Trading The Cliff's Edge

Includes: DIA, IWM, MDY, SPY
by: Kevin Flynn, CFA

I won't torment you with more analysis of whether or not Washington will lead us into default. There's been plenty of interesting prose written about it, much of it with an eye towards exerting some kind of pressure on our elected officials not to get too cute. There's also been quite a bit more prose of the uninteresting variety. For fear of falling into the latter category, I will give the subject a miss.

Since this column purports to be about the market outlook, let's instead review the market implications of the default and no-default scenarios.

If there is a default, pull your investments and wait until the dust has settled. That could be a long time. There are some who believe that a default won't be so bad. There are also some who believe that the earth is flat and the moon landings are fake. Of course they are. Have a cookie.

A default will be catastrophic, make no mistake. If you want to argue otherwise, good luck to you but I'm not going to join in, nor will I stick around afterwards to see if maybe it wasn't so bad. If you don't understand why default will be catastrophic, or think it won't be, my opinion is not humble but urgent - turn over your investments to someone else.

The broad sentiment in the investment community is that default is a low-percentage outcome, with a likelihood of about one percent being the most commonly cited one. I don't think it will happen either, but it's much closer to a coin flip for me.

Whether it's one percent or twenty, as we get closer to the deadline, there are some things that you can safely expect. One is that more selling will take place on a just-in-case basis. As we get closer to the edge without any safety net, the chances that the selling turns ugly will increase. Right now the downward pressure is due more to a disinclination to buy than it is to a burning urge to flee. Ten days from now, it may be the reverse.

As this takes place, the predisposition to a massive upside rip-reversal will also increase. We've lost a bit more than the four percent from the post-Fed high last month; any default pushback of more than a couple of months in duration will erase most of the loss in about two days. The longer the deferral, the bigger the rip-relief.

If that sounds to you like an exhortation to start loading up in preparation, it isn't. Equities were on their way towards the next support area (1640) on the S&P 500 until the Yellen nomination rally intervened. It didn't have the same visible effect it would have had in the wake of a debt deal, but nevertheless it helped out quite a bit on Wednesday. So far that's two rallies we've lost this month - the shutdown-avoided rally, and the Yellen-QE rally. Stocks will still try to make up for the missed opportunities if given the chance.

Yet the S&P, Nasdaq, small-cap and mid-cap indices have all broken down below their 50-day exponential moving averages in the last two or three days. Stocks are now short-term oversold. If the S&P does nose down to the 1640 level this week, I'll probably take a nibble because my cash levels are so high - but only a small one.

Partly that's because I won't truly believe in the no-default outcome until I see it, and partly because prices could easily lose another few percent over the next week before the default is theoretically avoided. The losses could easily turn into another five or ten percent, even more, if the incipient freeze in the short-term Treasury market starts to spread. The S&P 500 trend line in place since last November has been broken, and that isn't going to help matters either.

Last week saw a bit of insouciance in the markets about whether the shutdown could happen, and some couldn't wait to buy the dip. That sentiment is rapidly fading. I said the one sure bet was volatility, and the VIX has indeed moved up significantly. The two most important things you need to keep in mind now is that one, a one-percent chance is not a zero-percent chance. One-percent outcomes may not happen often, but they can and do happen.

Two, prices could lose a lot more altitude before the hypothetical agreement not to default is reached. Yes, such a deal rates to get a big upside rip, quite possibly one that in the span of a week or two reaches all the way to 1750 on the S&P. But it's better to miss the first two percent of the upside rip, and the bragging rights that go with it, if you first have to pay a blood fee of five percent or more just to get into position. Stick with volatility and don't start to deal until Washington does. The politicos may need to see a lot more blood before they finally blink - why should it be yours?

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.