Another week in the record books and pretty much what I expected - this market just doesn't want to go down. Last week I noted that there were four market drivers for the coming week:
- The "fiscal cliff."
- The debt ceiling debate.
- The prospects of credit rating downgrade.
- Continuing deterioration in the eurozone.
I was wrong as there was only one issue moving markets last week -- the "FISCAL CLIFF". Have we heard enough about the "fiscal cliff" yet? At least I had it listed first in order of priority.
To my credit I got the mini rally part right. I made the following comment last week and I think it comes as close as anything I've said in recent weeks to being spot on:
Traders are looking for something - actually anything - to hang their hat on that will reverse the bear market trend and allow the "Bernanke bull market" to continue. Consequently, even the slightest hint that a resolution to these problems might be forthcoming will produce a very short-term counter trend spike in market prices.
After starting out sharply lower on Wednesday morning we bottomed out at 12,766 on the Dow (NYSEARCA:DIA) before Speaker Boehner got us just what we were looking for. The Speaker said "I'm optimistic" and when I heard that I thought to myself - gee whiz -- that is surely good for a 200 point rally.
For those of you who fit into the "I'm optimistic too" camp I suspect you don't appreciate my sarcasm. Really though - "I'm optimistic" and we reverse a decidedly bearish start and rally over 200 points?
To put things in a proper time frame it is Thursday evening as I write this and my guess is we have pretty much run the course on the counter trend rally. I expect Friday to be the first day of the next leg down. There are a number of reasons - both technical and fundamental - for why I see us moving lower into the Holiday Season starting tomorrow.
- The President and Congress are more interested in posturing than resolving an irresolvable problem.
- The technical indicators suggest we've come close to exhausting a bear market correction.
I left the upcoming Congressional debt ceiling debate off my list of market drivers going into the end of the year for the simple reason that this subject is just to painful to consider with the Holiday Season approaching. Nevertheless, I think it should be mentioned as a side note.
Last years attempt to deal with the debt and deficit resulted in a mini stock market crash after Congress failed to reach agreement on spending cuts. Finally, out of necessity, Congress tried a novel approach - across the board spending cuts would kick in if the "Super Committee" couldn't arrive at specific cuts. Congress went ahead with a debt ceiling increase of $900 billion in August.
Interestingly, they added a second provision to the Budget Control Act that managed to avoid public scrutiny - a bit of a "sleight of hand" move in my opinion. Congress inserted an additional provision into the Budget Control Act that allowed the President to request another increase in the debt ceiling of $1.2 trillion subject to a congressional motion of disapproval.
In other words -- rather than approve the next round of debt -- Congress manages to avert that fiasco by saying that it will be OK unless we "disapprove" it. The whole deal has been a fiasco and demonstrates the inability or lack of desire to deal with our problems. To sum it up Congress threw the President a bone that avoided immediate default with the $900 billion. Realizing that $900 billion is chump change in an economy that needs an ever growing amount of fiscal stimulus to stay above water, they threw in a conditional provision for another $1.2 trillion that wouldn't require approval - rather it would require disapproval.
So, maybe this is a little bit more than a side note but it does relate to the main market driver - the "fiscal cliff". What the "fiscal cliff" debate amounts to is an attempt to renege on last year's commitment. It was a hard fought battle to arrive at a very convoluted series of provisions that required dealing with the debt and deficit. Standard & Poor's wasn't impressed with the provisions and issued a credit downgrade with the promise of another downgrade if Congress didn't get their act together.
So, here is my take on how Congress deals with the "fiscal cliff" going into the end of the year - they do nothing. Here is how the message is delivered to the public. The matter of the "fiscal cliff" is of such magnitude and consequence that we have elected to take it up next year as we tackle the issue of the impending debt ceiling matter. After all, it is Christmas and we need to get home to our families.
I don't have a crystal ball that predicts the future so I could be wrong, but unlike John Boehner - I am not optimistic. If my call is right, the markets will slowly see the talks eroding based on irresolvable philosophical differences and the markets won't like what they are hearing. Another outcome is possible of course but my guess is that Congress doesn't have the resolve to deal with the matter with the holidays approaching.
So let's move on to the technical factors that might drive the market going into the end of the year. I have been short the tech stocks since September - adding my last trades the Monday following the announcement of QE3. My logic was that we would be entering into a bear market as the inevitable recession began to loom larger and the tech sector had led the charge to the upside. My assumption was simple - the tech stocks were seriously overvalued based on the irrational "bubble" psychology precipitated by the QE3 euphoria.
