Hours Away from the Cliff’s Edge

The S&P500 fell almost 2% last week with much of the week’s losses realized on Friday when it looked like there would be no “solution” to the US fiscal cliff problem. Keep in mind that any so-called solution would in fact be no such thing; it would be merely another bubble-gum and tape patch that kicks the actual fiscal problem further down the road, perhaps a year or two.

Volume was light in equities trading, mainly due to the end of the year holiday season. But volatility rose….again suggesting that traders weren’t really selling down positions to reduce risk, but were only buying insurance to protect existing positions against possible losses.

In US macro news, housing prices continue to benefit from the Fed’s downward manipulation of interest rates (which increases demand and therefore pushes prices up) and of the government’s backdoor support of banks in their goal of preventing foreclosed homes from flooding the market (which reduces supply and therefore increases prices). The Richmond Fed manufacturing index disappointed. Initial jobless claims fell, but mostly due to lower activity at the end of the year. Consumer confidence plunged. And the Chicago PMI slightly beat expectations but its employment sub-component collapsed to a three year low.

The technical picture, after last week, weakened  for the S&P500….especially on the daily charts. If some sort of patch for the fiscal cliff is not worked out ASAP, then this bearish development could continue to build momentum. This would then echo the events from the summer of 2011, when the S&P fell by almost 20% before a compromise on the debt ceiling was agreed to (ironically, today’s fiscal cliff was part of that 2011 compromise solution). On the weekly charts, the downtrend that began in September is still in effect.

So how close are we to going over the cliff? Well as expected here last week, there was no deal over the last 4-5 days, leaving the government only hours away from “going over the cliff”.

And as of this writing, it still appears that no deal is close to being reached. This suggests that the cliff will not be averted and the US will start to kick in expense reductions and tax increases on January 1, 2013.

This could lead to a market sell-off providing more pressure on politicians to “do something”. As a result of this and public pressure in the first few weeks of January, it is very likely that some sort of compromise can-kicking deal will be reached reversing some, but most likely not all, of the revenue increases and expense reductions.

As part of this “deal” the limit on the US federal debt will also be increased to something over $18 trillion (remember that the debt was closer to $10 trillion when the president took office only four years ago).

Markets could then rally somewhat as the Fed continues its QE “forever” money printing program. But later this spring, US macro data will most likely continue to disappoint and US corporate earnings will also struggle.

This will leave the equity markets with a choice: to accept much lower earnings but keep stock prices elevated via higher PE multiples (with the hope of a quick recovery in the economy and earnings), OR to accept these much lower earnings with lower PE multiples and therefore lower stock prices (with the belief that a quick recovery will not be forthcoming).

The next two to three weeks will be very telling.

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