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The market tanked after the election and a warning shot was fired. Stocks rebounded and politicians know what lies ahead if they can’t reach a fiscal cliff agreement. The price action is very tenuous and traders are scrutinizing every word out of Washington.
Republicans have put tax hikes on the table, but Democrats have yet to counter with spending cuts. Unfortunately, if all of the Bush tax credits expire, the new revenues will only finance eight days of government spending. This puts the magnitude of the problem into perspective. This is not about revenue, it is about spending.
Both parties feel like they have the upper hand. Democrats know that if we go over the cliff, tax increases will take effect immediately and they can postpone spending cuts. Republicans know that in a couple of months we will hit the debt ceiling and then they can force Democrats to balance the budget.
The market tested the downside yesterday and it immediately snapped back. This morning, the reversal is providing additional momentum and stocks will open higher. Apart from a short squeeze, I can’t justify the move.
Republicans are being painted as the “bad guys” and they have started the negotiation by offering revenue increases. Democrats have yet to counter and the rhetoric has been argumentative. They want to postpone spending cuts and most won’t consider any entitlement reform. Senate Majority Leader Harry Reid is trying to change the rules so that Republicans can’t filibuster. This is an antagonistic move and it does not bode well for negotiations.
Politicians postpone decisions that involve pain. Ultimately, the market forces them to take action. The closer we get to the fiscal cliff without a resolution, the greater the chance of a nasty market decline.
A watered down agreement (minor tax increases, delayed spending cuts and no entitlement reform) would be temporarily bullish. Stocks would rally into year-end if this happens. Our deficits would balloon in this scenario and our credit rating would be downgraded. It would not take long for the market to rollover.
If politicians play “chicken” we could go over the fiscal cliff. Factions from each party seem willing to let this happen. Democrats will postpone spending, but Republicans will have their way during the debt ceiling negotiations in a month or two. This outcome would demonstrate that Washington is dysfunctional.
I’ve spent a great deal of time on this because the fiscal cliff is dictating the price action. From a trading perspective, bears are fearful that a deal could get done and they don’t want to risk getting caught in a short squeeze.
From a trading perspective, this is the best of times. We are getting wild moves in each direction and that will continue for at least a few months. I am taking short-term positions and I am focusing on stocks that are rising to the top of the Live Update table. Use key support and resistance levels on the SPY as your guide.
Once we rallied above SPY $140 yesterday, I knew I had to sell my puts. I also day traded stocks from the long side. I don’t trust this market and I am keeping my overnight exposure low. Resistance at SPY $143 could be tested today but I believe it will hold. The higher we go, the more attractive shorts become.
I don’t see any growth catalysts. The average baby boomer and $50,000 saved for retirement and consumers are tapped out. Federal, state and municipal debt levels are astronomical and spending cuts loom. Europe is officially in recession, Japan has a fiscal cliff of its own and China’s stock market is making multiyear lows. Central banks have fired all of their bullets and quantitative easing has not stimulated economic growth. Interest rates are at zero (US, Europe and Japan) and they can’t go any lower.
Corporations have painted a bleak picture for Q4. They will not invest or add to headcounts until they see a sustained uptick in demand. New government regulations, Obamacare and the fiscal cliff will keep them on the sidelines.
These are all long-term bearish influences. For the last decade, economic activity has been artificially supported. Now we will finally have to go through this economic cycle.
Major economic releases will hit next week. They will be impacted by hurricane Sandy and I believe the market will give them a free pass (not much of a reaction). There is a strong undertow and trouble lies ahead.
Keep your size small and be nimble. The rally this morning should fade and we will test the downside. If SPY $140 fails, buy puts. If you have bullish positions I would start scaling out. Even if politicians reach an agreement, that last spurt higher will be short-lived and at very best, we have another 3% of upside.