US stock markets have lost over a half a trillion dollars in market cap since Massachusetts affirmed an American political inflection point on Tuesday night.  The preliminary indicator of that inflection point occurred in November, when New Jersey and Virginia elected Republican governors.  Each of these was explained away by punditry.  But MA put the issue to bed.

So markets did exactly the opposite of what was expected. They started to sell off as soon as it became apparent that the political momentum to tax and spend has turned away from the leftward lurch of the Obama administration’s first year in power. Many are asking why markets moved this way.

Here are some bullets.

1. The stock market has been in a robust uptrend since March of last year.  It is long overdue for a correction.  No market moves in a straight line.
   
   
2. The political response to the Brown Senate seat win has been a harsh intensification of the Obama vilification of banks and Wall St.  This has introduced greater uncertainty.  Markets do not like uncertainty.  They can handle bad news and rise on it, but fear of diverse and unclear outcomes causes selloffs.
   
   
3. Markets are watching political uncertainty morph over to Bernanke’s confirmation.  That means the direction of Fed policy is being questioned.  The Fed’s liquidity program has been paramount in allowing markets to recover from the post-Lehman-AIG cascade that spanned the September 2008-March 2009 period.
   
   
4. Thursday’s selloff and Friday’s acceleration of the selloff were exacerbated by the spike in the VIX.  This is understandable, since many hedge funds immediately buy protection from shocks by buying the VIX.  The VIX is highly sensitive to sentiment shifts that arise from any source.  Friday’s VIX spike corresponded in lockstep with the selling.
   
   
5. China’s policy of tightening is adding to the worries.  The Chinese economy is growing at over a 10% annual rate. It is about to become the second largest economy in the world.  We are the largest.  Their central bank is worried about inflation and a real estate bubble.  We are worried about their policy shift inducing a slowdown of the global recovery.  Meanwhile, we continue to pick protectionist fights with China and then get annoyed when they respond.  This is an ongoing mistake of the Obama administration that commenced with an automobile tire tariff last year.  It continues to escalate.  Citizens don’t focus on the risk of protectionism but markets do, and this one is festering and worsening.
   
   
6. US policy in Afghanistan is another source of uncertainty.  Rhetoric aside, the issues of Obama administration policy in Afghanistan, Yemen, Iraq and other Al Qaida-esque places are also working against us.  George Freidman’s strategic forecasting service has an excellent analysis on this subject.  It is available at “Stratfor.com.
   
   
7. Barney Frank introduced the notion of resolution of Fannie and Freddie in his Friday commentary.  We think this is good news.  Finally the Congress will talk about what to do with these monstrosities.  But markets now have another uncertainty, and that means risk premia rise as the first reaction to this news. We applaud Congressman Frank for putting the issue on the table.  He showed leadership and is admitting that these agencies are failed attempts at government policy.  What the new policy will be is another issue, but Frank was a sponsor of this present construction over the years and should be praised for his forthrightness.  Notice the initiative came from the Congress and not the Geithner-Summers nexus.”
   
   
8. Lastly, we will go back to the Fed and will hit several items which may be technical for some of our readers.  Steve Liesman spent considerable effort explaining the difference between the Federal Funds rate and the interest that the Fed pays on reserves.  He is to be applauded for this effort.  The Fed is to be given an F for failing to explain this policy in language that is commonly understood.  Only technically trained monetary economists understand the mechanics of this new tool, which the Fed seems to be favoring as its policy-making apparatus of the future.  Also understood is that this is new territory for the Fed and that there will be errors along the way.  The Fed says as much through statements made by Governors or Presidents on occasion, but the tutorial that the public receives is not clear.  An example is found in the Fed’s $1 trillion holding of GSE mortgage-backed securities.  The Fed is not sure how it will deal with this over time.  Understandably so.  But it has options under study now.  Why not lay them out for all to see, and invite comments?  Here’s one: the Fed could sterilize the entire trillion by term auctions of reserve deposits.  That would withdraw the excess liquidity that the Fed created to purchase these securities, and it would therefore remove the inflation-risk uncertainty that crept into bonds at the end of December.  To do this the Fed must consider terms of longer than 28 or 84 days.  The Fed could also do direct reverse repos with the GSEs, which would give them an option from their current situation in which they are heavy sellers of Fed Funds.  The GSEs’ sale of Fed Funds depresses the Funds rate below the reserve deposit rate, which is causing the market to wonder how this unusual reverse spread will be rectified when the Fed ultimately begins to tighten.  And finally, the Fed could define the words “extended period.”  Markets are interpreting it to mean 3 to 4 meetings or about a half year.  That causes markets to add an uncertainty premium as an FOMC meeting date approaches.  Then the meeting occurs and the Fed repeats these key words in its new statement, and the markets breathe a sigh of relief .  This word-smithing crap should be stopped at once.  The Fed could say “at least six months” or “a year” or something else that would eliminate this guessing premium.  Here is another area where the Greenspan Fed’s semantically nuanced tactics have damaged the Fed’s credibility.

Okay, enough items are on this list for today.  It is much longer, but we will stop here for now.  The issue for readers and investors is what happens next.

We believe these uncertainties are presenting an opportunity to reposition portfolios.  We had done some selling prior to the Tuesday election-night news.  Some of that cash went into the market during the selloff.  A new position in biotech was specifically added in the industry section of the ETF portfolio.  We expect to become fully invested soon.  We also expect that the resolution of these uncertainties will lead to a decline in the VIX and a rise in US stock prices.  Our strategic target remains full closure of the Lehman gap, which translates into 1250-1300 on the S&P 500 Index. 

We view the political inflection point as a sustainable shift that will trigger positive changes in US economic policy.  And we are supportive of the notion that the Fed will not do anything to derail this fragile economic recovery.  Whether it is a Bernanke-led Fed or there are other personalities on the Board of Governors, the policy makers on the Board and at the FOMC know that the biggest risk they face is moving to tighten too soon.  Inflation remains tame.  The Fed will remain friendly to markets and, most importantly, to the economy’s recovery.