When it comes to assessing the Investment Climate, we pay particular attention to the trends of earnings, inflation and interest rates. As of last week's analysis, shown in the Climate section of the Views, we are in a Case 4, Bull Market Scenario in which earnings, inflation and interest rates are rising. Is this good or bad for stock prices?

As CNBC commentator, Mr. Larry Kudlow, likes to say, "Earnings is the mother's milk of the stock market." I agree. The VectorVest "Truth Chart," first described in my essay dated March 21, 2003, shows that Bull Market Scenarios exist when, and only when, earnings are rising. How do we know when earnings are rising? We access the S&P 500 WatchList, click on the Summary row at the bottom of the WatchList, click on Graph in the Local Tool Bar and display EPS to see the 52-week performance of average forecasted earnings per share of all the stocks in the WatchList. We then conduct a trend analysis of a 50-Day moving average of this EPS data and report it each week in the Climate section of the Views. It is also shown graphically in our Market Climate Graph, found by clicking Graphs on the Main Tool Bar. With a very favorable trend reading of 1.36, the earnings picture looks good. But what about those other rascals, inflation and interest rates?

I know, I know, we hear it all the time. Inflation is not a problem. But our trend indicators for the Consumer Price Index, CPI, and Commodity Research Bureau Index, CRB, show that inflation is rising rapidly. The CPI has a very unfavorable reading of 0.01 and the CRB has a modestly unfavorable reading of 0.92. Remarkably, a front page article in Monday's Wall Street Journal said that, "an influential band of policy makers (within The Federal Reserve) is fretting over the opposite: that the already low rate of inflation is slowing further." In other words, they are more concerned about deflation than they are about inflation. My goodness, this kind of cockeyed thinking got former Head of The Fed, Alan Greenspan, in trouble.

We also hear Dr. Ben Bernanke, current Chairman of the Federal Reserve Board, say that he will keep interest rates low for the foreseeable future. I believe him, but he doesn't control market interest rates. He has tremendous influence over market rates with his decisions on monetary policy, but he only controls the Fed Funds Rate and the Discount Rate. I prefer to track market interest rates, i.e., the 90-Day T-Bills, 10-Year T-Notes, and 10 Yr.+ AAA Corporate Bonds, because they give us a better reading on what the Investment Climate is really like.

October 24, 2003, I wrote an essay on, "The Case (4) Scenario." If you substitute the name of Ben Bernanke for Alan Greenspan, you would think I wrote that essay yesterday. Dr. Greenspan was severely criticized, if not berated, this past Wednesday by members of the Financial Crisis Inquiry Commission for his performance as Fed Chairman prior to the housing bubble and near collapse of our financial system. You may recall that Dr. Greenspan raised interest rates throughout the stock market's collapse in 2000 and only began to lower them in 2001. He lowered them again and again, bit by bit, until he got the Fed Funds Rate down to 1.00%; then kept them there for much too long of a time. He said he was fearful of deflation.

Now we have Dr. Bernanke following essentially the same path of raising interest rates too high; then lowering them to historically low levels. And it comes out that some members of his policy making team are afraid of deflation. Will he follow in Dr. Greenspan's footsteps and keep interest rates too low for too long? It all depends on his perception of inflation. Yes, inflation: The Wild Card.

Last week I said that "The key to deciding whether anything is good or bad for stock prices is what it does to earnings, inflation and interest rates. Rising earnings cause stock value to go up, so that's good. Rising interest and inflation rates cause stock value to go down, so that's bad." So, rising earnings is good and rising inflation and interest rates are bad. What is the net effect of these conflicting forces?

The answer is given by The Truth Chart. The Truth Chart was introduced to our readers on March 21, 2003. It presents the eight possible combinations of rising or falling earnings, inflation and interest rates that can occur and indicates what effect each combination will have on stock prices. It also arranges the eight possible combinations, i.e., scenarios, in accordance to bull and bear market cycles and identifies where the Investment Climate is within the cycle.

