A Fed Chairman Named Larry?

President Obama has referenced numerous times the need to avoid what he called "artificial bubbles", which led to our hypothesis the President may be leaning toward Larry Summers to fill Bernanke's chair. This weekend we received some information from the Summers camp that makes it clear he has a very realistic shot getting the nod over Janet Yellen. From Bloomberg:

Former U.S. Treasury Secretary Lawrence Summers has suspended ties with Citigroup Inc. (C) while the White House considers nominating him to serve as the Federal Reserve's next chairman, the company said. "Mr. Summers has withdrawn from participation in all Citi events while he is under consideration to be chairman of the Federal Reserve," Danielle Romero-Apsilos, a spokeswoman for the firm, said yesterday in an e-mailed statement.

Markets May Focus On Low Rate Pledge

As we outlined recently, the Fed's course of action is always well-planned in advance. The clear message since the late May utterance of "tapering" from Chairman Bernanke's lips has been, we plan to taper, but we also plan to keep interest rates low for an extended period.

The same "the Fed will still provide support after QE" script was being fed to the press this weekend. From The New York Times:

Federal Reserve officials, who have made clear that they intend to cut back on the Fed's monthly asset purchases (QE) by the end of the year, must decide next week whether it is time to tap the brakes or better to wait another month or two. Fed officials are concerned that the markets will misinterpret the introduction of tapering, as the impending move is popularly known, as a sign of a broader retreat. They are expected to discuss ways of reinforcing the Fed's continuing determination to encourage economic activity and job creation when the Federal Open Market Committee meets here Tuesday and Wednesday.

Skeptical, But Open Minded

If you follow the Fed and financial markets closely, you know tapering is a big deal. Over the past three years, the stock market has not performed well after the Fed announces anything even remotely close to a reduction in QE. What is the market's pricing mechanism saying about tapering and Mr. Summer's candidacy? As shown in this week's video using numerous markets, risk-on vs. risk-off ratios, and methods, the big picture still gives the nod to the bulls in roughly 70-80% of the risk tolerance tests.

Are Cyclical Stocks Afraid of Tapering?

The million dollar question is can the economy grab the baton from QE allowing the markets to remain in risk-on mode. The strength of the numerous risk-on vs. risk-off ratios used in our market model is that they allow us to compare greed and fear head-to-head.

Cyclical stocks tend to be more economically sensitive. When investors are confident about future economic outcomes and growth, they tend to favor cyclical issues (SPHB) over more defensive-oriented stocks (SPLV). The ratio below shows demand for cyclical names, such as Starbucks (SBUX), continues to be greater than the demand for defensive names, such as Wal-Mart (WMT). From a technical perspective, the recent "breakout" above the seven-month base in the ratio below supports confidence in future economic growth (see point A). The ratio also shows little in the way of concern, thus far, related to tapering or having a Fed chairman named Larry.

Investment Implications

The global financial landscape has an almost infinite number of inputs which drive asset prices, including monetary policy, fiscal policy, economic fundamentals, and asset market technicals. Forecasting in any business is difficult. In our line of work the "almost infinite number of inputs" makes accurate forecasting extremely difficult. However, we can monitor what is happening and what trends are forming with almost 100% accuracy since they are based on known, rather than forecasted, information.

Known information still sides with the pro-growth and bullish side of the ledger. Said another way, observable evidence does not yet align with the "death knell" scenario. Consequently, our model is allocated to U.S. stocks (SPY), and leading sectors, such as small caps (IWM), and technology (QQQ). One thing tapering may be impacting is the demand for foreign assets relative to domestic investments. Based on that emerging shift, we have added some limited exposure to emerging markets (EEM) and a basket of diversified foreign issues (EFA).