October 16, 2013

Once again stock prices bounced, defying the seasonal factor that has kept investors on edge. Commodities remain relatively weak following their bounce. Despite the markets actions, the current economic situation and the Fed, the main focus is on the budget and federal debt ceiling.

From the beginning to the middle of September stock prices rose sharply, lifting several benchmarks to new all-time highs. However profit taking ahead of the start of the October reduced the gains from their highest levels. The S&P 500 Index (SPX) rose 3.0%, the Dow Jones Industrial Average (DJIA) gained 2.2%, and the Russell 2000 Index (RUT) appreciated 6.2%. Low interest rates are keeping small-cap stocks strong.

Since October began, however, stocks have fallen sharply. The stalemate in Washington has hardened as far right Republicans, commonly referred to as the Tea Party, square off against the remainder of Congress and the White House. The conflict has resulted in the partial shutdown of the government, which of coarse has caused its own series of news items, finger pointing and name calling. Furthermore, as the participants dig in their heels, the government faces a potential full shutdown.

More important than the government shutdown is the fact that Congress has failed to pass law that increases nation's debt limit, which could result in default, the lowering of the credit rating and a drop in the confidence level for the country. The United States has never defaulted on its debt.

Commodities Bounce Continues

Meanwhile, precious metals have resumed their decline following a bounce in July and August. However the decline stopped mid-September. Gold and silver futures are showing some signs of strength as October began and the expectations of the shutdown became more probable. Meanwhile copper prices have been holding in a narrowing formation. We believe that recovery of the housing market is supporting copper and lumber prices.

After rising from the June lows, energy prices have contracted but still remain well above the previous mentioned lows. Prices at the pump have been also declining, with some areas reporting regular gasoline prices approaching the $3.00/gallon level. That is a positive implication for consumers and retailers.

Agriculture prices bounced slightly in August, which we mentioned last month, and have remained in a narrow range near those lows.

Currencies

The US Dollar Index remains in a negative trend and is currently near a one-year low. This is the result of strengthening economic conditions in Europe, which has proclaimed itself to be out of recession, and once again by the log jamb in the nations capital. Weakness of the "greenback" appears across the major currencies including the Swiss Franc, British Pound and Japanese Yen.

The Fed

For the past few months we wrote about two major factors for the Fed. According to media reports, President Obama appeared to have been leaning toward selecting Lawrence Summers to succeed Ben Bernanke as FOMC chairman. Summers turned down the opportunity. As we were going to press news hit Janet Yellen was going to be presented for the position. Yellen has been the vice-chairman of the Federal Re-serve and many economists feel she is the best can-didate for the job.

The Economy

The final revision to second quarter Gross Domestic Product (GDP) showed that the economy grew at a 2.5% annual rate. The reading for third quarter will likely be delayed due to the government shutdown. More important is that some economists believe that GDP could be reduced by 1.4% due to the impact of the shutdown.

Inflationary pressures remain in check, and there is little evidence thus far that the shutdown will result in higher prices for most items. However, failure for the passage of the farm bill could push milk prices up to $6/gallon.

Like other government reports, the Employment Situation Report, as well as most websites, are also locked out and will remain that way through the crisis. This lack of data is also impacting Wall Street, and will also impact investor and consumer confidence.

Equities: A Deeper View

Since the mid-September highs the internal market indicators, such as the NYSE Advance-Decline Index (NYAD), contracted and turned sharply lower. The percentage of stocks trading above their 200-day moving averages also dropped sharply, below the 60% level for the NYSE and below 66% for the Nasdaq. There was also a sharp decline in the number of stocks setting new 52-week highs.

Investor fear has been on the rise. The CBOE S&P 500 Implied Volatility Index (VIX), commonly referred as the "fear gauge," rose to a four month high. The CBOE Nasdaq 100 Implied Volatility Index (VXN) set a year-to-date high.

By industry, last month the groups that led the markets were footwear (+15.6%), healthcare (14.1%), house-hold appliances (+13.8%), airline (+13.3), and semi-conductor equipment (+13.1%). The lagging groups were gold (-11.6%), paper products (4.5%), special consumer services (-4.1%), and oil & gas refining (-3.9%).

Quarterly Recap

While the third quarter is typically the weakest period of the year, the benchmarks ended with gains. SPX rose 4.1%, DJIA added 1.0%, and RUT spiked 8.5%. The strongest groups were tires & rubber (+44.9%), household appliances (+26.4%), computers & electronics (+22.8%), consumer electronics (+22.0%), and gas utilities (+21.8%). The weakest groups were healthcare facilities (-10.9%), department stores (-9.8%), homebuilders (-7.4%), food distributors (-7.3%), and gold (-6.9%).

What To Watch For

October is known as the scariest month for investors, holding the title for market crashes. September was the historic month declines. The market is very sensitive to news and the government shutdown and potential for default is keeping investors and traders on defense.

We have pared back some positions, reducing risk exposure. For the positions currently on, we have been using risk reduction strategies and techniques, and are also positioned for buying stocks at lower prices.

The credit markets remain strong. Demand in that space has translated into higher stock prices since companies are using the capital created to repurchase shares, increase dividends and to make strategic acquisitions. We believe that this will continue for the next several years, keeping the market benchmarks rising and creating opportunities for high returns in the equities markets.

As noted, inflation remains in check and even a modest rise in interest rates could provide the drive for higher stock prices. November is the start of the strongest six and three month periods of the year, and we are positioned for that opportunity.

ABOUT THE AUTHOR
Michael J. Levas has been in the investment management business for over twenty years and is the founder,senior managing principal & director of trading at the Olympian Group ...