Wednesday, October 6, 2010's Wall Street Journal's front page headline read: "Central Banks Open Spigot.... Japan launches Bond Buying, Fed Officials Urge More Easing."

If the Federal Reserve led by Ben Bernanke adopts this much anticipated policy of a second round of quantitative easing , then U.S. economic deflation for the foreseeable future may be off the table. A cautiously rising stock market may be reflecting the belief that "the huge bond-buying effort they (the Fed) ended in March (2010) is likely to be resumed." We know that the U.S. Dow Jones Industrial Average peaked shortly after that bond buying ended and fell rather dramatically.

The Dow Jones Industrial Average rests at 11,006.48 and the S&P at 1165.15 as I write this. Gold is at $1,347.90 per troy ounce and silver at $23.23 per ounce. Oil is at $82.84 per barrel.
 
The fundamental precept behind a strongly rising stock market may be a resumption by the Fed of its bond buying campaign in order to "combat ineffective fiscal policy and high unemployment" (my quotes). A U.S. November 2010 Congressional midterm election result favorable to the markets may propel the cautious advance we are seeing today. However, the potential resumption of debt monetization does not offer good prospects for future U.S. inflation.
 
Bill Gross of Pimco has made the point that the last round of monetary ease after the 2008 financial debacle generated a 50% stock market rally. No one can guarantee that a rally of this magnitude is in the cards right now, but the first important line of price resistance should the rally continue appears in the Dow Jones Industrial Average at the 11,150 range, and further resistance at the 11500-12000 area. If this area should be penetrated, then we could reach the 15,350 area in well over a year's time. On the cash S&P, the first line of resistance on the daily chart appears to be at the 1175 range and then at the 1250 area. If we are fortunate enough to surmount those areas, then a rise to 1330 area may be possible and even the 1550 area in time. If I am wrong, then the only other two choices are to retrace back into the recent trading range or less likely, in my opinion, to violate the low of the trading range (presently the lows of the recent range are Dow 9760-9940 and S&P 1040 areas). In the event the lows of the range are broken, I believe potential downside risk are Dow 8850 or cash S&P 926 areas.
 
All Americans of voting age will hopefully vote in the Congressional mid-term elections in November. I would like to draw your attention to the Iowa Electronics Markets, an election futures market run by the University of Iowa. This election futures market has an admirable record predicting which party is going to win elections in politics, and correctly predicted President Barack Obama 's ascent to the Presidency.
 
Please see http://iemweb.biz.uiowa.edu/graphs/graph_congress10.cfm for the Iowa Electronic Markets October 2010 midterm elections futures results for control of Congress. In the chart, the the green line shows that these markets are predicting about a 60% chance that there will be a Republican House and a Democratic and Independent Senate.
 
Please see: http://iemweb.biz.uiowa.edu/graphs/graph_house10.cfm for the October 2010 midterm election futures results chart illustrating the race for control of the U.S. House of Representatives. This chart shows that the futures market is predicting an 81% chance Democrats will have 217 or fewer House seats after the election. Under this outcome the Democrats would lose their absolute majority in the House.
 
The Iowa Electronic Futures website reported on September 15, 2010 "that the strong showing of Tea Party supported candidates against more moderate Republicans in the primary elections hurt the chances for a Republican sweep of both Houses, but that traders believe a Republican takeover of the House of Representatives is even more likely." Please see:http://tippie.uiowa.edu/iem/media/story.cfm?ID=2457.
 
I believe we have three potential scenarios to consider concerning the election's outcome and its effect on the economy and our investments' future for the near and medium term. I believe the stock market is anticipating a change of control in the House of Representatives and thus is now ascending slowly and with some hesitation.
 
The first scenario is that the Republicans and the burgeoning Tea party movement take control of one House of Congress after the elections (in concert with Democrats disaffected by the Obama economic policies) and are able to effectively block the President's Progressive's legislative agenda, Obama might reflect at that time and decide to compromise with these new opposition forces in Congress. Under this outcome, the President, possibly unable to move his agenda forward, may show willingness to bend on some of his anti-growth policies and deliberate to stop class warfare rhetoric that has been dominate for two years (but I would not count on that). However, He presently shows no sign of discontinuing the rhetoric.

Obama's ability to compromise on issues important to small and large businesses under this scenario may be essential to our future economic progress and could bolster the stock market should one House of Congress fall to his opposition. Given the great leap of faith that after the election, Obama softens his rhetorical stance and compromises on policy, the banks may feel more confident lending out their reserves again to creditworthy businesses given the greater certainty of a more favorable business climate. Under the circumstances of increased bank lending, consequent business expansion and new hiring combined with healthy doses of Bernanke's monetary ease, stock market inflation hedge equities such as oil and oil service firms and materials equities could lift many other equities on their coattails. Yet monetary ease combined with greater economic growth might also dramatically accelerate the inflation rate under this outcome. Silver may also continue to do well and the bond bubble could start to pop as potentially increasing economic activity spurs interest rates upward.
 