For example, in the March 28, 2003 Climate Section of the Views, I said "With earnings trending downward, inflation trending upward and interest rates trending downward on average, our Truth Chart is telling us that we remain in the Case (8) scenario, looking forward to the end of the Bear market." We remained in this scenario until June 20, 2003 when inflation turned lower; then, on July 3, 2003, exactly five years ago, earnings showed an upward trend, putting the Investment Climate into a Case (2) scenario of rising earnings and falling inflation and interest rates, the classic "Goldi-Locks" scenario in which a Bull market thrives. The Truth Chart told it exactly the way it was. So where are we now?

Unfortunately, our Investment Climate indicators show that earnings are falling currently while inflation and interest rates are rising. This combination reflects a Case (5) scenario in which Bear markets begin. We have been in this scenario since March 28, 2008. Prior to that, the Investment Climate went from a Bull market to a Bear market scenario on February 15, 2008. It was no surprise. We could see this Bear market coming for months ahead of time. How did we do that?

Simply click on Graphs on the Main Tool Bar, select Market Climate Graph and check S&P Earnings and S&P Earnings - VV. Uncheck all other data, set the time Period to 5 Years and click on Get Graph. You could clearly see the path of rising; then falling earnings in the upper portion of the graph, and you could also see the trend indicator go from above 1.00 to below 1.00 on February 15, 2008. What could be clearer than that? You may also wish to read my essay of October 13, 2006, called "The Bull/Bear Market Indicator." OK, so when will this Bear market end?

According to what our Investment Climate indicators and the corresponding Market Climate Graph are showing for S&P 500 earnings, it's going to be many months, perhaps a year or more, before we see a Bull market scenario identified by The Truth Chart.

Ten years ago I wrote an essay called, "Not Surprised." The thrust of that essay was to let our subscribers know that Black Monday just didn't happen as a random event. There were several serious problems with the market in 1987 and our indicators were making them apparent.

For example, the market was overvalued. The Mighty Dow peaked at 2,705.5 on August 21st while our trustworthy VVDJIA stood at 2,184.3, 19.3% below the DJIA. Secondly, the market was in a downtrend. It sold-off sharply only one week after it peaked and the Canary died as our Buy/Sell Ratio fell from 1.44 to 0.50. The third major problem was that the Investment Climate was unfavorable. Interest and inflation rates had been rising for a year and stood at 10.52% and 4.53%, respectively. Dr. Greenspan was the new Head of the Fed and he wasn't going to do anything but push rates higher. The only good news was that earnings reports from large cap stocks such as EK, MCD and MO were strong. But you can't fight the trend.

So how did VectorVest guide its subscribers prior to the crash? On September 4, 1987, I wrote "Is the party over? Probably not, but it is getting late. It is a time for caution." From that point on, I became increasingly bearish. On October 9, 1987, I wrote, "It is a time to be defensive. Sell all "S" rated stocks. Place stop-loss orders on "H" rated stocks and take profits on strength."

By October 16th, the Friday before Black Monday, I thought the correction was essentially over. The Mighty Dow closed at 2,246.74, down 16.9% from the August high, and the BSR closed at 0.11. I wrote, "If you were unable to position your portfolio for this correction, don't panic. Although the correction is not over yet and the next several months may be very painful, the market will recover." Little did I know that the worst was yet to come.

Is another Black Monday on its way? Let's look at the facts. The current market is very much undervalued, not overvalued as it was in 1987. The Price of the VectorVest Composite peaked at $31.44 per share on July 13th, fell sharply to a low of $28.09 per share on August 16th and rallied back to a high of $31.36 on October 12th. The fact that it did not close above $31.44 suggests that the July 2007 high may be comparable to the August 25, 1987 high. In regard to the Investment Climate, we currently have the rising earnings and inflation while in 1987 we had rising earnings, inflation and interest rates. The fact that the Fed currently is lowering interest rates instead of raising them as Dr. Greenspan did in 1987 is a huge difference in the Investment Climate.

