Catch-22 For The Stock Market And The Cliff

 |  Includes: DIA, QQQ, SPY, VGK
by: Kevin Flynn, CFA

Uneasy lies the market that wanted to wear a crown. After last week's somewhat predictable sell-off, equities entered Monday morning with a burst of momentum that was at times difficult to explain. The two triple-digit moves in the Dow on Monday and Tuesday were perhaps one of the better illustrations this year of how the combination of robot and HFT trading can turn ten cents of news into a dollar of price change.

It wasn't a completely contrived move. While the rise was partly driven by somewhat ephemeral air currents of compromise over the budget impasse, clearly swimming alongside were a number of traders afraid of missing the big rally due to arrive as deal time approached. Enough of an agreement was getting priced in that by Tuesday traders were beginning to warn of the possibility of a sell-the-news reaction.

Now, however, it looks like we are in for selling news of a different variety. When quizzed on the cliff at his Wednesday press conference on gun control and the Newtown massacre, President Obama clearly threw down the gauntlet. The President appears to have been strongly affected by the Connecticut tragedy, feelings that may have shortened his fuse on the budget issue as well. In any case, as soon as he was finished speaking, I began cutting equity exposure and buying put options.

My reaction was based upon the inference that Speaker Boehner's leadership position can't possibly survive any appearance of rolling over for the President's tougher talk. I'll leave a fuller analysis of the President's strategy and its possible consequences to others, simply offering that whatever else may happen, his words are surely going to provoke the House Republicans. Indeed, the Speaker appeared curt and annoyed afterwards, with calling Wednesday "the lowest point" in the fiscal cliff process.

It is quite possible now that the House passes the "Plan B" bill on Thursday - the one that Obama called a non-starter - and then adjourns in retaliation. That could lead to a pre-Christmas sell-off of two days duration or more that erases Monday and Tuesday's gains with room to spare. I would not rule out a test of the 200-day moving average, which currently sits at about 1390.

It's December, yes, but let me note once again that the month is not a sure thing of relentless marches upwards, not for the month, nor even the second half. Last year saw a pre-Christmas drop of five percent before the market steadied itself, and only a helium-like rise in the last few days, largely set off by another Greek "rescue," was able to save the month (and year).

Yet the Greek rescue was a heavily favored event, and a pre-31st mini-bargain is not. Don't misunderstand; I don't rule it out either. A quite plausible scenario is that Congress is called back into session after Christmas to try to work out an emergency extension of sorts. Such an outcome would lead to a strong closing rally, I need hardly tell you.

And therein lies the market's Catch-22. If the S&P is sitting at 1450 on December 27th with no deal in sight, then we are highly unlikely to get any deal before 2013. Rising prices are the enemy of political action. In the absence of a truly mighty effort to paint the tape and feed stories of imminent compromise to the business press (thereby triggering the robots to buy hopeful word prints and the HFT boxes to inflate what the robots are doing), the market will sell off.

Right now it looks as if we will in fact need a sell-off to get a rally before year-end. For the House Republicans to pull something off before the end of the year is not out of the question, as the party is divided over its best course of action. But a rising market won't do the trick. The talk of going over the cliff and then saving us from it, much like the fire-bug who sets fires that he can fight, has been growing on both sides. In one way it's a positive sign that both the left-left and right-right are accusing leaders of selling out, as no compromise is possible that doesn't offend and disappoint both of those camps at once. I have always thought that the cliff outlook would start to get bleak at one point; now we are here it would appear that the next move is going to be down before up, both politically and market-wise.

In another example of how the tape makes the news, the two days of rally had people talking again about how great the global economy is going to be in 2013, which naturally makes me uneasy. Things are still quite mixed. The ECB just lowered its outlook for 2013, and Pimco followed up with a bleaker outlook, calling for a contraction of at least 1% in EU GDP. Is a falling Europe supposed to revive the export-oriented emerging markets?

The US remains in the same pattern. The November Industrial Production rebound was welcome, but we are only back to pre-Sandy levels. The New York Fed survey was better than it looked, as the percentage of respondents saying things were worse actually declined, and the drop in the index was due to respondents switching from the "better" to "same" category. Last week's jobless claims number, though, was not as good as it looked and benefited from a disturbingly large adjustment factor.

ShopperTrak just cut its forecast for the holiday season from +3.3% to +2.5%, and ComScore also cut its outlook (thanks to SA's inestimable "Market Currents" for bringing both of these to my attention). Architectural billings are up and commercial malls are being renovated, but mortgage rates just went up and purchase applications declined. The US economy is still in slow-steaming mode. It could get a good quarter or two-quarter lift in capital spending and consumption if and when the budget deal passes, at least the tax part of it, but we aren't there yet. The battle over the debt ceiling is starting to shape up as another real brawl, though it won't affect this year's market.

Talk of victory was premature; but talk of defeat may be as well. We need a crisis to avoid the crisis, and right now it appears that we may get one.

In a closing note, several readers have written to ask me about Apple's (NASDAQ:AAPL) stock, as I disclosed some weeks ago that I had a long call position or spread position. I have exited the stock completely, and for reasons that have nothing to do with the emails I get every day explaining why the market has finally caught on to the company's imminent (choose one) rise or demise. My decision is based upon my own conclusion that the stock price has been captured by options trading in recent weeks, and until that situation changes I intend to stay clear of it. Options dealers win this game about 99% of the time, in my experience, so I feel safer elsewhere.

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.