Say What Mr. Reid?

Via Michael Naso of FBN Securities,

Harry Reid’s publicly displayed dismay at the lack of progress in the fiscal cliff negotiations finally injected a dose of realism into the process after investors threw caution to the wind and seized on the optimism offered by the Senate Majority Leader and Speaker Boehner on November 16.  I view yesterday’s sound bite as more negative than the aforementioned statement on the White House Lawn, for we now sit 11 days closer to the New Year’s deadline.  Despite this asymmetry, equities suffered only moderate losses giving up just a modicum of the gains from last week.

The relative lack of a response to the comments seem puzzling given the price action from the prior several days; however with month end looming, enough buyers kept stocks from selling off violently.  This somewhat muted reaction to the headlines reminded me of the broader market response to GOOG’s disastrous earnings announcement in October.  Shares held up from that moment into expiration before falling back aggressively once the Double Witch had cleared.  Extrapolating this pattern suggests that month end money flows may artificially support equities until early next week at which time only new found positive sentiment surrounding the crisis can keep the major indices from giving back most, if not all, of last week’s returns.

My November 13 “Missive” outlined a game theory exercise that suggests this rancor will continue until very late into December and/or the capital markets dislocate thereby ensuring either a falling over the cliff or a band aid solution to avoid the crisis temporarily.  Both parties unfortunately may assume that by agreeing to postpone the tough decisions, they will have prevented a rout in equities; however, the August, 2011 precedent of raising the debt ceiling out of desperation hints otherwise.  Only a full and lasting compromise offers hope over the intermediate term after such an announcement, yet even this resolution offers complications over the long term, for the loss in economic growth resulting from an increase in taxes and a cut of government expenditures would far outweigh the benefits of making a modest dent in the deficit.

The EU’s approval of Greece’s next tranche of aid is welcomed albeit the passing of the event is negative for equities as it removes a potential tailwind for stocks.  Therefore, the light currently shines more brightly on the fiscal cliff.  Moreover, investors have started to show concern over China’s stock market returning to three year lows, for a primary driver of the current bullish argument for U.S. equities relies upon accelerated growth from the world’s most populous nation.

While the data over the prior month has stabilized, the unrelenting downtrend in the Shanghai Composite indicates that the recovery curve may be shallower than anticipated.  Given its prominence in international trade, China is the tail that wags the global dog such that its indices typically lead those from North America.  For example, Asian shares bottomed in the fall of 2008, several months ahead of the trough for the S&P 500.  This dislocation between the two regions is therefore highly concerning.

Some may argue that I am crying wolf, for Durable Goods solidly beat consensus while Consumer Confidence sits on four year highs.  I counter by arguing that the former survey reflects stale statistics largely unaffected by Super Storm Sandy and the budget fiscal crisis while the rate of improvement in the latter has flattened.  Furthermore, the downward revision in the University of Michigan sentiment reading was the sharpest since 2008.  In short, I continue to expect weakness as the calendar flips toward 2013.  This potential soft patch will arise regardless of an announcement of new unsterilized bond purchases by the FOMC at next month’s meeting for the benefits of central bank signaling dissipated upon the enactment of open ended quantitative easing in September.

Finally, despite almost reaching deeply oversold levels just ahead of the recent anticipated 5% bounce in the S&P 500, the average monthly NYSE closing TICK has quietly pushed up to +218, a moderately overbought level previously reached on October 5 as the snapback rally forced funds to increase their exposure, much of it via short covering, given the proximity to year end.  This makes the recent upward move tenuous and very susceptible to a sharp reversal especially with consideration to significant resistance supplied by the overnight down gap in the blue chip index after Election Night and Senator Reid’s blunt honesty in assessing the prospects for an imminent compromise to the fiscal cliff.