Either Way – Pain Lies Ahead. Stay On the Sidelines Unless SPY $140 Is Breached – Then Buy Puts

November 26, 2012

Last week, the market staged a massive rally on Black Friday. The SPY rallied above resistance at $140 and traders did not stand in the way. Shorts were forced to cover and the volume was light. Today, stocks are giving back some of those gains.

A fiscal cliff deal is priced into the market. Money Managers believe that both parties will find middle ground. The rhetoric was friendly after the election, but that could change in coming weeks.

The best case scenario for the market is for a scaled-down version of the fiscal cliff that includes a “grand bargain” promise in 2013. This might raise taxes for couples making more than $500,000 per year and it could cap tax deductions at $40,000. Spending cuts would be reduced as well.

Alternatively, both sides could squabble and we could go over the edge. Senate Majority Leader Harry Reid wants to reform Senate rules to curtail the powers of the minority party. This is a destructive path and this course of action will further polarize both parties. This is not “market friendly” rhetoric.

I believe this decision will go down to the wire. Either way, pain lies ahead. If we go over the cliff, it will demonstrate that both parties are so steadfast that they can’t negotiate. Taxes will climb and spending will get slashed. On the other hand, if they reach a watered-down solution our deficits will continue to balloon and our credit rating will suffer.

The ECB and the IMF are still squabbling over Greece’s next payment. Spain has not formally requested aid and yields will grind higher if they don’t do so in the next week or two. Europe is officially in a recession and that will weigh on global economic activity.

Japan faces a fiscal cliff of its own. It needs to increase taxes and reduce spending. They are in a territorial dispute with China and that is weighing on economic activity. Their national debt level makes us look good.

China has new leaders in place and economic growth has temporarily stabilized. As global conditions deteriorate, they will struggle to maintain current activity levels.

Domestic economic releases have been soft. This week, durable goods orders and GDP will be released. I don’t believe either one will have a major impact. The big releases are a week away. Official PMI’s (Europe and China) will be released next week along with jobs reports (ADP and the Unemployment Report) and ISM reports (manufacturing and services). The numbers will be weak, but some of the decline will be related to hurricane Sandy.

Corporations invest when they see an uptick in demand and when conditions are certain. Consumers are not spending and global conditions are weak. New business regulations, Obamacare and the fiscal cliff will reduce corporate spending. Corporations will keep headcounts/investment to a minimum and they don’t have either of the two required elements.

Earnings season has ended and Q4 guidance was dismal. Conditions in the last few weeks have been deteriorating and I don’t see any improvement. Black Friday saw decent traffic levels, but the spending was limited. Long hours and deep discounts will bite into profitability.

I believe year-end strength and unfounded faith in our politicians will push stocks a little higher. The rally will be very tenuous and resistance at SPY $143 will hold. The higher the market goes, the more vulnerable it is to a swift decline.

I bought back my put credit spreads last Friday according to the plan I outlined. I made nice profits on small positions. I also bought a handful of puts. Those positions are also in decent shape this morning. I will manage profits.

I believe we are in for a choppy week. The SPY should trade between $140 and $143. I plan to stay on the sidelines unless we break below SPY $140. If that happens, I will buy puts.

Unlike Wall Street, I have zero faith in Washington DC. We have partied for decades and now no one wants to pay the bill.
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