Tone In DC Has Soured Ahead Of the Weekend. Wait For A Breakdown – Buy Puts

December 6, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

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A month ago, we re-elected our president and the market tanked 8% in a matter of days. Republicans calmed investors and promised to “play nice in the sandbox”. After a few wild weeks of trading, we are right back where we started. The market is in a holding pattern and it is waiting for news from Washington.

Normally, this would be a busy week and major economic releases would impact trading. ISM manufacturing, ISM services, ADP and initial claims have barely moved the needle. Tomorrow’s Unemployment Report (90 K expected) won’t spark much of a reaction either. All eyes are on the fiscal cliff.

President Obama served up more ultimatums this week. He said that he would not consider any deal that did not include debt ceiling provisions. Treasury Secretary Geithner confirmed that the White House was prepared to go over the cliff if this was not addressed.

The tone in Washington DC has soured and the President has instructed federal agencies to prepare for cutbacks.

Senate Majority Leader Harry Reid is trying to change Senate rules. He wants to strip Republicans of their right to filibuster. President Obama is trying to find a way to circumvent the debt ceiling by dealing directly with the Treasury Department. These are antagonistic moves.

Many scenarios could play out, but I think this is the most likely one. Republicans and Democrats will agree to raise taxes on anyone making more than $250,000 a year. This would benefit a huge voter base (because taxes would not go up for everyone) and it would be popular with both parties. All of the other fiscal cliff provisions would go into effect and the debt ceiling negotiations will begin in January.

Spending cuts and entitlement reform will be addressed before the debt ceiling is raised. This could be a nasty ordeal.

Any way you slice it, pain lies ahead. Even with significant tax hikes and substantial spending cuts, we will add $6 trillion to our national debt in the next four years.

Global growth is slowing and corporations are sitting on cash. They are not investing because they have excess capacity and they don’t see a sustained uptick in demand. Obamacare, new regulations and the fiscal cliff are adding to uncertainty.

Companies are distributing cash in the form of dividends to avoid capital gains tax increases. This signals that they are running out of good investment opportunities. Q4 guidance has been weak and we could be off to a rough start in 2013.

With all of this uncertainty, Asset Managers who are looking to reduce risk will sell into year-end strength. The market might have another 2-3% of upside, but any rally will be contained.

If politicians reach an agreement before the end of the year (unlikely) and they kick the can down the road, the market will stage one last rally. It will be brief and at best it will challenge the highs of the year. After that, a sustained decline will set in.

This forecast assumes that politicians won’t address entitlement. They will simply find a quick fix that keeps voters happy and deficits will continue to balloon.

There is no deal in sight and time is running out. With each passing day the likelihood of a sharp decline increases. Investors will get nervous and they will reduce risk.

If the market breaks below the 100-day moving average today and it continues to drift lower this afternoon, I will buy puts. If the market breaks below the 200-day moving average, I will add. My positions will be relatively small. One positive comment out of DC could spark a massive short covering rally. I don’t want to run that risk and I don’t want to fight seasonal strength.

If the market does not breach support, I will day trade strong stocks. I do not want bullish overnight risk exposure. I will be in and out.

Be patient and wait for a breakdown. Buy puts and add on weakness. Keep your size small.
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