Market Should Find Support Today. If No Progress On Fiscal Cliff – Heavy Selling In 2 Weeks

November 8, 2012

The election results are in and President Obama will try to improve on the last four years. This time around he can’t blame his predecessor and we all hope he succeeds. The market is skeptical and it fell 300 points on the news.

There won’t be much of a honeymoon. The fiscal cliff looms and politicians only have six weeks to find a solution. This problem has not been addressed in over a year and confidence is an issue. Standard & Poor’s observed the chaos last year and they downgraded our credit rating.

If all of the sequestration provisions are implemented, our GDP could fall by as much as 5% next year. Politicians will barely get back to work and they will leave for Thanksgiving. When they return from that holiday, they will have a few more weeks before they depart again. It is unlikely that they will get anything done during this lame duck session. At very best, they will find a way to postpone the fiscal cliff for a couple of months.

If Democrats dig their heels in, tax credits will expire on January 1st. They can postpone spending cuts for a few months and this might give them the upper hand in the negotiations. Capital gains taxes will increase in 2013 and investors will sell stocks if they don’t see progress in the next week or two.

I believe yesterday’s knee-jerk reaction was over-extended. Support at SPY $140 is holding for now. Traders might be willing to give politicians a little time to negotiate. They will closely monitor the rhetoric and if there is any arguing, the market will decline. If everything seems to be going smoothly and there are signs of progress, traders will wait for a week or two.

Politicians rarely act unless they are forced to. Yesterday’s market decline was a warning shot across the bow. The stakes are high and they need to find a solution. Taxes need to go up and spending needs to be cut. We can’t continue to run $1 trillion budget deficits each year.

Obamacare will impact corporate hiring. The provisions will gradually take effect over the next few years and employers will only add to payrolls if demand is strong.

Conditions in Europe are fairly stable. Greece voted on its austerity plan and it passed. There is another vote on Sunday. Of course, citizens don’t like it and there is rioting. If the austerity measures are approved, they will secure their next bailout. Spain held a successful overnight auction and yields remain low. I don’t believe European credit concerns will be an issue in 2012.

China’s economy is gradually improving and they should be able to avoid a hard landing in 2012. The government is spending money and the PBOC is easing ahead of their leadership change. China’s growth will not be a problem in 2012.

Japan has a fiscal cliff similar to ours. Their balance sheet is weaker than any other developed nation and it could be the source of the next credit crisis. They are in a territorial dispute with China over a group of islands. China has reduced imports from Japan and this will have an economic impact.

From a seasonality standpoint, stocks tend to rally into the end of the year. If politicians continue to argue, we won’t get that rally. I don’t like shorting stocks and trading against seasonality.

The declines could be swift and deep but you need to take profits quickly and use stops. One carefully timed comment about a quick fix to the fiscal cliff will result in a massive short covering rally. Washington DC doesn’t even have to follow through; it just needs to make promises.

The difference between this decline and others is that there will be natural selling (as opposed to short selling). Investors will head to the sidelines to avoid higher taxes and uncertainty.

I see value in the market. Stocks are attractively priced and balance sheets are strong. Companies are lean and mean and when revenues rebound, profits will grow incrementally.

If support at SPY $140 holds today, I will sell out of the money put credit spreads on strong stocks. If there’s no progress on the fiscal cliff in the next week or two, I will reel in those positions and look for a shorting opportunity.

If the market continues to drift lower today, I will buy SPY puts. That would be a sign that confidence is very low. Now that we are at major support, a breakdown would be bearish.

The market has bounced this morning and that move will stall early. Traders were probe for support and we will test the downside. If buyers step in, the market will grind higher this afternoon. A new low late in the day would be bearish. Gauge the price action today and act accordingly.
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