Stocks made big gains last week, though not big enough to cause new highs in the Dow Industrials.  That may be a good thing, since markets rarely make tops unless the Dow does too.  The Dow’s most recent high was 13676 on June 4.  That gives us another 150 points or so before we can start worrying about non-confirmations. 

To remind you … Dow Theory states that highs in the Industrials must be confirmed by highs in the Transports in order to assure us that a bull market is underway.  We bring this up because Dow Theory has been a very valuable tool throughout the past century or so since Charles Dow first made his observations on market behavior. 

We should mention that one of the greatest proofs of Dow Theory has been the excellent track record of its leading practitioner, Richard Russell, who has published his newsletter, Dow Theory Letters, since 1958.  Richard has spotted the turning points in stock trends better than just about anyone. 

Mind you, Dow Theory has served us well in the past few years as well.  So until the Industrials surpass 13676, we’re not going to worry too much about the bull market. 

Of course, we rely on much more than Dow Theory to make our calls.  In fact, we have a host of other indicators, many of which I developed personally.  We find them pretty useful too.  They are one reason we have been consistently ranked among the top market timers according to Timer Digest.

Right now, our indicators are showing moderately bullish conditions.  Secondary stocks continue to perform well.  There is virtually no speculation in the market.  In fact, the public seems to be nearly absent (another bullish sign).  And even though specialist shorting may have lost some of its strength as an indicator, we take its exceedingly low level today as another positive.  The insiders, after all, must know something.  Plus, the huge amount of money sloshing around private equity funds naturally wants to flow somewhere, and we think much of it will end up in stocks.

Because of these factors, we remain shareowners, for now.  Of course, the long-term picture is rather different … A report out this week from the Paris-based International Energy Agency (IEA) suggests that collision could be just five years off. In its annual Medium-Term Oil Market Report the IEA attempts to lay out an unbiased forecast of the supply/demand picture in the coming years. The 80-page report is a fascinating read for data nerds like ourselves but we'll try to sum up some of key takeaways. The one thing that could force the bull market to a halt would be a real rise in interest rates. If the Fed eventually gets around to such a policy, the private equity firms would find themselves in big trouble. They would have to pay off all the hefty purchases they’ve been making with more expensive debt. The result could be a real day of reckoning. Central banks traditionally raise rates to fight inflation. For that reason, we continue to watch for signs that inflation is getting out of control. Right now, inflation seems to be only a minor problem, especially if you study only core inflation. Core inflation remains well under 2.5%. Nonetheless, we believe inflation is becoming more of a problem than our government cares to acknowledge. As we’ve suggested before, you must look beyond core inflation to get a real sense of where your cost of living is headed. Core inflation does not include food and energy prices. Yet clearly today’s long-term uptrends in both food and energy prices are adding significantly to everyone’s monthly bills. What’s more, we expect these uptrends to remain in place for some time. When we look at total inflation, including food and energy, we find that for the past six months inflation has been rising at an annual rate of nearly 6%. That’s the highest six-month rate since Katrina. Prior to that disaster, the last time inflation was as high as today was 1991 – nearly a generation ago. We are concerned that growth among developing nations will drive prices of commodities such as food and oil considerably higher over the next few years – which could possibly lead to double-digit inflation. However, growth isn’t the only thing driving inflation … Recently, the Chinese have been allowing their currency, the Yuan, to gain value versus the U.S. dollar at an increasing rate. Not surprisingly, the U.S. government has been encouraging this, because a higher Yuan makes Chinese products a little more expensive, and U.S. products more competitive. However, we doubt China is moving towards a pricier currency because it’s bowing to U.S. pressure. Rather, China is adjusting the exchange rate in order to contain inflation within its own economy. You see, a few years ago, inflation in China was close to zero. Today it’s closer to 3%. And we think the Chinese government is getting concerned. Keep in mind that one definition of inflation is a decline in the value of money. This implies that China can fight inflation by raising the value of its currency. The higher the Yuan goes, the cheaper imports will be, and the less the cost of living will rise. Unfortunately, as the Yuan rises, the U.S. dollar falls, making our imports more expensive. That means that as China’s inflation rate falls, the U.S. inflation rate will rise. So far, the rising Yuan has had only a minor effect on our CPI, but it’s an effect that will become much more significant in time. Clearly, the good news regarding inflation is all behind us. At some point, both investors and the Fed will be forced to recognize that soaring food and energy prices are driving real inflation higher than they can safely tolerate. In fact, bond investors already seem to be cottoning on to the inflation threat. That’s why we’ve had a downturn in bond prices recently, and why we think bond prices may go a lot lower in future months. As inflation rises, we also expect gold will become more valuable, along with other commodities. Oil prices are near record highs, and may experience a reaction soon. But supply/demand factors in the world today support much higher oil prices in the long run. What’s more, we expect these trends – lower bonds, higher commodities – will remain in place unless the world’s central banks get serious about fighting inflation. Serious enough, that is, to raise interest rates considerably higher. When will the central banks get that serious? Maybe never. To fight inflation in a serious way would risk a major economic catastrophe. The recent shakeup in the subprime lending market, though limited to this country alone, had a noticeable impact on the market. Yet this is nothing compared to what might happen if interest rates rose meaningfully and all the loans made to private equity funds became more difficult to service. So we will continue to invest in those items that will benefit from inflation, as that is where the winds are blowing. To summarize: The bull market remains in place, but inflation has now been set loose and will keep rising. We hope it will rise gradually, but who knows? Nonetheless, the inflation picture implies we are only part-way through the dominant trends of this decade, and can look forward to higher commodity prices. The best performing stocks should therefore continue to be the commodity plays – food, industrial metals, energy, and gold. Make sure you own some of them.