THE SMELL OF FEAR

Suddenly there is the smell of fear in the market. The DOW dropped Friday and the Asian markets are following the path down this morning.

ROTATION, ROTATION, ROTATION

The rotation continues but it also continues to go forward a eighth of a turn only to back up a 16th or so before making its next move. The big drop Friday was in energy shares, with a 4.15% decline in the broad category and a 10% hit to SLB. A couple of years ago, congress was investigating for price gouging, again. Of course, the free market for oil is too big for anyone to get away with price gouging for very long. Today, the margins for refining oil have collapsed. The price of oil has been pushed up due to the fear of war, raising the cost of the raw material while the final demand has not increased.


Pundits all around the world take the sharp rise in oil and gold to be an inflation signal. They conveniently ignore the flight to quality in the bond market. The bond market agrees with the CPI reports. Inflation is falling. The best way to understand this situation is to remember what happened during the great depression. The price of gold and bonds went up as fear trumped reason. The flight to gold was not a fear of inflation but fear of the total collapse of the currency. Fear trumps ration during tough times. Fear can spread quickly. Should Turkey invade Kurdistan, which is doubtful, the amount of oil coming out of Iraq will be changed very little. The fact that the market has moved so sharply to a "non event" shows that traders nerves are on edge. Investors should remember the Warren Buffet adage to be greedy when others are fearful.

As I have written many times during the past several months, one of the last events before the prosperity phase kick in is a strong rally in the bond market. The big bond market move is currently in full swing. The fall in bond rates gives the FOMC the room to lower short rates again. The probability of another cut in the fed funds rate just jumped.

The fantastic strength in the world economy made it seem like further cuts might not be necessary. In particular, it seemed that the congress might be ready to make significant fiscal policy changes which would have stimulated the economy even more than a cut in the fed funds rate. When Charlie Rangel decided to give up on the "monster of all tax reforms" last week, he threw us all back into the "do nothing congress tar pit". With government receipts surging at the annual rate of better than 7% and government outlays growing at only 2.7%, THE GOVERNMENT IS TAKING IN TOO MUCH MONEY and it needs to respond. Unfortunately, it does not appear that a major compromise can be reached this session.

Over the past several days, the risk of recession has jumped. Whenever the US government starts to soak up such a huge amount of money, the risk to economic expansion is great. The good news is that the congress is still in a heck of a box and it might be forced into fiscal stimulus. Trying to pass even a one year patch to the AMT is going to be difficult. The congress will need to pass about $65 Billion of tax increases to patch the AMT. The congress will need 60 votes in the Senate to pass these offsets. I wish them lots of luck.

To pass even a one or two year patch, the congress might need to recognize that the AMT does not need to be offset. The truth is that the congress never expected to realize the extra taxes from the 19 million families that will be caught in the AMT trap for the first time next year. A few powerful Senate leaders on both sides of the isle are willing to pass an AMT tax without offsets. Wow, a sticky wicket indeed!

Bush and the republican congress have been lambasted for deficit spending. Can you believe that during the first term after the take over by the democrats that tons of earmarks will be passed and then not paid for according to the democratic "pay go rule"?

Even though the odds of comprehensive tax reform keeps dropping, it is still the best "way out". It is needed by the American people, it would stimulate the economy, solve the AMT problem once and for all and it would dramatically cut carbon emissions. The beautiful thing about the proposed reform is that conservatives would win energy independence while environmentalist would win the fight against global warming.

TRICKY SITUATION

The FOMC will most likely cut short term interest rates on October 31. Given that there is a high probability of a cut, you want to stay 100% invested in the market. However, the next 10 days might try your patience once again. Indeed, the congress is likely to pass a poor set of bills while knowing that they will be vetoed. They will continue to try to push through the SCHIP funding. The current deadline for congress is November 16.

Again, getting out of town in one piece is going to be tough. The option is to be a do nothing congress that failed to live by its own rules or to enact major reform. Either option is going to be tough.

PROGRESS, PROGRESS, PROGRESS

The war in Iraq continues to go our way. The terrorist are being "fingered" by the citizens of Iraq. A year ago, 161 Iraqis were being murdered on the average week. The rate has recently fallen to about 5 murders per week. In the USA, about 42 of our people are murdered per week. With continued success, troops will be coming home or they will be redeployed to finish the job in Afghanistan. No American president can allow Iran to develop nuclear warheads for use against Israel. Israel has sent a delegation to China to lobby for the sanctions needed to "break the will" of Iran. Continued success in Iraq and Afghanistan will add to the pressure on Iran. Unfortunately, the situation is Pakistan is still volatile, however, there is a good chance that the new administration will be even more pro USA. A strong pro American administration in Pakistan could put the squeeze on the terrorist hiding in the mountains of Afghanistan and Pakistan.

GOOD NEWS, GOOD NEWS, GOOD NEWS

We are living through a "Ken Fisher moment". The majority of the people have a very low opinion of congress, the war, the president, the tax law and they simply have about negative attitudes. The result is opportunity. There is likely to be a strong sentiment shift as the election cycle progresses. Even without positive results from congress, the politicians will be able to brag on the nearly balanced federal budget. The success in Iraq will be reported time and again. One of the more accurate market indicators is that the market does well when the public opinion of the president and congress has been very poor but then rises to at least the 35% positive rating. The set up is here. BUY, BUY, BUY! When Fear turns to Greed, you want to be out in front!