O MATTER HOW COMPLICATED IT MAY APPEAR, much of what goes on in the financial markets can be explained by supply and demand. The concept is simple: If supply of good exceeds the demand for it, prices will fall and vice-versa.

Believe it or not, this little relation can help explain some of the current market's apparent contradictions. Just consider:

The general consensus is that the Fed's next move is tighten credit, yet bonds rallied in June.
Bond prices move inversely with yields. If the Fed were to tighten (raise rates), you'd expect bond prices to fall. They did the exact opposite in June as yields on the benchmark 10-Year Treasury Note fell from 5.1% to 4.7% -- a significant move in bondland.

Actually there are several factors at work here. First, investors are coming to the realization that although the Fed won't be lowering interest rates any further, rate increases may still be awhile off. After all, the economy is still sending mixed signals (more on that later). The Fed's ill-advised tightening two years ago was a major contributor to the current economic downturn and they certainly don't want any premature action now to be blamed for prolonging it.

Indeed, the Fed could be on the sidelines for quite some time. That's made bond investors a little more willing to buy and/or hold bonds at the current level.

Which brings us back to supply and demand. As investors flee the volatility of the equity bear market, they need a safe place to park their proceeds. Bonds offer such an alternative, especially if the Fed is on hold. This drives up the demand for bonds.

Over on the supply side, the federal government's done its part in limiting availability. Back in the autumn of 2001, the Treasury announced the end of the 30-Year Treasury Bond auctions. That, in essence, froze the supply at the long end of the yield curve and reduced volatility when rates rose in March.

Congress gets involved, too, when they periodically posture over raising the national debt ceiling. As recently as June, the Treasury had to delay the 2-Year Treasury Note auction for that very reason. When that happens, potential supply is diminished sending prices (at least temporarily) up.

So it seems fair to say that the recent bond rally has had more to do with supply and demand than the repeal of the usual relation between rising yields and falling prices. With diminished supply and increased demand, it's no wonder bond prices have risen. This condition can persist as long as inflationary pressures remain in check. Of course, that might make you wonder,

If the economy is really stabilizing, why isn't inflation heating up?
Back in March when the Fed shifted from an accommodative to a neutral stance, bond yields jumped 1/2% as investors anticipated a similar degree of tightening. That seemed logical at the time. With interest rates near 40-year lows and the recession coming to an end, couldn't the economy quickly overheat?

In the past, a rapidly expanding economy has often been blamed for fanning inflation. The traditional "wage/price spiral" occurs when rising demand for finished goods drives up prices. In order to meet demand, businesses must maintain or add to their workforce. Given the demand for their services, workers can extract wage increases that businesses ultimately pass along in the cost of their finished goods. As the price of goods continues to rise, workers seek higher wages, and the spiral continues.

So far, however, this has been more of a threat than a reality. Following a brief spike at the beginning of the year, commodities have remained relatively stable. As the basic inputs of industrial production, stable commodity prices indicate demand is not be increasing.

Too Much Stuff

Source: Baseline Most businesses have spent the last year and a half drawing down inventories. This has been great for consumers looking for a bargain, but it hasn't helped to get the economy moving again.

That makes sense when you realize that most firms entered the current recession with excess inventory. In the late '90s, most were operating at full capacity so when the bottom fell out, an unusually high level of products remained in inventory. As the nearby chart shows, inventories have been high but have been coming down, especially over the last 18 months.

So with companies working through bloated inventories, there's very little demand for the inputs for new production. This is good for inflation, but not necessarily for business.

At the same time, workers are finding they have little pricing power. With their employers working off inventory rather than ramping up production, many feel fortunate to just have a job. Indeed, many firms have been laying off workers rather than hiring more. That's why the unemployment rate has been so slow to improve. In terms of supply and demand, there's an oversupply of labor and reduced demand. Again this is good for inflation, but not for the unemployed.

This is typically the case at this point in the economic cycle. During recession, demand for finished products drops so firms curtail production. The excesses of the late '90s exaggerated the situation. The dramatic economic slowdown immediately following the terrorist attacks last year prolonged the process.

Until demand picks up for finished products and inventories are brought back in line, inflation will not be an issue. In fact as we've said here before, a mild increase in commodity prices and the PPI may actually be a good sign since it would signify a pick up in demand.

