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The Market Calm Between Two Storms, One Real, One Fiscal

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The East Coast storm has silenced the markets, but more upheaval is just around the corner.

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Hurricane Sandy has slowed the pace of Wall Street this week. That is probably an understatement. The markets are closed for the second straight day due to weather. This is the first time that's happened in over 100 years.

I love this kind of unexpected chance to take a breather. It gives me a chance to think about the markets and read a little bit more market research.

My current thoughts on the market: We are in for a bumpy ride at year-end and in to early 2013. Right now is the calm before the storm that just happens to coincide with the mayhem after the storm of the century.

Here is my logic:

1. I think the Fed's quantitative easing efforts have taken the market about as far as they can. I don't see any more Fed action as having enough power to provoke a market leg up again. The S&P 500 (INDEXSP:.INX) keeps stepping in to this mid-$1400 range and then retreats. It can't seem to power past it. Some other good news is going to need to power the market.

2. The best kind of good news that can power the market is corporate earnings. When corporate earnings surprise to the upside, it provides optimism about the forward earnings power of the businesses that make up our economy. Alternatively, when the C-Suite provides positive forward guidance, that can drive markets higher also.

But given the earnings season we are in the middle of right now, there is no new optimism about positive forward earnings. There have been way too many revenue misses for stock investors to get optimistic. So, valuations will continue to be under pressure. Investors are looking for signs of 'green shoots' in the earnings numbers but aren't finding many.

3. The most common search area for green shoots is economic data that shows sector specific or broad market recovery. Analysts look for these positive signs ahead of the corporate earnings. They hope the signs at an aggregate level capture some hidden economic activity. But the current economic indicators don't expose any significant green shoots.

The GDP numbers were middling at best for the latest quarter. The growth of 2% is below average and not going to inspire investors. Some have hoped that the positive green shoots in housing might pick up steam. But at this point, it has been nine months of green shoots in housing with no flowers blooming.

It is encouraging that the consumer confidence numbers have improved. But all of the commercial spending and investment numbers continue to lag. So, the consumer seems to be getting a little more inspired, but the businesses that serve them are not investing in excess capacity according to the capital and durable goods investment numbers.

The point is that economic indicators are not going to spur this market to a rally – particularly when the poor economic data is substantiated by the poor earnings numbers from corporate America.

4. Which brings me to the point that probably matters most. We are electing a new president on Tuesday. The two candidates have polar opposite views on addressing our economic malaise. No matter which one you support, the first task on the agenda will be addressing the fiscal cliff.

The fiscal cliff is where the storm sets in, I believe.

If Obama keeps office, I believe the Republicans will hold him hostage on the cliff issue. Imagine if Obama actually wins the electoral college but not the popular vote. This is a real potential outcome. That will embolden the Republican Congress even more – especially since the Republicans are expected to be net winners in both houses, but still will not control the Senate. It will get ugly and the uncertainty of resolution will drive market volatility. Imagine the huge defense industry that's planning tens of thousands of layoffs in the new year if the defense cuts that are part of the "cliff deadline" take effect. The imposed tax increases will also place a 'tax' on the economic recovery. A deal is possible – but it will not come easy – or promptly.

Hence, my belief that the storm after the storm could really start next Wednesday.

If Romney wins, I expect the Congress to pass a resolution to extend the cliff issue until after Romney is sworn in. Our Congress will want to resolve this issue with the new leadership. This will still spin up a lot of uncertainty. A new leadership team will need to be formed and every selection of economic advisor and cabinet member will signal a potential policy view. A Romney win will likely still feel like a storm, but not nearly as drenching.

In fact, a Romney win will likely be viewed by the markets positively, until they remember the looming fiscal cliff. There could be a mini-rally on that news – but it likely won't last. Poor earnings, poor economic data, and a Fed running out of powder will be a reminder that the markets face a lot of headwinds.

Either way, don't put your rain jackets away yet. The next storm is right around the corner.
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No positions in stocks mentioned.
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