Where Does The Market Go from Here?

Not much has changed in the world since my last post.  Japan is still bleeding radiation.  The participants in the Libyan civil war are still pushing each other east to west and west to east.  Europe is still grappling with debt and the notion of possibly raising interest rates.  In the Middle East, demonstrators are still clamoring for change and the governments are quelling the demonstrations with brute force.  China is still battling inflation and trying to curb its overheated economy with interest rate increases.  Oil is still above $100 per barrel, gold is still a crowded trade yet unable to break through to $1500 per ounce, and silver, well, that precious metal still seems to be on a magical ride.  Oh yes, and the three major indices (DIJA, NASDAQ, and S&P 500) are still trying to break out to the upside of their respective trading ranges … 

Fascinating and confounding simultaneously is the fact that the major indices have not fallen heavily.  Given the geo-political issues above, and the threat of still higher oil prices, one might reasonably conclude the overall market should be down, but it is not.  In fact, it is slightly up, and the three indices mentioned are bumping against the upper end of their ranges.

So, where do we go from here if the magnitude of the geo-political outside influences is not enough to knock the market down?  I would say look to the continuing and magnifying debate in Washington D.C. for a possible answer.

As the news from Japan, the Middle East, and Libya stales, and investors absorb the higher prices of oil, the next peg in the climbing wall of worry could well be the issue of U.S. debt and what to do about it.  Specifically, will the debate over our debt and deficits, and the resulting resolutions, spook the global market, or has the overall market factored in the possibility of a government shutdown and a possible refusal to raise the debt ceiling?

Certainly, as I write today, the debate is on, and it has been in the news daily for over a week now.  This fact has not seemed to spook the market; yet it is possible that the market a) believes that a government shutdown and/or a refusal to raise the debt ceiling are not likely outcomes, or b) the market is in a holding pattern until things are clearer.  The latter would explain the light volume of trading we have seen in the last week or so.  It is hard to know which is the case as other influences are at play here that confound the situation even more.

Most all indicators, leading and lagging, point to a strengthening economic recovery in the U.S., which is the ultimate driver of global economic direction.  Specifically, manufacturing and employment are showing strength, although the former is softening a bit.  The latter, however, is improving month to month, and by all accounts, the latest report shows a labor market clearly improving.  One “interior” piece of the latest report is slightly discomfiting, but in that is also a silver lining the market might see as it goes through each trading day.  The piece I refer to is that wages and benefits are showing no sign of inflating; they are flat.  Since these two elements of the U.S. economy are what the Fed looks at to determine if core inflation is rising (they comprise 70% of core inflation), then one could assume the Fed will keep interest rates down, at least for a quarter, maybe two.  This, of course, leads me to the final piece, which has to do with the Federal Reserve policy of quantitative easing.  Will the Fed end QE2 in June as scheduled, and how does the market view this possibility?

Two weeks ago, I presented this same issue as it related to the “amazing resilience” of the market.  Then, I said the following.

The market is not tanking while the world seems to be falling apart because the market believes the economy will be able to grow under its own power after the stimulus goes away.

I still hold to this, even as the market grasps the next peg in the climbing wall of worry.  Given the Fed course followed thus far, and given that it seems improbable that the politicians in Washington would willingly jeopardize the economic recovery, the “good faith and credit” of the U.S., as well as their jobs, it appears that prudence coupled with overheated rhetoric is what the end game will be. 

If the above becomes reality, the market may well solidify its hold on the latest upward peg in the climbing wall of worry and then begin to reach out for the next peg above.  What will constitute that peg?  My guess is that it will be inflation, specifically the rise in retail gas prices.  If so, then the energy sector will continue to hold opportunity.