DC Shifts To Debt Ceiling. This Will Take Weeks and It Will Get Ugly. Air Pocket Back On

October 2, 2013

Yesterday, traders completely ignored the continuing resolution (CR) believing that an agreement would be reached quickly. I did not trust the rally and I stuck to my game plan. The SPY was not able to close above $170 so I did not get long. Tuesday’s gains are being erased this morning and there is a silver lining to this dip.

Democrats were not willing to negotiate with Republicans when the debt ceiling is only a couple of weeks away. The GOP did not have much leverage and both parties are focusing on the debt ceiling. This means we won’t get the fake mini-rally and the reversal. The stakes are much higher and Republicans know that this is their best/last bargaining chip.

The rhetoric will get ugly over the next few weeks and the partial government shutdown will continue. Investors will get nervous and the selling pressure will be steady.

In exchange for a debt ceiling extension, the GOP will be negotiating for some of the items on its wish list (Congress goes back on Obamacare, the Keystone pipeline, repeal the medical device tax, delay the individual mandate by a year and reduce entitlement spending). This will be a major battle ground and it will take weeks to resolve.

This negotiation process will take place as earnings season begins. Banks dominate the first two weeks and estimates are being lowered. Trading volumes are low, refinancing is declining and legal expenses are up. This will play into our hands and the selling could accelerate. Profits will be a little soft, but they will still be decent.

In general, earnings growth will be flat but profits are still at record levels. There have not been many warnings and that is a positive sign. Corporations have maintained margins through cost-cutting and cash flows are strong. Companies are using that money to buy back shares.

All of the other puzzle pieces are in place for a big year-end rally. Global economic conditions continue to improve and domestic activity is good. Chicago PMI, ISM manufacturing and ADP all came in better than expected. Any uptick in demand will increase corporate profits.

Asset Managers are anxious to get long. They won’t chase stocks but they will buy dips. If the debt ceiling negotiations sour, they know that our credit rating is at risk. The last time the US suffered a downgrade, the market tanked. They will wait patiently for the debt ceiling to be resolved. Once that is behind us, they will buy aggressively.

I am going to trade from the short side today. If the market makes a new low after a few hours of trading I will buy some puts. I want to see continued selling pressure and if we are closing near the lows of the day I will hang on to my put positions overnight. This negotiation process will take a couple of weeks and the selling pressure will be steady.

My short positions will be small. I don’t want to take my eye off the ball and I know that the next big move is higher.

DC continues to fund more and more government agencies during this shutdown so there is no real urgency to strike a deal. Investors will get nervous as the banter increases and the SPY will test the 100-day moving average. Asset Managers will pull bids.

My forecast assumes that a mini-deal will not be reached and that the debt ceiling negotiations will get ugly. I have history on my side, but when it comes to DC, you never know.

If you are an aggressive trader, keep your shorts small. If you are a swing trader, be patient and wait on the sidelines. It looks like we will get that buying opportunity we have been hoping for.
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