Blame Game Begins

Were gains in stocks all that surprising on the first day of a government shutdown? Somewhat, but we noted Monday the markets were not tipping a bearish hand. Monday's late night posturing did result in some agreement between the two houses of Congress. From The Wall Street Journal:

The fight now heads into an uncertain phase in which both parties will blame the other for furloughing hundreds of thousands of federal employees and shuttering nonessential government services. Negotiations between the House and Senate effectively concluded when House Republicans decided late Monday night to name a committee of lawmakers to negotiate a final spending resolution, a move Democrats had been requesting for months but one that came too late to hammer out a meaningful deal.

Relative Fear 2012 Fiscal Cliff

Since stocks took off after the fiscal cliff scare in late 2012, we can use that period as a "what to look for under bullish conditions" example. The chart below tracks the demand for stocks relative to the demand for the VIX, which is often referred to as The Fear Index. While the press continued to report with a bearish slant on the fiscal cliff story as New Year's Eve approached, the fear in the financial market peaked almost two weeks before the calendar turned on 2012, which gave hope to the stock market bulls.

Relative Fear 2011 U.S. Downgrade

The waterfall August 2011 decline in stocks can serve as a "what to look for under bearish conditions" guidepost. The ratio of stocks/fear consolidated for a few months before breaking out convincingly in favor of fear and the stock market bears. A downgrade of U.S. debt was the straw the broke the camel's back in 2011. If the 2013 debt ceiling negotiations push the financial markets too far, a similar plunge in the ratio below could still occur in the coming weeks .

Relative Fear 2013 Budget Battle

If we examine the same risk-on vs. risk-off ratio as of Tuesday afternoon, we see a set-up that currently looks more like the bullish 2012 case. The bottom of the chart also highlights the current bullish trend in stocks (green dotted line).

VIX Hints At Economic Confidence

The supply and demand balance between stocks and the VIX tells us to be open to higher highs in stocks looking out several months. The ratio currently points to favorable economic outcomes. Market participants did get some support for that thesis Tuesday. From Bloomberg/Econoday:

Sales of total light motor vehicles rose a very solid 1.8 percent in August to a 16.1 million annual rate for the best showing of the recovery going back to November 2007. August's gain was led by domestic light trucks but also included a solid gain for import cars.

Investment Implications - The Song Remains The Same

Our market model has recently called for some padding of our money market funds, but it has not (a) recommended hedging (SH), or (b) adding exposure to conservative assets, such as Treasury bonds (TLT). Based on observations of the market's pricing mechanism, our core holdings have not changed. We continue to hold positions in U.S. stocks (VTI), technology (QQQ), small caps (IWM), emerging markets (EEM), and foreign stocks (EFA).

Debt Ceiling Still On Risk Management Radar

The outlook for the markets calls for the possibility of ongoing volatility until the two hurdles are cleared within the framework of the U.S. Constitution. On a brighter note, the chess moves being made behind the scenes (see ETF leaders) leave a significant bullish crack in the door once the focus shifts away from what can be a messy political process.