Resistance Should Hold. Debt Ceiling Clock Is Ticking. Q4 Earnings Season Will Start Soon.

January 3, 2013

Wednesday, the market started the New Year off with a bang. The S&P 500 rallied 35 points and we are within striking distance of the 2012 highs. Politicians were able to pass a mini deal and investors rejoiced. Unfortunately, the real battle lies ahead.

Republicans held their nose and signed the bill. The first stage of the negotiation process was all about revenues and they did not want raise taxes on the middle-class. The GOP will dig its heels in now that we have hit the debt ceiling. Spending cuts and entitlement reform will be addressed before the debt ceiling is extended.

The U.S. Treasury can avoid default for about two months, but the clock is ticking. Republicans know that this is their last chance to stop runaway spending.

Obama said that Republicans are mistaken if they think this is the end of tax hikes. The President will limit deductions and he will try to close loopholes. On the other side of the ledger, most of the spending cuts will come from the Department of Defense. Phantom Medicare cost savings will also be promoted as spending cuts.

The Bush tax credits and payroll tax credits were meant to be temporary. This was just another federal maneuver to artificially support the economy and to keep the natural cycle from happening. Once you give something to people it is very difficult to take it away. Most Americans will still enjoy the lowest tax rates in decades.

Unfortunately, tax revenues are a tiny piece of the puzzle. The mini deal will generate $60 billion in revenue this year. That isn’t even enough to pay for hurricane Sandy. Spending is the real issue. Even if all of the tax hikes from the fiscal cliff had taken effect, it would only finance our government for eight days.

The debt ceiling battle will get ugly. Republicans did not have leverage during the fiscal cliff negotiations. Democrats were willing to go over the cliff. The stakes are much higher this time around. Default and a possible downgrade to our credit rating are at stake. We don’t know how far the GOP is willing to go.

Here is some good news. The US is not alone. Central banks around the world are running massive deficits and they are printing money like mad. Who’s to say that this Ponzi scheme can’t go on for a few more years?

The key will be interest rates. As long as they remain low, there is not a problem. If interest rates climb to 5% on a five-year US bond, all of our tax revenues would not even cover our interest expense. If interest rates in Japan climb to 2%, all of their tax revenues won’t cover their interest expense. When this happens, there will not be any money left for Social Security, Medicare, defense, homeland security, Department of Education, Department of Justice…

Don’t worry; interest rates are not close to this level. There will be warning signs along the way. Once yields start to reverse, the move will happen very quickly.

If global interest rates remain low in 2013, it means that investors are still willing to buy sovereign debt. This would be “market friendly”.

This morning, ADP employment climbed to 215,000 in December. Private sector job growth was much better than expected and that bodes well for tomorrow’s jobs reports. Initial jobless claims rose to 372,000 last week and that was slightly higher than expected. China’s PMI also came in better-than-expected.

The news is generally positive, but the market has rallied 5% in two days. We are bumping up against major resistance and this move should stall. As the rhetoric in DC turns negative, I am expecting a pullback. Asset Managers will not chase stocks ahead of the debt ceiling negotiations.

I am evaluating from the sideline. If I see late day selling I will buy a few puts. If I see follow-through the next day with weakness in the afternoon I will add. My positions will be fairly small and I know that this retracement could be temporary.

If the rhetoric in DC turns ugly and the SPY falls below the 100-day moving average, I will get more aggressive with my shorts. The market will give politicians a free pass for a couple of weeks, but the closer we get to February the greater the danger of a market decline. This could be accentuated by weak earnings reports/guidance.

The beginning of the year tends to be bullish and I don’t want to be early with my shorts.

Day traders can use the first hour SPY range as a guide. Buy if we are above it and sell if we are below it. Maintain tight stops.
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