $50.8 billion gain in disposable income on the month, the largest single month increase on record. The last time an increase in energy consumption was higher than an increase in disposable income was December 2000. In the past 30 years there has never been a significant move higher in energy prices that has not been followed by a recession. When energy prices go up, businesses and consumers put more of their money into keeping the lights on and their gas tanks filled. That leaves them with less to spend, slowing growth. The economy is likely in a sweet spot as we start November, the driving season has just ended and the country has just begun to turn on the heat for the winter.

Let’s first look around the world as we so often like to do. Richard Russell writer of the Dow Theory Letters, the oldest financial newsletter in the United States, and a must read for serious market observers, noted on October 28, “all the world’s markets are heading down, and I mean all of them”. He showed charts on India, China, Singapore, Shanghai and Hong Kong. All were down big and breaking below their 200 day moving averages.

The World Trade Organization last week, predicted that world trade would grow by 6.5% in 2005, that is down from 9% growth in 2004. Pascal Lamy, the WTO director-general stated “the decelerating trend is cause for some concern”. In Europe the FTSE Eurofirst 300 Index, ended last week off 4.6% for the month. Benchmark government bonds in the US and Europe have just suffered their biggest weekly falls since early this year as expectations rise for interest rate increases. Corporate bond yield spreads are widening, indicating risk is being taken more seriously. In the US, issuance of “junk” bonds in October was around $2 billion, its weakest month since October 2002.

Axel Weber, head of Germany’s Bundesbank and a member of the ECB’s governing body said last week, “the ECB would have to act” if price pressures remained above target. They are worried about inflation. Japan has just announced in its semi-annual report on economic activity and prices, their intention to begin to raise rates within the next 6-12 months. The US Federal Reserve has raised rates 25 basis points today.

During the week of October 17-21 Morgan Stanley visited nearly 30 European equity investors, where attendance at the group meetings was very strong (a new experience). Two universal views were evident. The first was the attraction of Japan as an investment opportunity and secondly, the bearish view for the economic outlook in the United States.

China announced this morning that they are preparing to list part of its huge rail network on domestic or international stock markets within the next two years. They will offer foreign investors and companies the chance to take minority interests in national lines and majority stakes or even full ownership of local railways. China is addressing their transportation bottlenecks. They are determined to become an economic powerhouse.

A subscriber to the Dow Theory Letters that is attending a 2 month education program at Harvard Business School, had this to say about a class he is currently sitting in, “the course I’m taking here is interesting – there are 150 executives from business and government from 30 countries around the world, including several senior people from large, state – owned businesses in China. One of the more interesting notions that has come up is that exporting companies in China are experiencing rising sales – but falling profitability. The reason is two – fold; First, most major retailers (lead by Wal Mart, Target and Sears) are now buying in China and passing the savings associated with low cost production through to the American consumer, so an exporting company’s low cost value is effectively being wrested away and transferred to the US and other western nations. Secondly, the cost of doing business in the popular coastal cities (particularly Shanghai) is exploding, which is forcing companies to look to locate new plants in cities in the interior, where costs are still low but regulatory uncertainty is higher.

That said, it is still true that the Chinese are dead serious about fully participating in economic growth. They are reforming the banking system (too slowly, some feel) and building transportation infrastructure at a feverish pace. Much of this infrastructure is new, first class highways between all major cities to allow rapid transit of goods to tidewater.

Here’s what we are concerned with, The US is the dominant deficit economy in the world. We have very little national savings. There has been talk of unsustainable deficits for over 3 years. China is the third largest surplus saver in the world. They have provided much of the liquidity to fund our imbalances. China is determined to invest domestically; it will be forced to draw on its own savings. That is likely to mean a weaker dollar and higher US interest rates.

That is only one of the factors that concern us. Add rising home inventories across the country. Energy prices are likely to be at least as high by the turn of the year ($59 barrel) as they are today. Rising US interest rates are likely to slow the housing sector. The transition to a new Federal Reserve Chairman has had an uncertain history. Nobody knows the amount of derivative risk in the system. Hedge funds around the world are likely coming off their worst performance month in a long time.

We know the technical levels seem poised to move higher. If it does we don’t think it will be a strong rally, for instance, reach the 10,900 level on a point & figure chart, which would signal a new breakout. We think we will see 9300 on the Dow before we see a breakout to new higher levels. Some have been waiting for a break in the market for months. We don’t think it will be a catastrophic break, but it could be swift and deep. If the break is bad enough, or unsettling enough, the Federal Reserve will likely cut rates. That will present us with opportunities. But something doesn’t feel right. We would be selective buyers, if at all.

Source: Copell Financial