"Dangerous But Necessary"

As we've discussed a time or twenty, the primary objective of this oftentimes meandering morning market missive is to identify and understand the "drivers" of the market action. At times this task is child's play. A piece of economic news comes out and the market reacts accordingly. One doesn't need a PhD from Wall Street's school of hard knocks to connect the dots when that happens.

However, there are also times when the action in the stock market makes little sense. And in short, Wednesday was one of those days.

The Driver of Wednesday's Action Wasn't Easy to Identify

So, let's go to the video tape and see what we can see. Tuesday night, traders got word that the boys and girls in Washington had been able to make a deal on the budget (insert shocked, gasp here). Yep, that's right, there would be no government shutdown this time around. And what was more astounding was the fact that the deal got done without any public bickering, name calling or hair pulling. Nope, Paul Ryan and his counterpart in the Senate just got it done. Bravo.

To the uninitiated, such news may have created expectations for a rally in the stock market. And in fact, the futures did move up modestly when the first headlines hit the tape. However, it appeared that traders were taking a wait-and-see attitude regarding the potential for the deal to be approved in both the House and Senate before popping the champagne. After all, this wasn't the first go round on the topic of the budget.

To the astonishment of many, word came down on Wednesday morning that the Ryan/Murray deal was expected to get done. Speaker Boehner endorsed it. The Senate seemed to be onboard. Heck, even the President said it was a compromise he could live with. So, cue the buy programs, right?

So Much For The Celebration!

Wrong. Instead of celebrating the fact that lawmakers in Washington had not acted like infants for a change, stocks started heading down at the open. And unfortunately, they continued to head down throughout the day. And by the time the closing bell rang, the Dow DIA had surrendered 130 points, the S&P 500 SPY was down 1.13 percent, the NASDAQ QQQ had given up 1.4 percent, and the Russell 2000 smallcaps IWM were off 1.64 percent. Ouch!

So, what caused the dance to the downside, you ask? The bottom line is nobody seemed to know. There wasn't any economic data. The members of the FOMC were in their "quiet period." And there wasn't anything terribly big going on across the pond or in Asia. Hmmm....

Here's a tip. When the folks in the mainstream financial media start talking about "profit taking," you know that there is confusion as to why the market is doing what it is doing. In short, this is code for, "We don't have any idea why stocks are heading down, so we're just going to assume there are more sellers than buyers." Not helpful.

The Real Keys

To be sure, one of the reasons behind yesterday's drop was the idea that the budget deal getting done would cause the Fed to begin tapering QE sooner rather than later. Recall that one of the thoughts that led economists not to expect the taper to begin before March was the idea that the economy might be interrupted by the ongoing games being played by lawmakers in Washington. But with a deal done, some argue the taper could begin next week.

However, it appears that another key reason stocks fell hard on Wednesday were the words "Dangerous, But Necessary."

You see, word got out that President Obama is close to nominating Stanley Fischer to become the vice chairman of the Federal Reserve. No, not Dallas Fed President Richard Fisher, rather former Bank of Israel chief Stanley Fischer.

Mr. Fischer's resume is impressive to say the least. According to the WSJ, "Mr. Fischer is a former professor at the Massachusetts Institute of Technology and former top official at the International Monetary Fund. His former students include Fed Chairman Ben Bernanke, European Central Bank president Mario Draghi, and Lawrence Summers, the former head of Mr. Obama's National Economic Council."

In addition, Mr. Fischer has loads of experience with financial crises (a requisite to get a Central Banker gig these days). As the number two guy at the IMF, Fischer helped shape the response to the 1997-98 emerging markets crisis in Russia, Asia, and Latin America. And then for the past eight years, Fischer served as a governor of the Bank of Israel. According to reports, his guidance helped the country come through the 2008 financial crisis nearly unscathed. And in 2010, Fischer was named by Euromoney Magazine as the Central Bank Governor of the year.

Back To That Headline

As word got out that Fischer was likely to replace Janet Yellen (who is known as an uber-dove) as the Fed's Vice Chairman, reports began to circulate about his views on Fed policy. Boom, there is was.

The WSJ reported that earlier this year, Mr. Fischer had some serious concerns about the Fed's new tool - forward guidance. “You can't expect the Fed to spell out what it's going to do,” Mr. Fischer said. “Why? Because it doesn't know.” Uh oh, that doesn't sound good.

However, the real key was the fact that Fischer had called QE3 "dangerous but necessary" earlier in the year.

During an interview at the WSJ CEO Council last month, apparently Fischer had stressed that the Fed's QE efforts, which he termed "extraordinary" were not without risks. “Without the Fed, we'd have had a much deeper recession. Without the extraordinary things that it's done, the economy would be in much worse shape today and we need to remember that."

This is all well and good. But it's the next part that gave traders pause. Mr. Fischer went on to say, "Precisely how to get out of it [QE], at what speed to get out of it, is a much harder thing to measure and to calculate.”

In English, Please...

Apparently nothing Mr. Fischer has said recently is untrue or overtly hawkish. However, when one combines the fact that the next #2 at the Fed isn't onboard with forward guidance and is concerned about the state of the QE program, well, this changes the face of the Fed. And the bottom line is that it's not nearly as friendly as the Bernanke/Yellen combo was.

So, forget all that nonsense about "profit taking." Forget the talk about "tax selling." Ignore babble about stocks not going up on the good budget news. No, this market has been and continues to be all about QE and the taper. And word that Stanley Fischer will likely sit at the right hand of Janet Yellen suggested to investors Wednesday that monetary policy could change sooner than the markets had expected.

In sum, this created a bit of uncertainty relating to what the Fed might do and when. And we all know how the market feels about uncertainty...

Click Here For More of Dave M's "Daily State of the Markets" Commentary

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of the Taper (aka Fed Policy)
      2. The Outlook for Economic Growth
      3. The State of the Budget Deal

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Moderately Negative
(Chart below is S&P 500 daily over past 1 month) Intermediate-Term Trend: Moderately Positive
(Chart below is S&P 500 daily over past 6 months) Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 12 months)

The State of the Tape

The Early Warning Indicators

The State of the Market Environment

Weekly State of the Market Model Reading: Positive

Thought For The Day...

"When the facts change, I change my mind. What do you do, sir?" — John Maynard Keynes

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Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

• Trend and Breadth Confirmation Indicator: Neutral
  
• Price Thrust Indicator: Moderately Positive
  
• Volume Thrust Indicator: Neutral
  
• Breadth Thrust Indicator: Neutral
  
• Bull/Bear Volume Relationship: Moderately Positive
  
• Technical Health of 100 Industry Groups: Neutral

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

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