The second likely scenario is that the Republicans and the Tea party gain control of one House, and Obama does not compromise on policy. The stock market rose from March 2009 to May 2010 during Obama's Presidency even with the anti-business rhetoric . When the Fed took away the punch bowl of bond buying, the stock market corrected. Even if there is gridlock after the midterm election and our elected officials agree to butt heads and do nothing, the stock market could still rise with the potential and reality of resumption of Fed bond buying. Faced with potential political gridlock for two years: at least the rhetoric wouldn't be all bad for small and large businesses.
 
Under this second scenario of political gridlock, the economy might not do nearly as well as under the first. it is not clear to me whether the banks would feel confident enough to lend out their reserves to companies to expand their businesses and hire new workers due to a prolonging of the uncertain regulatory and political environment. Also, the inflation rate could rise a bit less than in the first scenario if the economy continued to stall. Stock market inflation hedge equities and a broad range of other equities may still do relatively well in the muddle in this scenario.
 
The third scenario is that the progressives are reelected. I think that in this case the banks may continue hoarding their reserves and business may be inhibited from making capital investment and making new hires by the potential continuation of uncertainty and the open waging of class warfare. I think that in this case the economy may struggle mightily and the stock market may be left at the mercy of the generosity of the Federal Reserve - which would in this case probably would oblige the equities markets and a faltering economy by further monetizing the debt. We could get an illusionary playable stock market rally which might run out of gas as soon as the Fed takes away quantitative easing.
 
The economy and the stock market are in an important way fueled by confidence. Without business confidence to invest and hire new workers and consumer confidence to purchase goods and services, the economy may not make much progress. Without the confidence of individual and institutional investors in the stock market, there may be nothing to hold the market up. There has been much discussion that the recent "flash crash" removed some of the underlying confidence of individual investors in the integrity of the stock market: the rules of the game favor some moneyed interests over the individual investor. Time will tell whether the retail investor returns to the stock market. See related posts below for my entry on the essential role of investor confidence in keeping the stock market ball rolling.
 
I have made the point many times before on this blog that the U.S under Obama is spending its financial resources profligately, effectively placing one out of two dollars of spending on the national credit card. Simply put, I believe that the growth rate of spending should be less than the growth rate of GDP.
 
Gold and silver have broken through ceilings of resistance and the prospect of Bernanke's continued "monetary ease" augurs for higher prices for the metals for the medium term.. I would caution that these markets are highly volatile andsusceptible to violent corrections at any time. I would not consider them as "forever" investments but I personally have core insurance positions and do speculate in gold miners occasionally. That said, though there appears to be room for price expansion. A continued parabolic (straight-up) move in the metals would likely be a signal that the move may be exhausting itself for now. It appears to me that hard assets, including "hard currencies" such as the Swiss franc may still have play left for the intermediate term as the decline of the dollar shows increasing force.
 
Should U.S. policymakers decide after the election to get religion and cut back spending in a serious way, I think that the gold market might take that as a signal that the American government wants to preserve the value of its money and not debase the currency any further. But I still believe that in many ways, an unseating of political power in the Congress in November and the actions of Ben Bernanke's Federal Reserve may determine the course of the U.S. stock market, gold and silver, as well as the rest of our U.S. investments. Some investors may determine to escape this cycle by investing outside the direct sphere of American influence, but this brings additional political risk into the picture. These investors who invest abroad (either through ADRs, certain widely available mutual funds, or directly on foreign exchanges may wish to benefit from the progress of companies domiciled in creditor nations.
 
Bernanke's debt monetization is historically quite inflationary. It simply may create a bubble in gold and another bubble in oil, and finally debase our money. Hopefully, a changing of part of the guard in Washington D.C., courtesy of a vote of the People, will lead to an improvement in the economy and a conclusion to the greatest bailout of all time.
 
I added to my stock market exposure commencing on September 22, 2010. Among additions to my portfolio are dividend paying foreign companies domiciled in creditor nations in Asia as well as one major consumer products company traded in both the Netherlands and England. Dividends in the nations' respective currencies are converted into dollars. I have held various other equities for many years including an international oil firm, a Canadian gas pipeline company, a railroad company and various other U.S. equities. I continue to hold a diversified equity fund investing throughout Asia and the Franklin Templeton Hard Currency Fund. I still maintain an insurance gold and silver position. Should gold experience a violent correction in the near future, I would consider adding an additional position.