Washington Wars

Jim Brown
 
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Get ready for some volatility. The House and Senate are digging in for a couple weeks of high profile campaigning over the budget and debt ceiling. I called it campaigning because this is all high priced theater as each member of both houses positions themselves for the 2014-2016 elections.

The votes this week are only symbolic so they can say they voted for or against some specific topic when they are campaigning for votes in 2014. The way the votes are constructed each member will be able to vote for and against the same item in different votes. That way they can brag about their positions even though it did not matter. If you know a particular bill will not pass a lawmaker can vote for it to lock in votes from that portion of the population. When the measure comes up again in a different fashion you can vote the opposite way when it counts.

The republicans have voted 40 times to repeal or defund Obamacare but it continues moving towards an October 1st start. The House vote on Friday passed a continuing resolution approving the government budget until mid December but it had provisions for defunding Obamacare. The House republicans knew it had no chance in the Senate. The Senate will strip out the defunding provisions and send it back. After much wailing and whining for the camera the House and Senate will come together at the last minute and pass some form of budget bill that kicks the can farther down the road.

Meanwhile the headlines about a possible government shutdown have a very good chance of tanking the equity markets. Every time Obama, Reid or Boehner says "government shutdown" to the press the market could drop another -100 points.

The most logical end to this battle will be a delay in the implementation of Obamacare for individuals for one-year just like the president did for corporations. Unfortunately there are hundreds of headlines and sound bites between now and that end result.

Barclays does not appear concerned. They raise their yearend S&P target to 1,800 and the highest on Wall Street. This suggests a +4.5% gain from Friday's close. The analyst for Barclays had formerly targeted 1,600 for yearend. Barry Knapp said the Fed's QE policy would last longer than previously expected with the initial taper announcement probably in December. The new expectation for Janet Yellen to become the new Fed Chairman also factored into the forecast. Yellen is the most dovish of any current Fed head and will likely be slow to remove stimulus from the economy. Knapp said he was less positive about equity returns in 2014 as weak earnings continue.

Citigroup raised its price target for the S&P to 1,900 but put a 2014 yearend date on it. Citi believes economic growth will continue but at a slower pace. They believe the markets will be volatile in early 2014 and that is a belief I share.

The S&P has gained +24% since the November lows and earnings continue to be a problem with only +3% growth expected in Q3. The Russell 2000 has gained nearly +30%. Eventually there will be a correction of more than 5%. Whether that happens as a result of the Washington induced volatility or some other unforeseen event in the weeks ahead is of course unknown.


Pimco's Mohamed El-Erian warned that the Fed has created increased volatility by not cutting QE as expected. He said the volatility will not be good for the market as confused investors back away from equities. He said, first we were told the economy was too weak and QE expectations moved to December and the market rallied. Then we are told the decision was "border line" and tapering could begin in October and the Fed could call a special press conference. The markets declined and this volatility is not good for the economy.

It suggests the Fed does not have a real plan and they were shocked by the spike in interest rates when they began their taper talk. Higher interest rates will slow already tepid growth and delay the recovery even more. The Fed saw the spike and it scared them. A 3% rate on the ten-year was a big hit to home sales and mortgage originations. This forced the Fed back into QE mode to force rates back down. Fed direction is now even more uncertain and that will dictate where investors place billion of dollars in Q4.

Markets hate uncertainty and we are going to have a lot of that over the next two weeks. The dollar is imploding and that is an upward pressure on oil prices but a weak economy means lower demand. The Fed's lowered forecast suggests further problems ahead and that should push oil prices lower despite the falling dollar.

Libyan production is set to return to 800,000 bpd by month end after falling from 1.3 mbpd to only 150,000 bpd on strikes all over the country. Worldwide about 2.7 mbpd was offline in early September and that was the most since January 2011.

Syria completed the first task of the peace deal by supplying a list of weapons stockpiles to the UN. Obviously nobody knows how complete it is but the list was delivered and now the pressure is off. Syria should continue to fade into the background unless there is another chemical attack.

However, on Sunday Russia rejected the plan by the U.S, U.K. and France to require the UN Security Council resolution to provide for the use of force to enforce the chemical weapons disarmament deal. The U.S. security adviser said there needs to be consequences for noncompliance. Since Russia has veto power on the Security Council this deal with Syria could take an ugly turn next week.

One positive for the U.S. markets on Monday is the win by Angela Merkel in the German elections. She is pro eurozone and her opponent is anti euro. Merkel won her third term and her party is close to winning a super majority in the parliament. Early returns show the CDU party with 42.2% and the CSU party at 41.7% of the vote.

In Colorado the massive flooding the prior week caused at least 10 oil spills. Anadarko was forced to shut down 600 wells with two spills totaling just under 500 barrels. Nearly 1,900 wells were shut down out of the 51,000 statewide total. Noble Energy and Encana also shut some wells. Encana had restarted 150 last week out of the 400 they closed.

The floods were caused by a stationary thunderstorm that settled in over a mountain watershed just north of Denver. The storm was fed by cold air coming over the mountains and warm moist air flowing "upslope" from the plains. Rain totals of 16-18 inches were common over the 2 day storm. More than 1,500 homes were destroyed and nearly 20,000 flooded. More than 100 roads and bridges were washed away. The flood widened when it hit the flat land and floated oil storage tanks off their platforms, washed away pump facilities and gas pipelines. Industry officials said it could take a year to repair all the damages to well sites that were flooded.

Market

All the major indexes broke out to new highs on the FOMC decision. The Dow gave back all of its gains while the S&P and Nasdaq retained about 50%. The most bullish sentiment indicator was the Russell 2000. The Russell rallied from 1053 to a high of 1080 on Wednesday and then gave back only -8 points over the next two days. The Russell only lost -2 points on Friday when the Dow lost -185.

A strong performance by the Russell small caps is the equivalent of a marker sentiment test for fund managers. The Russell small cap index is the first index bought in rallies and the first to be sold in corrections. Fund managers were not selling the Russell on Friday. In theory the Russell can continue higher inside the current trend channel. As Yogi Berra said, "In theory there is no difference between theory and practice. In practice there is a difference."


I still believe the Washington induced volatility will cause some market declines over the next two weeks. Most investors are assuming everything will eventually work out alright the same way Egypt, Syria, Larry Summers and the FOMC decision did. I agree there will eventually be a resolution to the Washington war but the battles still need to be fought. Look to buy stocks cheaper over the next two weeks.

Jim Brown

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