The fact this hasn't yet occurred doesn't mean the economy isn't stabilizing. Quite the contrary, economic signals have become mixed -- just what you'd expect when you move from recession back to growth. In the month of May alone,

• It was reported that 1st quarter non-farm productivity showed the greatest increase in 19 years.
• Industrial production rose .2%.
• In a surprising development, unemployment fell .2% to 5.8%.
• Leading indicators rose .4%, reversing a slight decline in April.

So cheer up, some things are getting better. Bringing the economy around is like turning a battleship -- it takes a little time. And yes, it can happen without inflation.

The economy's improving, but stocks aren't.
How can this be? The stock market is a leading indicator so it should have been improving before the economy.

Or maybe not. One thing investors miss is that there is very little correlation between economic growth and stock prices. Over the past 5 years, the correlation coefficient between the two series is 0, indicating absolutely no relation -- either positive or negative. As counter-intuitive as this may be, the nearby chart illustrates the remarkably weak relation.

No Relation

Source: Baseline Wouldn't you think stock prices would follow economic growth? Well you'd be wrong. Over the past five years, there's been absolutely no relation. The correlation coefficient is a nice round 0.

Back in the '90s the economy was growing, but not at a steady pace. Quarterly results ranged from 8% to as low as 2%. Throughout it all, the S&P moved higher and higher. In late 2000, both rolled over with economic growth going negative in first quarter of 2001. Yet aside from these general trends, stock prices and economic growth really aren't that closely related.

This doesn't mean the stock market doesn't discount future growth, it just means it discounts other things as well.

Recently there's been a lot to discount. With the war on terrorism and ongoing threats in this country as well as the (seemingly) never ending stream of corporate scandals, it's no wonder investors have other things on their minds than the nascent economic recovery.

More precisely, there are three main factors weighing on stocks:

1. Fear -- Company-specific risk is running high with almost daily revelations of accounting shenanigans and illegal corporate activities. As long as well-known CEOs continue to be carted off in handcuffs, investors can't be blamed for their reluctance to jump back into the market.

2. Distrust -- Ironically, in this environment, even good news is greeted with skepticism. Companies meeting or exceeding analyst's estimates immediately come under suspicion. If results are better than expected, they're automatically presumed to have cooked the books. This doesn't provide much incentive to invest your hard-earned money, either.

   Been There, Done That

   Source: Baseline Despite two rallies, one in the final months of 2001 and one in March 2002, in late June the Nasdaq found itself back around its September lows. Is this a base-building double-bottom or just another mark of a prolonged bear market?

3. Failures of Recent Rallies -- Throughout all this, there have been some short-lived rallies. Last year ended with a fairly powerful run-up in growth stocks, only to see the gains erode in January and February. Stocks rallied again in late March yet lost all their gains by mid-June leaving large cap stocks near their September 2001 lows, and the remainder at the their 2002 lows.

   If previous rallies have failed, why should investors rush to commit cash in the next one? In fact, most have been doing the exact opposite: Each time stocks are able to pick up some ground, sellers rush in the next day to either lock in short-term trading profits or cut their losses from the long bear market. That's not how sustainable rallies get started.

Once again, it all comes down to supply and demand. Fear, distrust, and the failure of previous rallies are disincentives to investment, limiting demand for stock. Supply, however, is abundant as few companies have the profits or cash flow to engage in repurchase programs as they did in the '90s. In addition, sellers' willingness to come forward after each rally also adds to supply.

Too much supply and too little demand for stocks is not a recipe for rising share prices. Currently, concern over corporate governance and political uncertainty is outweighing positive economic news. As long as this situation persists, don't expect any sustainable gains.

Confidence will eventually return. Contrary to the way it may now appear, most companies haven't been cooking the books. The revelations from those who have will soon die down, leaving investors to once again focus on the economy and corporate earnings.

As we move into the third and fourth quarter, both will be improving. Unless there are some really negative earnings surprises, 2nd quarter results are already factored into stock prices. While we don't expect great things from the actual announcements, we are hopeful that managements' forecasts for the coming quarters will turn more upbeat.

Presently there's a tremendous demand for good economic and financial news yet unfortunately, there's been a weak supply. As we move into the second half of 2002, we suspect the good news premium will begin to dissipate as positives will be in better supply. It's a supply and demand thing.

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