Another major difference between now and 1987, is that I was feeling bullish up until today, but I turned bearish six weeks before the crash of 1987. So are we going to have another crash? I don't think so. We certainly can have another downturn - even a Bear market, but I'm not anticipating another Black Monday.

THE CANARY'S WARNING.
In the Strategy Section of last week's Views I said, "The bad news is the "blast-off" stage of this rally has been completed and the momentum of rising prices has peaked." How did I know that?

I saw it on the Market Timing Graph. Please set the graph up in the Daily mode and show the BSR at the bottom. Please note that the Price of the VectorVest Composite went up on 10/10/07, but the BSR went down. I have seen this happen before and each time it was the precursor to a serious downturn. Look at the peaks of 06/04/07, 05/09/06, 02/01/06, 04/05/04, 06/17/03, 03/10/00, 01/19/00, 07/06/99, and 10/10/97. The most famous, of course, are the peaks of October 10, 1997 and March 10, 2000.

The "blast-off stage" is one in which the BSR rises as the Price of the VectorVest Composite rises. It ends when the Price of the VVC rises and the BSR fails to rise. I call this "The Canary's Warning." It's telling us that the fuel tank is empty and the Price of the VVC, if it continues to go up, is on a glide path. This path is defined by the price of the VVC hitting higher highs while the BSR is hitting lower highs. It does not necessarily mark the end of a rally as soon as it occurs, but it has done so on several occasions, such as 03/10/00.

While the 10/10/07 close wasn't the high point of this last rally, it appears to have marked the beginning of a downward journey for the market and the BSR. I didn't expect this to happen, but we can't ignore The Canary's Warning.

Three weeks ago, I wrote about the Investment Climate and how we track the key factors affecting stock prices. Then I wrote about the Truth Chart and the role that The Fed plays in deciding the fate of the economy and the Investment Climate. Two weeks ago, the Truth Chart said we were in a Case (2) Bull Market Scenario, the most desired Investment Climate. This combination of factors, in which earnings rise while inflation and interest rates fall, is often called the Goldilocks scenario.

Now we need to see whether Dr. Bernanke does, in fact, lower interest rates in time to sustain a Bull Market Scenario or whether he waits too long and allows the economy to go into the tank. I believe he will lower interest rates soon simply because of the Presidential Election Cycle. Nevertheless, what is the factor in the Investment Climate that will signal to us whether Dr. Bernanke has done his job or not?

It's the earnings trend. The Truth Chart shows that earnings must be rising in order to have a Bull Market scenario. In other words, the market will be in a Bull Market scenario as long as the earnings trend indicator is above 1.00 and a Bear Market scenario when it is below 1.00. So does this mean that the earnings trend is the only thing we have to watch?

No, not at all. As noted in my essay of 03/28/03, the only difference between Case (1), Bull Market Begins, and Case (4), Bull Market Ends is that interest rates were falling in Case (1) and rising in Case (4). Currently, the market is in a Case (3) scenario. It attained a Case (2) scenario three weeks ago, after being in a Case (4) scenario for months on end. It is very difficult to avoid a Bear Market scenario after being in Case (4) for a long time. That's why it's important to watch the earnings trend so closely. There are several ways to do this.

The easiest way is to simply go to the Investment Climate section of these Views and read what it says in the row marked S&P Earnings. Another way is to click on Graphs on the Main Tool Bar and Market Climate Graph. Once you have checked S&P Earnings and S&P Earnings-VV, you'll see that while earnings have been rising smartly for over three years, its trend indicator peaked at 1.19 in mid-2004 and has now fallen to where it was three years ago. A third way to see S&P earnings is to click on WatchLists on the Main Tool Bar, click on Stock WatchLists, click on S&P WatchLists, click on S&P 500, click on the data row at the bottom of your screen and click on Graph on the Local Tool Bar. Use the Edit Field List to chart EPS.

The sum of all this is that earnings are still rising, but the rate of increase has been diminishing. Nevertheless, I don't expect to see a Bear Market scenario soon. In any event, we'll let you know when we get a change in The Bull/Bear Market Indicator.