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We are now post QE3 and post 2012 election -- and the market focus has shifted. The new focus -- repeated over and over ad nauseum -- is the matter of the "fiscal cliff." Pundits, politicians, CEOs and economists continue to weigh in on the political deadlock in Washington. The message -- please reach a compromise that avoids the scheduled tax hikes and spending cuts.

Little mention is being made of the approaching debate in Congress on the matter of the debt ceiling. Perhaps the reason is that we can only tolerate one major economic crisis at a time. It really doesn't matter though, as we must still deal with the fact that the United States is about to run out of money.

On Friday, President Obama assured us of his willingness to compromise with the House and Speaker Boehner:

. . . . I've invited leaders of both parties to the White House next week so we can start to build consensus around the challenges that we can only solve together. And I also intend to bring in business and labor and civic leaders from all across the country here to Washington to get their ideas and input, as well.

Sounds conciliatory, and one would think the discussion is open for debate and that some form of compromise might be in the offing after all. Further on in the President's remarks, he lets us know what he means by compromise. I am willing to compromise, so long as we do it my way:

I'm not gonna ask students and seniors and middle class families to pay down the entire deficit, while people like me making over $250,000 aren't asked to pay a dime more in taxes.

I'm not going to do that.

In response to the President's remarks, Speaker of the House John Boehner set forth his version of what compromise means:

. . . You know, on Wednesday I outlined a responsible path forward to avert the fiscal cliff without raising tax rates. About 24 hours after I spoke, the Congressional Budget Office released a report showing that the most harmful consequences of the fiscal cliff come from increasing tax rates. According to Ernst & Young, raising the top rates would destroy nearly 700,000 jobs in our country.

So much for compromise. The President is willing to compromise so long as it is done his way, and Speaker Boehner is willing to compromise so long as it is done his way. Unfortunately, neither agrees on the way as it relates to tax cuts.

It appears little will be done on the 'fiscal cliff." The odds of some kind of "Grand Bargain," or even a "kick the can" approach is not likely with such a sharp divide and neither side offering to concede to the other.

The real problem, though, is going to be the debt ceiling debate as we move into the first quarter of 2013. Our current debt, subject to debt ceiling limitations is $16.040 trillion, leaving us with a debt ceiling surplus of just $350 billion. We are running about $100 billion a month in deficit spending, meaning we should run out of money in February.

As far as the stock market is concerned, I don't think it matters much. The situation is simply not resolvable in any way that keeps us out of recession. So what are the market drivers going into the end of the year and on into the first quarter of 2013?

We have come off the high about 6 ½ percent on the S&P 500 since QE3 was announced. On September 16, 2012 -- just three days after QE3 -- I wrote an article explaining "Why QE3 Can't Work: Understanding The Liquidity Trap". My concluding remarks follow:

In conclusion, I think Ben Bernanke goes down in infamy as the one who created the monetary policy stock bubble of 2012. When will the market bubble finally pop? That's anybody's guess. My guess is this coming week. There is no rational justification for stocks adding on to a 37% gain in a year. Even if one sees the Fed policy as positive the market has already discounted the perceived success of the policy.

As it turns out that was as close to a perfect call as I have ever made. To be honest though, it was pretty obvious what was going to occur. It was based on a "buy the rumor, sell the fact" approach, combined with very solid fundamental analysis.

I also use a rule-based statistical trading algorithm that I developed several years ago and discussed in an article published on September 18, 2012 - "The Era Of Buy And Hold Is Over - Using Trade Structure To Play The Swings".

(click to enlarge)

The chart above reflects calculated points for the mean and the one and two standard deviation above and below the mean. The jagged line represents the closing price. Statistics tells us that 95% of the time, the next data point -- in this case, the closing price -- will be contained within the two standard deviation band.

Data point 47 was the closing price on September 14, 2012 -- one day after QE3 was announced. The close was in excess of the two standard deviation level, and the probability was exceptionally high that a pullback was going to occur in a day or two. My approach on stock forecasting relies primarily on fundamental analysis, but I do use the chart above in conjunction with my "trade structure rules" as a timing tool. My call on a market top was the result of a rare confluence of the three events mentioned:

  1. The fundamentals did not support further price increases.
  2. The recent rally suggested a "buy the rumor, sell the fact" situation.
  3. My statistical grid indicated a major trend reversal.

