RJH writes...

"They say I slept with seven Miss Worlds. It was only four."

George Best, RIP

Everyone can disappoint expectations, even the greatest of soccer geniuses (albeit not always in the sporting arena). Perhaps unsurprising then that even the unglamorous, non-footballing and unacclaimed-by-the-opposite-sex métiers of investor and trader must consider them to prosper.

Take, for example, the talk of year-end rallies, January Effect et al just now. Bullish expectations are high; and markets have moved much faster than this scribe would have believed in those low-October moments. But reflect awhile on another set of expectations.

Exhibit 1: S&P500 vs. US inflation expectations (nominal less inflation linked 5 yr Treasury rates)

The S&P500 data, lagged in the graph by 7 months, correlates with the inflation expectations by over 85%. And this leading indicator of inflation expectations is calling an imminent drop in US equities. Money illusion for the economists, and not a bullish picture.

Exhibit 2: US inflation expectations vs the euro

Inflation expectations drive the S&P500 not only via money illusion (it would seem); they also have the effect, in this declining case, of weakening the dollar's major rivals (this graph holds for sterling also). Why mention this? Because - and this is truly Yuletide fare - there is (for now, anyway) a strong negative link between the dollar and the S&P500 (yes, yes - counter-intuitive) which at its current level is suggesting that the next fall in the S&P500 will not be of the buy-the-dip variety.

Exhibit 3: S&P500 vs. the euro:$ rate, offset by 12 months

Why the dollar weakens whilst the S&P500 strengthens (and vice-versa) is a link the scribe is unprepared to attempt meaningful explanation of here although research may reveal the answer lies simply with the bond market (or complicatedly not).

However, so long as this predictive relationship holds (86% correlated since you ask), the euro is signaling that the S&P500 may be expected to commence a retreat in earnest below its 200-day moving average around end-May 2006. But the inception of the slide will have started well before then. About now/January, actually.

Nonetheless, the problem with this entire line of reasoning is that it is not backed by the economic data in the scribe's main model. Six months may, or not, change that.All in all, unseasonally low-key thoughts revealing this writer's mastery of timing and killjoyism; qualities explicative of the lack of Miss Worlds in his life (to date). Or at least that's preferable comfort to the "butt ugly" school of thought.

Merry Christmas and a Happy 2006.

Sources: Federal Reserve Banks of New York and St Louis; Yahoo Finance; European Central Bank

Credits: The idea for this post came from an article by Howard Simons .

NB: Don't know George Best, one of the top 5, perhaps top 3, footballers of all time? Video download here.

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