Going Over the Cliff?

The S&P500 edged up 1.1% last week on moderate volume. Interestingly, the volatility index for the S&P rose quite notably, suggesting that traders were buying insurance against near-term losses using options, rather than actually selling down their long positions.

US macro mews was mixed, and to the extent it was positive, there are indications that post-hurricane economic activity provided the boost. Nice to have, but certainly not sustainable. On the negative side, Empire State manufacturing missed badly. Housing starts also failed to hit estimates. Initial jobless claims were worse than predicted. And consumer sentiment plunged, when it was expected to rise. On the positive side, durable goods orders and the Philly Fed survey beat expectations. Personal expenditures only met expectations, but personal income exceeded them.

Technically, the S&P500 is approaching a crossroads on the daily charts. It is appearing to turn away from the downtrend line that began in September. If this price retreat continues, then the downtrend will still be in effect. If prices continue to climb, then the downtrend will get broken, to the upside.

And just what might provide the catalyst to push prices lower? Well it seems that the US fiscal cliff—and the failure to resolve it—could be it.

As of Friday, with only a handful of business days left in the year, there was no viable deal between the Democrats and the Republicans. What’s worse, the Republicans could not even agree among themselves to offer anything to the Democrats. A bill their leadership devised was not voted on because it would have failed to get approved by the Republican controlled House.

So as it stands, unless a Hail Mary deal gets passed over the next four days, the US will automatically see major tax increases and spending cuts hit the economy starting on January 1, 2013. While this will improve the fiscal condition of the Federal Government (by reducing the deficit), this will be in effect an anti-stimulus. one that could hurt GDP growth by 4-5%.

And even if a deal does come about, after January 1st, some damage will have already been done. Related to this damage is the fact that corporate earnings continue to fall.

As a result, the pressure on stock prices will be great. Despite the fact that the Fed has stepped up its money printing schemes, Ben Bernanke has warned that if a solution to the fiscal cliff is not achieved, then there’s little the Fed could do to stop the damage to the economy. If we do end up with some compromise solution, then the damage could be limited.

Either way, this is not a prescription for higher stock prices. It appears that the two most likely scenarios are 1) economic recession and big market correction, or 2) economic stagnation and stalling market action.

There is certainly little to be bullish about, at this time.

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