Fundamental Market Drivers Going Forward

There are a number of fundamental drivers that will move markets in the coming months. The following is a short list:

  1. The "fiscal cliff."
  2. The debt ceiling debate.
  3. The prospects of credit rating downgrade.
  4. Continuing deterioration in the eurozone.

The debt crisis will be the major driver in the market over the coming months. We are an economy in the United States and globally that is literally surviving on life support, fueled by a borrow and spend fiscal policy that has added close to $7 trillion to the national debt since 2008. As the matter of the "fiscal cliff" and the debt ceiling debate approaches, we are again reminded that GDP has been flat since the recession if one adjusts for inflation, and unemployment has not responded to any of the fiscal and monetary policy plans.

Additionally, there are still approximately 10.8 million mortgages that exceed property value. That number represents 22% of the total mortgage market. The total value of negative equity in the mortgage market remains at approximately $689 billion, and presents a continuing risk problem to those holding the mortgages.

We are at a tipping point -- a "Catch-22" situation -- where we are damned if we do and damned if we don't regarding the "fiscal cliff" and the debt ceiling. I wrote on the debt situation and the "fiscal cliff" on October 14, 2012 - "Dealing With The Fiscal Cliff". I made the following call on just how far I see the markets selling off:

At the risk of raising the ire of those in the "Feds got our back" camp, I am on record as one of the more pessimistic prognosticators. No doubt any call is somewhat subjective but I think there is a solid case to be made for why we will once again penetrate the 2011 lows and very possibly make a good run at the 2009 lows.

We have reached a point where the only way to avoid a recession is to continue to keep the economy on life support through a continuation of the borrow and spend policy. I have likened the economy to a patient in a coma. There comes a point where a decision comes to pull the plug and see if the patient will live on his own. It is not likely that the economy can stand even a modest cut in spending or an increase in taxes. At the same time, there is no way that a continuation of the borrow and spend policy can continue, either. It's an unresolvable problem -- at least in a way that avoids recession.

Technical Market Drivers Going Forward

Perhaps the most significant indicator is volume. We are still in a market that hasn't fully embraced the fundamental dilemma we are faced with. Most market participants recognize the dismal state of the economy and have chosen to hold stocks on the outside chance that Bernanke could somehow drive the price higher, or that a "fiscal cliff" fix will spawn a big rally. Very few have been willing to buy, but many have been willing to hold.

Friday's attempt to rally garnered little follow through enthusiasm, and tends to support my position that there are no buyers. Having fallen 100 points on the S&P, Friday's attempt to correct what some see as an oversold market managed to finish the day up a mere two points. After opening lower, the market rallied about 18 points to 1390 before the rally fizzled and the market closed at 1379. The VIX seems to suggest a degree of complacency as well. Although it has moved higher in recent weeks, it is hard to make a case for the VIX signaling a major sell-off. We are drifting lower and moving into a major technical breakdown area but so far, no real fear is visible in market action.

The real driver here is a simple lack of buying enthusiasm -- not a major rush to the exits. What we are experiencing at the present is simply a lack of buyers. The tech sector is probably the one area where significant selling volume has taken hold. My Apple (NASDAQ:AAPL) short call has been a real stunner to many. Apple is pricing in the fundamentals at a much more accelerated pace than the broader market. Apple is off $163 at the time of this writing -- a fall of 23% from its September high. There is a gap on the Apple chart at $428, and it is hard to imagine that gap not being filled by year-end.

Finally, we have moved below the 200 day moving average on a number of stocks and indices, suggesting a legitimate bear market is in its early stages. This too seems to be of no major concern to investors, as it has not resulted in significant selling. Other than the 300 point sell-off on the Dow the day after the election, we haven't seen a major down day that would suggest investor capitulation.

My closing thoughts are that the markets are in the early stages of a major bear market. At the present, both the fundamentals and the technicals support that position, but investor sentiment is still hopeful. Consider that the market participants and the industry in general are strongly biased toward the bullish side of the argument. We just don't want the markets to go down, and I include myself in that group. That said, we do have bull markets and bear markets, and all the wishing and hoping and denying in the world doesn't alter that fact.

Source: What's Driving The Market And Where Do We Go From Here?

Additional disclosure: I am short a group of tech stocks, financial stocks and crude oil.