Tuesday's Brew - Oct 17

Enjoy your fresh morning coffee with our summary of the market outlook for the day and a medley of important information you should find useful. Stock futures are broadly lower after news of the Producer Price Index indicating inflation concern is not likely to ease at the Fed. Also, markets are pressured today by the intensifying situation around North Korea. Please also see our weekly update, "The Greek's Week Ahead," for the market moving calendar for Tuesday.

OVERSEAS

The NIKKEI reversed Monday's move, falling 0.49% on Tuesday. Clearly, concerns about North Korea are weighing on the Japanese market. North Korea yesterday broke its silence, declaring that the newly passed sanctions upon it could not be construed as anything less than a declaration of war. In a statement issued by the North's Foreign Ministry, the North said it "wants peace but is not afraid of war" and that it would "deal merciless blows" against anyone who violates its sovereignty. Keeping pressure intense, Japan and South Korea point toward evidence that the Stalinist state is preparing a second nuclear test. With this kind of tense environment in place, we view it unlikely for neighboring markets like Japan, South Korea and China to sustain any upward momentum.

Britain's FTSE 100 index slipped as well, ending a six-day rising trend. The index was impacted by banks, down on concern about the growing likelihood of higher interest rates and lack of foreign bidders, whose interest has recently supported the sector.

COMMODITIES
Oil is rising, topping the $60 a barrel mark as tensions intensify in North Korea, and the EU appears prepared to sanction Iran. OPEC is scheduled to have an emergency meeting in Qatar on October 19th, where it is expected to nail down the details of its 1 million barrel per day production cut. The 8:30 AM released Producer Price Index also raised a red flag that inflation remains a concern (see below for further economic details). In this kind of environment, precious metals remain a solid investment. We continue to favor gold shares.

GEOPOLITICAL CONCERNS
As we expected, North Korea has responded to sanctions in a less than favorable manner, raising the possibility of armed conflict in the Korean Peninsula. China's fears are being highlighted by the North, as it threatens merciless response to attacks on its sovereignty. We assume that this means that any boarding of North Korean vessels at sea by Japanese or American warships will lead to military conflict. We fully expect North Korean vessels to prove the aggressor versus Japanese fishing ships and other commercial ships, once Korean vessels are "threatened". Tensions appear set to rise, not decline, as a result of the sanctions. North Korea is in fact becoming a cornered dog with quite a bite. We expect a second nuclear test before year end, and we expect the North to expedite its nuclear weapons production effort as well as its covert sales through Chinese black market routes.

ECONOMIC & OTHER MARKET MOVING NEWS
The government reported the producer-price index for September this morning, a key measure of inflation. The overall PPI fell 1.3%. Economists polled by Reuters forecast that the overall PPI would fall 0.6 percent in September (a Bloomberg poll showed consensus at 0.7% decline). At first brush, this data looks like a positive for the market and indicative of light inflation, however, it is reflective of decreases in energy prices.

Economists expected the core PPI, excluding volatile food and energy prices, to be up 0.2 percent. The core PPI rose 0.6%, the highest rise since January 2005. In August, overall PPI rose 0.1 percent and core PPI fell 0.4 percent, and that gave lift to markets. Today's news poses the potential of severely deflating that rise, especially if tomorrow's CPI numbers coincide.

Later Tuesday, The Johnson Redbook retail sales index will help the market gauge consumer spending strength. Likely less important, the government will release its latest data on U.S. industrial production and capacity utilization. Bloomberg consensus shows expectations for a 0.1% drop for industrial production and a 82.2% measure for capacity utilization. This measure's importance is diminished because of service sector dominance in the U.S. economy.

The Treasury will report foreign purchases and sales of U.S. assets in August. This measure may increasingly be valuable in measuring the world's confidence in the future of America. Heading the Fed's tour, Governor Susan Bies will be participating in the Economic Outlook strategy session before the American Bankers Association's Forum.

STOCKS
On the earnings front, Intel, Johnson & Johnson, Office Depot, IBM, Motorola and Yahoo! are scheduled to report. Yahoo! shares have not kept up pace with other large-cap Internet shares of late, and have an opportunity to make up the lost ground if they can report a positive outlook. At $24.42 YHOO shares are well off their 52 week high of $43.66, but recently weak revenue guidance raise the red flag.

Merrill Lynch (MER) reported results of $2 a share Tuesday, destroying estimates, as the company benefited from the closing of its merger between Merrill Lynch Investment Managers and BlackRock. Merrill shares were down slightly, versus a larger decline for the market, due to inflation concerns.

We believe markets had previously been inflated by the news of August inflation weakness, and now that September is showing a returning inflation threat, with the Core PPI posting the highest rise since January 2005, the market could be threatened. If CPI numbers also show inflation hanging around, we expect major deflation to stocks' P/E multiples and price collapse. In turn, the dollar should weaken and gold should rise.

We continue to strongly favor gold shares here, and suggest investors take advantage of the trader panic that had sent gold shares lower on the opening today. Among our favorites is Yamana Gold (AUY), a company that will soon benefit from a copper production revenue stream complementing its gold production efforts. Note that Yamana is unhedged to gold prices, and will move dramatically with the price of the commodity. Earnings are expected to increase significantly in '07, and the P/E on the $0.97 estimate for '07 is 9X. This compares to industry players of similar size: Meridian Gold (MDN) 21X; Rangold Resources (GOLD) 22X; Agnico-Eagle Mines (AEM) 25X; and larger firms with slower growth potential Barrick Gold (ABX) 15X; and Newmont Mining (NEM) 20X. There is a real opportunity to take position in a sector likely to attract capital due to inflation and safe-haven reasons. There is even greater reason to take position in an undervalued stock in that sector in Yamana Gold (AUY). We hope you enjoyed "Today's Morning Coffee" and wish you a good day trading. See our disclosure at the Wall Street Greek site.