For a money flow analyst, there are two things that point to the direction of the primary trend - Money to Zero Maturity (MZM) and the X-adjusted Yield Curve (adjusted for inflation and dollar devaluation). The use of these two indicators has usually helped me identify and define the primary trend throughout much of the 30 years I have been studying both the stock market and the economy. I say usually because presently these two indicators are only able to provide the direction of the market on short and intermediate terms.

During the massive inflation of the 1970s, analysts followed M1, M2 and M3 to gauge the U.S. money supply. However, with the advent of the Negotiable Order of Withdrawal (NOW) Account, an interest-earning bank account with which the customer is permitted to write drafts against money held on deposit, banks practically rendered M1 worthless as an indicator for money available for immediate use. Moreover, with the advent of the NOW account, M1 became both a checking account and a savings vehicle.

In 2007, the Federal Reserve Bank of St. Louis announced it would no longer publish M3 data, leaving MZM the only measure of our nation’s day-to-day money supply. The reason MZM and the X-factored Yield Curve are limited to only divining short-term trends is attributed to the current subprime loan chaos. There is no device that can measure how much money is being taken out of circulation by defaulting loans and bankruptcy. Longer-term estimates can be made, however in the shorter-term, it is a matter of “your guess is as good as mine.” My guess, based on MZM data, is that money supply is falling, but not as quickly as the popular media would have you believe.

Over the past month and a half, MZM, currently at historic levels, has dropped 13 percent (from 36 to 23 percent). The good news is the IRS will soon issue checks as part of the government’s economic stimulus package. However, we must question how much of that money will be put back into the economy and how much will be salted away for a rainy day. We can make an educated guess to how the money will be spent by reviewing MZM data for May, June and July. If MZM is down significantly during all of these months, we must then examine the nation’s real estate default and bankruptcy rate to see if the subprime meltdown is still active. If not, the odds are that the rebate money is being deposited into consumers’ savings accounts. Although this may be a good move for the average citizen, it is a bad move for the American economy.

What is the X-factored Yield Curve telling us? When you subtract inflation and dollar devaluation from the Fed Funds Rate and the 3-year note and then compare these two adjusted numbers to the 10-year note of 3.82 percent, what you will note is that the X-factored Yield Curve is very steep. In fact, the Fed Funds Rate is moving closest to zero. The Wall Street Journal describes this as "monetary policy in overdrive." Thus, the X-rated Yield Curve is indicative of a very bullish economic environment.

The bad news is that banks are constantly forced to place more and more of their cash in reserves to provide a cushion for potential loan defaults. Consequently, money that should be spent making loans is forced into bank vaults. Nonetheless, there is good news: inflation is pushing dollar value lower, providing U.S. exporters a more level playing field to sell goods abroad. In addition, it helps U.S. companies doing business abroad to prosper. These companies include Coca Cola, John Deere, Hewlett Packard and GE, to mention a few. Once the monetary drain (defaulting loans) peters out, the economy should take a surprising leap forward. In the meantime, do not rush to buy stocks. Instead, just nibble. There will be plenty of time for heavy buying later this year.

Finally, the sell off in gold is a result of investors’ need for money; they are selling off what has obviously made them money. Eventually, gold will move up several hundred dollars once the drain in dollar value from loan defaults slows to a dribble.

Sincerely,

Kenneth Coleman