Market Adapting to Ugly Realities

We said last week we expect the market will behave much better once the Fed finally gets past the first rate hike. But at the risk of being too cheery, there are other factors impacting the markets, of a decidedly less joyful variety.

Not Oil, Not Interest Rates: We believe rising interest rates and crude prices are “baked in” the market. I would posit that “other uglies” are now impacting investors. These gyrations are a reflection of the collective mindset adapting to newer and unpleasant realities:

The Iraq War is a Mess: The situation in the mid-east has been getting worse since the uprising in Fallujah. A WSJ poll last week found over 60% of respondents believe the situation in Iraq is slipping out of control. That was before the prisoner abuse/torture scandal erupted. Its likely to get worse. Defense Secretary Donald Rumsfeld, in testimony last week, put Senators on notice that additional recordings showing rape and severe beatings are in his possession.

The Incumbent is Vulnerable: The Iraq situation is a vulnerability for President Bush. Barron’s big money poll revealed the vast majority of fund managers – nearly 80% – want to see the incumbent re-elected. The history of presidential elections shows that the markets have a distinct preference for incumbents over challengers, especially in the period leading up to elections.

Backlash May Hurt U.S. Companies’ Sales: Many large U.S. multinationals derive over half of their revenues from overseas. Any damage to the U.S. reputation can negatively impact sales, recruitment, strategic partnerships, etc. Remember, merely because “Old Europe” didn’t vote our way in the U.N., some quarters in the U.S. had called for a boycott of all things French. How might the world respond to more disturbing images of torture and abuse?

Greenspan Warns on Deficits, Taxes: Regardless of who wins in November, your taxes are likely going higher. In a speech last week, the Chairman reversed gears (yet again) and has returned to being a deficit hawk. I suspect he is warning the markets of eventual tax hikes.

The technical damage is happening: Support lines have been breeched, including the major indexes are now below March’s lows. In our opinion, that’s an ominous signal, which bodes poorly for the immediate future. We will continue to look for signs of extremes, which suggest an oversold market, which can be bought. We are not quite there yet – but the week is still young.