Dangerous Grind Higher – Market Pricing In Cliff Agreement. Day Trade Rally and Wait For Breakdown.

December 10, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

Last week, the market drifted higher on seasonal strength and decent economic releases. The daily trading range has been very tight and all eyes are on Washington DC.

The jobs reports, ISM manufacturing/services and economic releases from China were all positive. The market has established a small pattern where it opens near the low and grinds higher into the close. We are likely to see that price action today.

The economic releases are light this week. The FOMC will release a statement and we can expect them to remain accommodative. On Thursday, China will release its flash PMI. I’m not expecting much of a reaction from either release.

President Obama and Speaker of the House Boehner met this weekend and that is a positive sign. It doesn’t mean that we are any closer to a deal, but at least they are talking.

Republicans and Democrats seem miles apart and we are not likely to see a deal until the last minute. With each passing day, investors will get nervous. The market is pricing in an agreement and I believe any surprise favors the downside.

I believe the most likely scenario will include a swift market decline and a “mini-deal”. Republicans are likely to concede on tax hikes for people making more than $500,000 a year. Extending the Bush tax credits for anyone making less than $500k would be popular with both parties. Spending cuts and the rest of the fiscal cliff provisions would be negotiated in January when we bump up against the debt ceiling.

A quick market pullback will force politicians to take action. They will strike a “min’s- deal” and stocks will finish a little higher than they are currently. Any rally above this level will represent a longer-term shorting opportunity.

The debt ceiling battle will get ugly. Spending cuts and entitlement reform will be demanded and Republicans won’t raise the debt ceiling without them.

If both parties find a way to kick the can down the road before year-end, stocks will jump and we will make a new 52-week high. The probability of this happening is less than 10%.

If both parties can’t reach an agreement and we go over the cliff, stocks will decline into the end of the year. I don’t believe Republicans will let this happen because they will take the blame. If we go over the cliff, Democrats will heroically propose to reinstate Bush tax credits in January for people making less than $250,000 a year. Republicans will agree. Going over the fiscal cliff would damage Republicans and I don’t believe they will let it happen. This scenario has a 20% chance of playing out and the rhetoric would be very heated into year-end.

Given the possible outcomes, here is how I will trade this market. As long as we are above the 100-day moving average, I will day trade strong stocks. We don’t have much of a tailwind (market strength) so I am looking for attractively valued stocks that have formed a base and are breaking through minor resistance. Asset Managers are bargain-hunting and these stocks should continue to rebound even without strength from the market. On the other hand, stocks that are breaking out to a new relative high are vulnerable. Many investors will take profits before year-end to avoid capital gains taxes on stocks that have performed well.

I am keeping my overnight exposure on bullish positions to a minimum. I feel that the market is pricing in a best case scenario and the rug could get pulled out at any moment. Besides, the market has not been gaping higher overnight and it has been easy to enter the next day. You are not rewarded for overnights at this time.

I will continue to use this strategy as long as market support holds. If the market closes below the 100-day moving average, I will buy puts and I will hold them overnight. If I see follow-through selling, I will add.

The news will dry up over the next few weeks and rumors out of DC will drive the price action. Look for choppy trading on light volume.
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