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FirstAlert(tm) Friday Digest: The State Of The Markets

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- Market & Economic Commentary -

July 1, 2011 (FinancialWire) (By Craig Drill) -- Editor's note: FinancialWire(tm) contributor Craig Drill offers perspectives relevant to the entire market spectrum, represented by bellwether-type ETFs such as the Health Care Select Sector SPDR ETF (NYSE: XLV), the Market Vectors Agribusiness ETF (NYSE: MOO), the SPDR Gold Trust (NYSE: GLD), the iPath Goldman Sachs Crude Oil ETF (NYSE: OIL), the iShares Dow Jones US Real Estate ETF (NYSE: IYR), the PowerShares Global Progressive Transportation Portfolio ETF (NASDAQ: PTRP), the Claymore U.S. Capital Markets Bond ETF (NYSE: UBD), the Technology Select Sector SPDR ETF (NYSE: XLK), the Industrial Select Sector SPDR ETF (NYSE: XLI) and the PowerShares DB US Dollar Index Bullish Fund (NYSE: UUP), to name a few. To that end, here is Craig Drill's latest entry:

In June, a confluence of concerns, here and abroad, exacerbated the emotional and volatile nature of the U.S. stock market. Like a rollercoaster, the market ended the month almost where it had begun...less the price of the ticket.

Starting the second half, many market participants hope that the correction from the April highs is over. A primary uptrend in the U.S. stock market is being fueled by zero short-term interest rates, which is fodder for speculators.

In addition, corporate profits and free cash flow continue to grow at a faster rate than the economy. Unit labor costs (about two-thirds of business costs) continue to decline as revenues rise. Businesses are also benefiting from selling to countries with strong currencies and faster growth rates.

Money is being returned to shareholders through share buy-backs, dividend increases, and strengthening merger and acquisition activity. Shareholder value is also benefiting from debt reduction and restructuring. Liquid assets on balance sheets are near a 45-year high.

The U.S. stock market is selling at a P/E below 13X consensus earnings per share for 2011. Even if these earnings estimates prove high, many believe that these valuations are attractive taking into account history, current interest rates and inflation, dividend yields, strategic and private market value, and preferential tax treatment for long-term capital gains and qualified dividends.

In Europe, Greece continued its slide down a dangerous slope (at least dangerous for Portugal, Ireland, and Spain). But the month ended on a more optimistic note with the Greek Parliament approving additional austerity and fiscal adjustment measures, skirting a domino-like financial crisis.

Greece's enormous debt is intertwined with political and social issues that transcend the financial reality. Of note, there are few mechanisms in the European Union for recapitalizing insolvent banks in insolvent countries.

Questions also arose in June as to how long and strong the Chinese expansion can be, now that the "credit controls" seem to be biting into the real estate market. There were further suggestions that commodity prices may have peaked for a while, which would have serious consequences for Brazil and other raw material exporters.

In the U.S., there was a drumbeat of disappointing, and conflicting, economic data. Even Chairman Bernanke admitted that he does not have a "precise read" on why the sluggishness persists.

At the same time, it may be more correct to include energy and food in the inflation numbers. Chairman Burns only took out energy in 1973 (after the oil embargo) and food in 1974 (after the anchovies swam away from Peru) to help President Nixon.

We are celebrating the second anniversary of the end of the Great Recession in June 2009. The crisis has been ameliorated, but the consequences linger. The U.S. economy continues to struggle with weaker-than-normal growth in income, high unemployment, depressed home prices, and the ongoing deleveraging process.

We are learning about the limits of monetary and fiscal policy. The overall credit market debt of all sectors in the U.S. still stands at 350% of GDP. Interest rates cannot go lower and budget deficits cannot go higher. As Dirty Harry said, "A man's got to know his limitations."

Many economists argue for a modest rebound in U.S. growth in the second half as supplies from Japan recover and car production resumes at some temporarily idled plants. Also, crude oil prices are down more than 15% from their April highs, with retail gasoline prices starting to follow.

How long-lasting such a rebound would be is the question. The U.S. economy is about to be challenged by tightening monetary and fiscal policy, as they shift from radically easy to more neutral, at best.

The Fed's quantitative easing program, dubbed "QE2," ended yesterday, with the Fed's balance sheet topping out at just under $3 trillion. On the fiscal side, numerous programs are rolling off, and the debt-limit negotiations are likely to lead to cuts in federal spending.

To what extent will private sector re-leveraging accelerate so as to make up for the withdrawal of public stimulus? It may not be adequately understood that the growth of the economy depends on the growth of credit, i.e. the growth of debt.

As Al Wojnilower wrote in his latest piece, "Stormy Weather" (see, Treasury borrowing and spending have been offsetting the gap in private activity. If these diminish without a compensating increase in private debt, a new recession following the 2012 elections becomes a looming threat. Well-intentioned actions to reduce the deficit may actually widen it.

Markets have ignored the budget problems for decades. I remember visiting Senate Majority Leader Frist's office in the U.S. Capitol during heady times. The Republicans then controlled both the White House and Congress, and Congress was about to cut taxes and increase spending. "Can we do this?" I was asked. "Doesn't anyone care about the deficits?"

Also, I visited Pete Domenici's offices in the Hart and Dirksen Senate Office Buildings when he ran the Senate Budget Committee. His worried staff asked again: "Doesn't Wall Street care about the deficits? Doesn't anyone see the effects of double-compounding of an aging population times the rising cost of healthcare?"

Wall Street's response: "Don't worry, be happy. Go ahead. Cut taxes and increase spending. Business will like it." Remember Vice President Cheney's famous comment: "Deficits don't matter!"

What is new this time around is that the public would probably be elated if the federal government were finally to attack its bloated budget imbalances, whereas in Greece and other parts of Europe, austerity causes riots. This is partly because federal spending in the U.S. has grown so quickly that few want more of it, as we discovered from the shortage of "shovel-ready" projects.

More importantly, the pain of reducing the budget would not be felt until after the election year. It is like deciding to go on a diet...after a big dinner.

The risk is that Congress does not raise the debt limit before recessing on August 5, 2011. As early as August 2 and probably no later than August 9, the Treasury will not have sufficient money to pay all of its bills.

There would be an estimated 44% cut in current federal spending. The Treasury would be forced to "prioritize" its payments -- to Social Security recipients, Medicare and Medicaid providers, defense vendors, soldiers operating in Afghanistan and Iraq, veterans in hospitals, and the Departments of Agriculture, Homeland Security, Commerce, Interior, Transportation, State, Education, and Justice -- to avoid a debt default.

The reality of the Treasury choosing among different payments would be chaotic, accompanied by public uproar and intense global media focus. If the debt ceiling is not raised by August 2, all three rating agencies will put the U.S. on watch for a downgrade, at a minimum.


Source: Craig Drill Capital ($/SEC/Name.asp?X=craig+drill+capital%2C+l%2El%2Ec%2E); This and all original content authored by Craig Drill is subject to proprietary trademark, intellectual property and copyright Laws. Copyright (C), Craig Drill Capital; All rights reserved.


This communication is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to purchase any interest in any investment vehicles managed by Craig Drill Capital or an associated person or entity. Craig Drill Capital does not accept any responsibility or liability arising from the use of this communication. No representation is being made that the information presented is accurate, current or complete, and such information is at all times subject to change without notice. Opinions expressed may differ or be contrary to the opinions and recommendations of Craig Drill Capital.


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