Understanding The Gov't Crisis Play Book

Daily State of the Markets Friday, October 11, 2013 The DJIA soared 323 points on Thursday and the S&P 500 posted its biggest one-day percentage gain since the first day of trading in 2013 (a move that coincidentally was also sponsored by Congress finding a way to avoid sending the economy into a depression). Although yesterday's move left many investors scratching their heads, the reason for the joyride to the upside can be summed up in one simple phrase: a path forward is developing. After finishing lower almost daily for the last three weeks, stocks were clearly oversold. As such, a bounce was certainly to be expected at some point. However, Thursday's blast wasn't the prototypical oversold bounce. No, this one had some oomph behind it as shorts scrambled for cover, dip-buyers did their thing, and all those opportunistic fast-money types that had been looking for a sign that it was safe to get back into the pool dove in as well. There are two question from here, of course. First, why did stocks suddenly and without warning reverse course? And second, will the rally hold up given that there is still no deal in sight and the deadline remains a long way off? The short answer to the first question is that traders have been implementing the government-crisis trading play book developed in 2011. Here's the way it works. The Play Book First, stocks are sold off in earnest on the fear that the government might default on its debt and create a recession/depression along the way. This fear causes sellers to become more active and buyers to simply stand aside. The thinking on the buy side of the equation is simple; why buy now when stocks are likely to go lower until the deadline occurs? The combination of emboldened sellers and buyers sitting on their hands creates a vacuum. Whoosh, down they go. Stocks then continue to head lower due to the fact that a deal to save the day won't occur until right before (or right after) the well-publicized deadline. Each passing day creates more tension, more uncertainty, and more doubt. And while logic dictates that Congress wouldn't do anything to actually harm the country or the economy, as the debate becomes more acrimonious, doubt on this topic continues to creep in. But then, just when it looks like the deadline clock will expire and the economic calamity being predicted by the bears will actually occur, Congress pulls a rabbit out of their hat and somehow, some way, makes a deal. Stocks soar in response as traders breathe a sigh of relief. Short-covering ensues and before you know it, the entire worry-induced decline is erased. But This Time Around... However, this time around the game was played a little differently. In the beginning, traders didn't want to buy into the game. The bottom line is nobody wanted to get fooled again. After buying into the doom and gloom being espoused at the end of 2012, traders didn't appear interested in biting on the idea that Congress might actually cause the sky to fall this time. But as this drama has unfolded and neither side has appeared willing to budge, the fear of what might happen clearly took hold. Just as the play book calls for, a vacuum was created and stocks then started to tank. With the President doing nothing, the Tea Party making unreasonable demands, and the Democrats sitting on their #Winning position, it became clear that nothing was going to get done before the October 17th deadline. Therefore, the fast-money types thought they had a no-brainer trade to the short side. However, what short sellers didn't count on was the idea that the Republicans might not want to take the blame for this thing going south. So, with plenty of time left on the clock, the negotiations began again. And as the saying goes, as long as the two sides are talking, nothing bad is going to happen. Suddenly the doom and gloom scenario has been removed. Boom, the bulls look to be back in business. Will It Stick? The next question investors face is whether or not the Thursday move will stick. The bears contend that there are many twists and turns left in this drama/debate and that there is still no guarantee that a deal will get done. In fact, the headlines came fast and furious out of Washington Thursday evening. First, the White House announced that Obama had rejected the GOP debt limit plan (because they didn't do exactly what he wanted). Then House Majority Leader Eric Cantor said that talks are expected to continue into the night. So, to say that this remains a fluid situation is an understatement. The key however, is that the two sides are indeed talking. They are clearly not talking nicely and there is no Kumbaya moment at hand. But given that the GOP has backed away from the early demands related to ObamaCare, it does appear that there is a possible path forward to an eventual deal. So, even if a deal doesn't get done until the very last minute, as long as there is hope for a deal, stocks could easily remain buoyant. Publishing Note: I am traveling on business early next week and will publish morning reports as time permits. Looking for a disciplined approach to managing stock market risk on a daily basis? Check Out My "Daily Decision" System. Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them "in" the stock market during bull markets and on the sidelines (or short) during bear markets. Turning to This Morning... Optimism ran high on Wall Street Thursday in the hope that a deal would get done to avoid a debt default in the U.S.. However, today the focus remains on the actual negotiations in D.C. and the reality is that the two sides remain far apart. This morning investors were treated to earnings from JPMorgan Chase and will also get some economic data to review. At this stage, futures point to a flat open on Wall Street. Pre-Game Indicators Here are the Pre-Market indicators we review each morning before the opening bell... Major Foreign Markets: - Japan: +1.48% - Hong Kong: +1.16% - Shanghai: +1.69% - London: +0.74% - Germany: +0.39% - France: +0.02% - Italy: -0.12% - Spain: -0.23% Crude Oil Futures: +$1.32 to $101.69 Gold: -$9.10 to $1287.80 Dollar: lower against the yen, euro and pound. 10-Year Bond Yield: Currently trading at 2.688% Stock Futures Ahead of Open in U.S. (relative to fair value): - S&P 500: -0.11 - Dow Jones Industrial Average: +1 - NASDAQ Composite: -6.39 Thought For The Day... He is richest who is content with the least --Socrates Positions in stocks mentioned: none Follow Me on Twitter: @StateDave The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of StateoftheMarkets.com and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment. Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided. The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed. The information contained in this report is provided by Ridge Publishing Co. Inc. (Ridge). One of the principals of Ridge, Mr. David Moenning, is also President and majority shareholder of Heritage Capital Management, Inc. (HCM) a Chicago-based money management firm. HCM is registered as an investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Ridge is a publisher and has not registered as an investment adviser. Neither HCM nor Ridge is registered as a broker-dealer. Employees and affiliates of HCM and Ridge may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice. Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.