In my May 16th commentary, I wrote:

It seems the stock market has reached a crossroad between an improving economic backdrop and increasing nervousness about the direction of long term policy under the Obama administration. The economic outlook has gone from bleak and getting bleaker to bleak but not getting bleaker over the last two months and that was enough to get us a nice rally in stocks, but a further improvement in stock prices will require that things actually start to get better.

Here we are a little over a month later and I could easily write the same paragraph once again. The economic news continues to improve from awful but has yet to even reach okay, much less good. This is what life is like in the trough of a recession - or at least we hope so. Is this the trough or is there another shoe to drop? Will an improving housing market be overshadowed by a deteriorating commercial real estate market? Will rising interest rates snuff out the nascent housing recovery altogether? Will the slowdown in mortgage refinancing - another victim of rising interest rates - slow the recovery? Will the falling dollar have more impact on inflation or exports? Will healthcare reform destroy the private insurance market or will it relieve business of a significant expense that will allow them to compete better with foreign companies? Will financial market reforms prevent future excesses or limit risk taking so much that it impedes recovery?

The  uncertainty surrounding these questions has pushed investors to the sidelines and volatility has continued to recede:

One good sign is that while the stock  market averages have retreated somewhat from their highs, the rally seems to be broadening. The previous laggards are starting to play catch up and the rise in defensive sectors is partially offsetting the decline in the previous leaders. This type of sector rotation is associated with bull markets and gives me hope that there is more upside to come for the market as a whole. Of course, hope isn’t a strategy and I have no illusions about the economic outlook which can best be characterized as not so bright that I need to don my shades nor so dark that I need my night vision goggles. Recovery will come but to expect something robust is to ignore the numerous long term problems facing the US economy. So while I expect more upside when this trading range is resolved, that is subject to changes in market expectations about the recovery which could change on very short notice.

The economic news, as mentioned, continues to improve at a glacial pace. Housing starts were reported to have jumped in May by 17.2% but that was primarily due to a jump in mulit-family starts which are notoriously volatile. Nevertheless, single family starts were up 7.5% and permits also rose 4% indicating that at least some builders are gaining confidence about the outlook for housing. All that sounds encouraging until one compares the current pace of building to last year - down 45.2%. While construction seems unlikely to detract much from GDP growth going forward neither does it look likely to be a significant contributor on the positive side.

Both the inflation readings from last month (PPI here and CPI here) were less than expected and while some claim the readings support the deflation thesis, I think they serve to show that even during lousy economic times one shouldn’t underestimate the ability of the Federal Reserve to create higher prices. One factor in producing a low CPI reading was the seasonal adjustment for gasoline prices which will surely be reversed next month. Even with a benign May reading, CPI is rising at a rate of 2.3% over the last three months versus a 1.5% rate over the preceding three. Inflation, even in a world of ample excess capacity, is already accelerating. That is discomforting to say the least.

Industrial production is showing no signs of improvement and capacity utilization is down to 68.3%, an alltime low. If CPI can still rise in the face of falling production and decreased capacity use, how fast will it rise if the Fed is able to manufacture a recovery? One wonders if Milton Friedman is in heaven (or somewhere else depending on your economic school) yelling, “It’s a monetary phenomenon, stupid!”. Bernanke apologized once to Friedman about the Fed getting things wrong in the Great Depression and promised not to make the same mistake again. Bernanke is keeping that promise only by making new and different mistakes.

Jobless claims rose very slightly in the latest weekly reading while continuing claims fell for the first time in 6 months. Unfortunately, most of the decline in continuing claims was due to benefits running out rather than a rush of job creation. That would not seem to be a good omen for future consumer spending as the unemployed can only be classfied as consumers (rather than producers) and their ability to consume even the most basic of goods just declined. The index of leading economic indicators and the Philly Fed survey did provide some much needed good news at the end of the week. The LEI rose for the second straight month and the Fed survey nearly broke into positive territory at -2.2. That’s the highest reading since last September when the onset of recession was still hotly debated.

Most markets and sectors were quiet last week with a slight downward bias. One exception was the healthcare sector:

The healthcare sector is held hostage by the debate over healthcare reform which seems to ebb and flow by the minute. For the healthcare providers, reform is a double edged sword. Universality may mean a much expanded client list, but the potential for a public option means a much lower profit margin per capita. We don’t yet know the form of healthcare reform but the one thing I feel confident in saying is that the odds of the healthcare industry’s lobbyists coming out of this poorer are quite low. I’ll have more to say on healthcare in the near future, but suffice it to say for now that none of the reforms on offer - Democratic, Republican or bipartisan - are likely to have the intended effects of expanding coverage and lowering the cost. You can’t increase the demand for a service, hold supply constant and reduce the price. There are very few things in economics that qualify as a law, but supply and demand analysis falls in that category.

As for the rest of the markets, last week’s action revealed little. I remain bullish on commodities and stocks with a bias toward international markets. Next week will be busy with a raft of new economic statistics (existing home sales, durable goods orders, new home sales, another 1st quarter GDP revision, jobless claims, personal income and outlays and last but not least, consumer confidence), an FOMC meeting and a record $104 billion series of Treasury auctions. I suspect the outlook for the markets may be a little clearer by the end of the week.