Another week has passed, but the same conditions persist. We’re now going into the third week of the same story. Underlying conditions are strengthening while perceptions of risk are rising. Market participants are simply waiting. A few show nervousness and cause some price deterioration, then others see lower prices as a great short term opportunity and buy almost every intra-day dip. I won’t go into the details of every indicator this week, but for those of you interested you can read this post since the conditions are the same.
There seems to be a general consensus that this budget battle should be compared with July/August 2011. I believe that comparison is incorrect. Everyone seems to have picked up the narrative without taking time to think about conditions in 2011 (so this post falls into the category of eating cat). I believe that the fiscal cliff debacle of December 2012 is a much better guide for the current market. August 2011 had the overhang of bond rates all across Europe skyrocketing as it was apparent that Greece would default unless there was intervention (a bail out) by the rest of the European Union countries. A deal was struck in late July, but it quickly became apparent that the deal had a high risk of unraveling which put additional downward pressure on the market. Here’s a few clips from a New York Times article from August 4th 2011…which was two days after President Obama signed the debt ceiling increase and one day before Standard & Poor’s downgraded US debt.
With a steep decline of around 5 percent in the United States on Thursday [August 4th, 2011], stocks have now fallen nearly 11 percent in two weeks. Markets have been plunging as investors sought safer havens for their money — including Treasury bonds, which some had been avoiding during the debate over extending the nation’s debt ceiling.
Sparking the drop was an unsuccessful effort by the European Central Bank to reassure the markets, which instead ended up spooking investors. The bank intervened with a show of support to buy bonds of some smaller countries, but not Italy and Spain, whose mounting troubles have come into the spotlight. This was taken as a sign that the recent rescue packages by Europe could soon be overwhelmed by the huge debt burdens in those two countries.
Investors were further unnerved by a candid remark by José Manuel Barroso, the European Commission president, who seemed to confirm fears about the sense of political paralysis. Rather than play down the problems, as European officials have done since the debt crisis began last year, he said, “Markets remain to be convinced that we are taking the appropriate steps to resolve the crisis.”
Those conditions don’t apply today. Instead, we’re looking at the same type of
bargaining posturing we saw during the fiscal cliff negotiations.
I expect the game to play out much the same as December 2012. Price will continue to deteriorate and volatility will rise (when people hedge against a deal failure) as we get closer to October 17th. Odds favor a deal just in the nick of time, but the uncertainty will most likely generate a signal from our market risk indicator where all but one of its components is warning. If it signals we’ll be adding hedges to the hedged portfolio, going to cash in the long/cash portfolio that recognizes risk, and staying 100% long in our core long/cash portfolio.
Our Twitter sentiment indicator for the S&P 500 Index (SPX) has been painting mostly positive readings (+6 to +10) on a daily basis. There are a few negative readings, but they’re not far below the zero line (-4). These modest readings came even on sharp down days for SPX indicating that market participants aren’t too concerned about the posturing in Washington. The current pattern of daily sentiment suggests this is healthy consolidation that should resolve to the upside. Unfortunately, the debt ceiling deadline is still a week and a half away (October 17th) which will add some downward pressure on the market as investors protect their portfolios ahead of the event.
Smoothed sentiment is reflecting the general perception that the debt ceiling deadline isn’t a big deal. Or rather, that it is an easy environment to manage a portfolio. Traders simply step aside while large money managers add some protection by hedging. Sentiment bounced above the last dip which had a positive divergence that was less than three weeks old so I’ve redrawn the up trend line to the current dip. We now have a good trend line to follow. If it is broken it will suggest lower prices ahead. I suspect we’ll see a drift lower in smoothed sentiment as the volume of tweets mentioning short selling and hedging increases while at the same time buying dries up the closer we get to October 17th without a deal.
Support and resistance levels gleaned from the Twitter stream for SPX stayed very tight again this week with 1700 being the most tweeted level above current prices and 1680 the most tweeted level below. 1660 is getting a low volume of tweets, but they’re persistently coming every day. This is creating another minor level of support and a place that the index could bounce if 1680 is broken. SPX is currently sitting right in the middle of the range at 1690 which suggests that traders are simply waiting.
Sector sentiment is painting a mixed picture this week with technology, consumer discretionary, and consumer staples all showing a negative bias. A positive bias for financials, basic materials, and industrials gives a slight advantage to the bulls.
Overall sentiment suggests the market should move higher, but there is an event looming which will put downward pressure on prices as it moves closer. The best we can do is watch smoothed sentiment and see how it reacts if/when prices deteriorate.
Market participants are clearly waiting for a resolution of the impasse in Washington, but protecting their portfolios. The vast majority of underlying indicators suggest higher prices, but our market risk indicator is very close to warning. The closer we get to October 17th, the more risk will rise and the more likely we’ll hedge. However, we’ll wait for a signal before making any changes to our core portfolios.