Via Michael Naso of FBN Securities [9],
The crowds are slowly starting to fill up Times Square, and despite the imminent countdown to New Year’s, Washington still has not conjured up a resolution to avoid the fiscal cliff. Over the prior two months I have leveraged game theory, Venn diagrams, option “greeks,” and basic investor psychology as tools to decipher the ultimate path of the crisis and subsequent market reaction. Alas, regardless of all the analysis I and countless others have supplied; the short, intermediate, and long term prospects for stocks rest exclusively on headlines. More poignantly, the fate of the U.S. economy, global equities, and net incomes for hundreds of millions now depend upon the decision making of a group so small, its numbers can be counted with one hand.
Throughout this process, I had argued that the debate would go into extra innings. My contention with such late hour bargaining always has been the inflating of the risk premium corresponding to the event as the deadline approaches. I have associated this overhang on shares as “theta,” a term that one typically defines as the change in value of a derivative as the time to expiration decreases. As we progressed through last week, the downward forces on the market increased exemplifying this concept. The Friday afternoon flush that extended aggressively beyond 4PM via the E-Minis fittingly provided the crescendo. The parabolic acceleration of this model suggests that every material utterance from the major players in this debate going forward will affect the price action with an impact of tectonic proportions.
[10]
and sure enough...
[11]
For E-Mini traders, Christmas has arrived six days late, for the exaggerated movement in the tape will be driven by hedge funds using the security’s liquidity and anonymity to swing their portfolio beta around in a desperate effort to maximize 2012 profits. For many, every dollar made or lost today fattens or thins their wallets respectively by 20 cents or more. The S&P 500’s massive underperformance versus the Russell 2000 on Friday continues a pattern throughout the month. The blue chips have swung around more wildly than the small caps because of the use of futures to protect a respectable year of returns. This unusual divergence should hit extreme levels this afternoon.
I foresee three scenarios for today’s session:
- First, Congress and/or the President either announce some sort of compromise or, at a minimum, major progress in achieving a workable solution. Such comments, regardless of the quality of the deal, would rocket up equities upon the printing of the headline which would offer a fitting coda to such a strong year for most of the major indices. Some modest giveback near the Close would be inevitable as firms book their year happily with an assist from this late gift. If an agreement can be cobbled together, I surmise that the raising of the debt ceiling would mark the biggest omission as the Republicans retreat and regain strength for this next fiscal battle. Despite a potential rally in response to avoiding the cliff, this uncertainty would weigh on shares into the first few weeks of January as institutions have twelve months to construct a path to positive performance such that they will gladly sit these early days out after navigating the prior fortnight with the singular goal of hanging onto respectable annual returns.
- Next, the talks can collapse completely with Mr. Obama readying his own “Plan B” by proposing legislation already passed in the Senate which raises taxes on all earned income less than $250K. One should expect stocks to get hammered immediately after such an update leaks to the various news outlets. The weakness would not abate until later in the week, most likely after John Boehner is reelected Speaker on Thursday thereby allowing him to bargain more earnestly toward a bipartisan solution. Ironically, the dislocation in equities would accelerate the debate as my game theory exercise predicts. As with each of these scenarios, the flipping of the calendar only complicates matters such that no one will have the temerity to step in front of the avalanche of weakness until both sides indicate they have returned to the table with the anticipation of imminent progress.
- Finally, today’s session could also progress with little news beyond each party’s declaration that it will continue to try to avoid the worst case, yet the other side is to blame for the stalling of the negotiations. Investors still would have hope that both the President and the House can find common ground ahead of the 6AM EST reopening of the futures on Wednesday morning such that shares likely would whip around directionless until late in the day when managers pare risk to a more comfortable level out of fear of taking a significant loss in the early portion of 2013. With the average monthly NYSE closing TICK sitting in solidly overbought territory and intraday volatility projecting an environment far too skittish for value portfolios to step in front of the weakness, I suspect a troublesome tape into the Close that would continue until a passable bill bounces its way around Capitol Hill. As a reminder, approximately 221% of all the losses in the S&P 500 since October, 2001 have arisen with the blue chip index’s average trading range over the prior week exceeding 12 handles as it does currently.
In the absence of a deal, asset allocators will succumb to the wave of the squaring of positions for year-end while the upcoming global PMIs, though important, pale in importance to the political news.
[12]
If we reach Friday without any guidance out of Washington, even the Jobs Report would have minimal significance after its immediate release. Consequently, for those nimble enough, playing a game of chasing headlines should supply ample opportunities for the week. Although exposed to the event risk of some sort of an agreement arriving at any moment, those more constrained by strategy or liquidity should engage in a more defensive posture until valuations become too attractive to ignore. I envision such a prospect arriving sometime in mid-January.
Lastly, as I do every December 31, I offer some words uttered by Nenge Mboko, one of the most lovable characters among all Wall Street movies, to everyone who has endured my daily thoughts on the market’s machinations during the past twelve months. “Merry New Year!”