My thinking was that the tech sector led the markets higher and would likely lead the markets lower. That turned out to be a good assessment of how the market would develop going into year end as the following chart illustrates:
XLK Tech Sector ETF vs S&P 500
This chart shows that the market has turned lower moving through the 200 day MA average before mean reversion players bought the marginally oversold market driving it back to the 50 MA. There is little doubt in my mind that the 50 day MA will prove to be critical overhead resistance preventing any further advances. Additionally, price action has moved the market back up to the post QE3 lows offering additional overhead resistance.
The more interesting chart though is XLK:
XLK Tech Sector ETF
This chart tells the story for me. XLK broke well below the 200 day MA and the recent counter trend rally has moved the market up to the 200 day MA. If we move lower from here we will complete the 4th bear market fractal with each one gaining in terms of the breadth of the down move. I see this market moving lower into the end of the year with little in the way of upside support until we move back into the middle of the consolidation area established in the 4th quarter of last year.
Another significant market driver for this ETF could be the "Death Cross" that is going to occur sometime next week based on the current trajectory of the short and long term moving averages. XLK seems particularly influenced by the cross over of the short and long term moving averages. Coincidentally, back in August of 2011, this situation occurred at exactly the same time we last visited the matter of the debt and deficit. The result was the mini crash of 2011.
Additionally, when the short term MA moved above the long term MA in the last quarter of 2011 it spawned the tech rally that led the broader market higher throughout the year up to the time the Fed announced QE3. This ETF is particularly responsive to this cross over phenomenon and not something to be ignored.
I have heard a few pundits suggest that failure to arrive at what the market sees as a solution to the "fiscal cliff" could cause the Dow to give up 1,000 points rather quickly. I tend to agree. I see the "fiscal cliff" scenario developing just as I noted above -- Congress will throw the whole matter into next year and simply go home for the holidays. As this becomes clear to traders it will provide downside fuel based on the fundamentals. The "Death Cross" will provide fuel for the technical traders as the 50 day MA moves through the 200 day MA some time toward the end of next week.
One last chart and I will sum it up. As many of you know I am a strong advocate of trade structure in that I try to achieve at least a 50% win rate and a profit to loss ratio on trades of at least 2:1. To achieve that I use a grid that is created by calculating the mean and the one and two standard deviation values. I then overlay the daily closing price which I use to make entry/exit decisions. The chart below is based on the 20 day moving average (mean) and the 20 day standard deviation calculations.
I normally use a 90 day mean chart to determine longer term moves but I do use the 20 day version to identify support and resistance points. On occasion I use the chart as a form of mean reversion and trade the market for a short term spike against the major trend.
The chart below broke below the 2 SD level on November 14 suggesting an oversold market. For those inclined to use the grid as a form of mean reversion trading, when price action moves to the outer band most of the time - though not always - these points can be reliable for predicting short term trend shifts.
With that in mind we have moved to the upper end of the range. If I were going to play this using a "mean reversion" strategy I would sell the market when it moved to the upper band which is currently at 1433. An alternative is to play my standard rules and sell the market when it moves below the mean value which is currently at 1390.
As an advocate of trade structure I want to see a potential profit of at least 2 times my risk. That said, I can create that trade by selling the market at Thursday's close of 1415 with a stop at the 1433 price level or I could wait till the market moved under the mean at 1390 and sell there with a stop at the plus 1 SD level of 1411. I think either trade will produce good short term results moving into the end of the year.
My profit target is the bottom end of the range at minus 2 SD. That level is currently at 1347 and what I see as a likely price level in the next 4 to 6 weeks. Using the first scenario -- a short position at 1415 with a stop at 1433 and a profit target of 1347 - my trade structure is an 18 point risk with a 68 point profit target or 3.55:1.
Under the second scenario I would sell at 1390 with a stop at 1411 and a profit target of 1347 giving me a risk of 21 points and a profit potential of 43 points resulting in a profit/risk ratio of 2.05:1.
As I see it, we have a confluence of a number of factors that virtually assure a continuation of the bear market.
- A deterioration of the "fiscal cliff" optimism that is certain to occur with the ultimate outcome being that we just move it into the larger discussion of the pending debt ceiling debate that will begin in January.
- Major technical indicators that point to a market that has reached significant resistance and approaching an overbought situation.
- The technical implications that occur when the 50 day MA moves under the 200 day MA next week.
As I finish my remarks it is now Friday morning. I don't know the specifics of the President's proposal being kicked around this morning but I do understand that the President's proposal involves in excess of $1 trillion in tax hike and includes a provision that would remove the budget control from Congress and grant the President control over the budget - in effect providing a vehicle for unchecked spending.
The mere fact that such a proposal would be presented for consideration makes a mockery of the whole "fiscal cliff" process. I try my best to avoid political commentary but this proposal is an affront to all parties and demonstrates the President is simply not serious about providing responsible fiscal leadership. My take away from this - don't look for any kind of resolution to the "fiscal cliff" before year end.
That is how I see it, and how I would play it going into the end of the year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.