No Deal Yet – Market Over-confident That Washington Will Reach A “Good” Agreement

July 25, 2011
Author: Peter Stolcers, Founder of OneOption

Last week, stocks staged an impressive rally. Earnings were excellent and politicians seem closer to reaching a debt ceiling agreement. As buyers stepped in, shorts ran for cover and the S&P 500 rallied 50 points. A month ago, Sen. Colburn walked out of the budget talks. He was one of the "Group of Six" who we're trying to curb deficit spending by drafting a long term plan. Both sides were so far apart that he left in frustration. Two weeks ago, the President tried his hand and also stormed out. These actions indicate an inability to negotiate and I could not fathom how widespread differences could be resolved so quickly. Apparently, they were not. First, there was the McConnell proposal designed as a fallback plan. Congress would extend the debt ceiling and the President would request it to be raised by $900 billion in three tranches over the next 18 months. This plan would avoid default, but it would put all of the weight of our national debt squarely on Obama's shoulders heading into 2012 elections. He did not like this solution and said he would not endorse it. Political opinions aside, Obama is not a good negotiator. From the very beginning he rammed his national healthcare program down the GOP’s throat. This put Republicans back on their heels and they got very defensive. Next, he publicly slammed the Republicans plan (Ryan) that tried to solve our structural debt problem. He did not offer a plan of his own and Democrats have yet to produce one. Last Friday, Republican Speaker of the House (Boehner) got defensive. He stated that both sides are far apart and he immediately dispelled rumors circulated by the New York Times that there was a deal. Republicans have drafted the "Ryan Plan", “McConnell Plan” and Cut, Cap and Balance". In his speech, he said that Republicans are offering solutions and Democrats are simply shooting them down without providing any revisions or alternatives of their own. The President keeps painting himself into a corner every time he gives an ultimatum. "I won't consider any short-term solutions.... I won’t consider cuts to Social Security... I won't consider any proposal that does not include substantial revenue increases." He needs to stop addressing the public. Both sides are inflamed and each is working on their own deal. This is not an encouraging sign when we are days away from the deadline. The market has priced in an agreement. When I listen to CNBC, every analyst believes a deal will get done. This morning, I heard a number of people mention that this will be a buying opportunity. When I hear that level of confidence, it tells me that we are vulnerable. With both sides a mile apart, the market should have tanked this morning. The S&P 500 is only down four points. This is my final comment on the debt ceiling. If a temporary solution is reached, we will avoid default, but we are likely to lose our credit rating. That will send a shockwave through the bond market. Many pension fund managers are already trying to rewrite their investment policies. They have to have a certain percentage of assets in AAA bonds and if the US loses its rating, they will be forced to liquidate. There will be clearing issues and the SEC is trying to establish emergency procedures. A temporary solution would also demonstrate that we are not able to address long-term structural problems. Even if we come up with a balanced solution that trims $4 trillion from our national debt over 10 years, there are other looming issues. The two-year economic recovery has been propelled by an inventory rebuild, fiscal stimulus, lose monetary policy and growth in China. When all of these catalysts were working in our favor, we were still barely able to add jobs. Now, each one of these "drivers" has been removed. Business inventories have been rebuilt to pre-crisis levels, the government has blown through its $800 billion stimulus plan and the Fed said that QE3 is not being considered. Perhaps the darkest cloud comes from China. Last week, the flash PMI reading was the lowest in 18 months (48.9). That level indicates economic contraction and China's stock market was down 3% overnight. Finance ministers said last week that they will stay vigilant and they will defeat inflation. They have raised rates six times this year and bank reserve requirements six times. By design, their economy will contract and it will weigh on global markets. This week, the economic releases include durable goods, the Beige Book and preliminary Q2 GDP. Analysts are expecting GDP to grow by a meager 1.8%. Last week, initial claims rose by 15,000 and job growth is starting to slow. The market might be able to get through this week on earnings strength, but that will fade quickly next week. I believe there will be temporary solution to the debt ceiling to buy another 6 months of time. At first, the market will like the news. After a few days it will decline when our credit rating is in jeopardy and job growth stalls. Politicians will flavor the news with encouraging rhetoric that a longer term solution is just around the corner, but months will pass without an agreement. The earnings this week will be good, but not excellent like last week. Insurers could post some nasty results after storms/wildfires have destroyed homes nationwide. I like owning puts now! The market should be down today and it is not. There is too much confidence and Washington keeps disappointing us. From a technical perspective, the market is right up on resistance and I don’t see the firepower for a breakout given all of the uncertainty. Finally, stocks have a tendency to rally into earnings season and that momentum lasts into the first few weeks. After that, the market has a pattern of pulling back. I am getting back into my put positions right now with the S&P down only 4 points.

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