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FX Trading – A second guess.

The fun has begun and fiscal conservatives have taken back control of the US House. The rally in US stocks over the last couple months has been credited in part to this expectation that a shift in power within the US House of Representatives will help ease the burden of potential taxes and regulations that have heretofore been among the biggest reasons corporations have held back from hiring and investing.

Sounds good for the economy, right?

But almost as quickly as the Democrats fell from favor, commentators are now expecting a gridlock between the US House and Senate will be a disaster for the US economy. We’re in the middle of a balance sheet recession, and it’s said consumers sure won’t be able to take up the slack when government spending gets thrown back; financial support for the economy will go the way of Democrat congressmen.

Sounds bad for stocks, right?

But there have been some small and scattered bright spots in some economic numbers (manufacturing activity, jobs numbers, etc.) all while we continue to be dumbfounded by the fact that stocks haven’t already turned over based upon reality over QE2’s certain lack of effectiveness setting in. It’s almost as if investors really want to test the Federal Reserve’s bailout threshold before they admit there’s no solid reason to be buying stocks at these levels, in this economy.

Although, maybe the Federal Reserve action (rather than Federal Reserve effectiveness) is a solid enough reason … as it is widely believe that wealth effect from a juiced stock market can help along a struggling economy.

But still – has it been too far too fast for stocks?

Here’s an excerpt from Pragmatic Capitalism’s blog trying to sift through the psychology behind market tops and bottoms:

The beauty of mean reversion is its simplicity. If we take a graphical look at the current environment we can visualize the imbalance that occurs in a market. Market peaks and troughs tend to occur when a market enters a state of disequilibrium with its underlying fundamentals. This can be due to a number of varying factors, but psychology tends to be the primary driver. I often say that it is always brightest at the top. The current environment is not only displaying excessive bullishness, but the general equity mentality has become one of extreme complacency. You either think the Fed is going to push the market higher or you think the economy is on the path to recovery. As Tepper said, it’s a “win win”. The problem with a market and its mean reverting nature is that investors place their bets before the cards are dealt. This is why markets always peak on good news and bottom on bad news.

So now Quantitative Easing Part Deux becomes all the more important. Despite the fact that it will not substantially change a single thing it is meant to change, there is still a lot of hope riding on the fact that maybe it’ll somehow be there to fall back on when fiscal spending disappears. If it is, then maybe a bull market will be there to fall back on too.

So … as we look at everything under one giant microscope, it seems obvious to us that stocks are outpacing their fundamentals, QE2 expectations have more than overshot their merit, and the absence of risk has the potential to rear its ugly head in a big way. And that’s why we think it makes sense to buy stocks, sell the dollar, and pretty much go long on risk appetite.

Sounds perverse, we know. But after all, our analysis amounts to a big fat negative while price action tells us we’re fat wrong. Maybe we’re missing something here, but we might as well not fight it … because the Federal Reserve probably can’t afford doing anything that would jeopardize the stock market … even though they have absolutely no problem putting the US dollar at risk under the guise of a boost from exports. If we get some fiscal conservatism in Washington, it means the burden of stimulus is squarely on the back of monetary policy.

That gives the Fed seemingly two outlets today:

1) Be aggressive with plans to implement QE2 and keep alive the notion that the Fed works to keep the markets well supported a la higher asset prices help consumer confidence through the magic of the wealth effect.

2) Be somewhat reserved with plans to implement QE2 and talk up the more optimistic points of the economic recovery so as to keep alive the notion that the outlook for stocks is positive as far as the eye can see.

We will find out soon—maybe!