Fundamental Coals Have Not Caught Fire

Those of you who have experience with old-school charcoal grills know lighter fluid is used to prime the proverbial pump until the coals can take over. Quantitative easing (QE) is the Fed's lighter fluid for the economy. The hope is that money printing will help spark economic growth. Once economic growth picks up, the Fed can put its lighter fluid away. The problem is if the Fed stops pumping lighter fluid onto the economic coals, the present day fire may go out. Yahoo Finance recently asked American economist Robert Shiller what keeps him up at night, is it asset bubbles? His response speaks to the Fed's reluctance to put the cap back on the lighter fluid:

"The world economy is softening a bit," he tells us in the accompanying interview. "There's always a chance of another recession. It's been six years since the last recession started - they tend to come along with some regularity. Congress is now unable to get things done, and so we won't have a good response if there's another recession."

How Important Are The Recent Cracks?

This week's video covers evidence of defensive posturing that has been slowly creeping into the battle between economic confidence and economic fear. The video puts recent gains in Treasuries (TLT), weakness in credits spreads, and lagging performance from economically-sensitive stocks in perspective.

Rough Draft Wednesday's Fed Statement

With the recent less-than-stellar reports on the economic and earnings fronts, it is difficult to see the Fed adding a "we are about to taper" clause to this Wednesday's statement. From Bloomberg:

"Investors are going to be overly focused on this Fed meeting," Scott Wren, senior equity strategist at St. Louis, Missouri-based Wells Fargo Advisors LLC., which oversees about $1.3 trillion, said by phone. "I suspect that when the statement is released there's going to be very little change to it."

Therefore, we can use the last statement as a preview of this week's Fed event. Below is a key portion of the statement released on September 18:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

Economy: Good and Not So Good

Monday brought some conflicting data on the economy. Industrial production numbers looked good from a headline perspective, but has some concerning internal elements. From CNBC:

U.S. industrial production recorded its largest increase in seven months in September as utilities output surged after several months of declines, but manufacturing showed signs of cooling. Industrial output rose 0.6 percent last month after increasing 0.4 percent in August, the Federal Reserve said on Monday. Economists polled by Reuters had expected industrial output would rise 0.4 percent.

Worst In Three Years

In terms of looking at the broad U.S. economy, the housing market may be the most susceptible to any tapering schedule devised by the Federal Reserve. In the process known as quantitative easing, the Fed buys bonds to drive down interest rates. When the Fed's demand for bonds is tapered, then interest rates tend to go up. Rising interest rates means higher monthly mortgage payments for homebuyers, which dampens demand for housing. From NBC News:

Contracts to purchase previously owned U.S. homes fell by the most in more than three years in September, a sign that a softer economy and a rise in mortgage rates are hurting the country's housing market. Mortgage rates have risen sharply since May on bets that the U.S. Federal Reserve would soon begin winding down a stimulus program, although rates have eased slightly in recent weeks. Many investors believe the Fed will keep its bond buying stimulus at full throttle given recent signs the U.S. economy lost a step in September.

Investment Implications - Stocks Tentatively Higher

The S&P 500 advanced 15 points last week. The stock market bears had taken the S&P 500 down to near break-even with "return to risk-off" Wednesday. The bears were not able to produce any follow through on Thursday or Friday, which is indicative of a market where the desire to sell is relatively weak.

The chart below shows economic confidence is clearly in control relative to economic fear. Points A and B highlight the 50-day and 100-day moving averages; notice their slopes are beginning to rise again. Thus far, the S&P 500 has not stalled below resistance near point C. Points A, B, and C are all positive developments for the economic and stock market bulls.

Would the stock market be going up if the Fed were not in the picture? The answer is most likely no, but the Fed is an important part of the investing equation. From Bloomberg:

It's premature to assume that yields are bound to increase after reports last week signaled the U.S. economy still needs the Fed's support to ensure its recovery, said Jack McIntyre, a Philadelphia-based money manager at Brandywine Global Investment Management LLC, which oversees $44.5 billion.

The expectation of taper later is unquestionably impacting the market's pricing mechanism. As we noted last Friday, the present day market is in much better shape than it was during the 2007-2008 peaking process, allowing us to maintain exposure to economically-sensitive investments, such as U.S. stocks (SPY), technology (QQQ), financials (XLF), and emerging markets (EEM). However, the aforementioned cracks in the market's profile must be respected allowing us to remain flexible.