Market Participants Begin Move to Sidelines

Next week, with the fiscal cliff approaching, many market players will  begin to reduce daily exposure to trading in futures and equities leaving  the bulk of price action to professional traders to play thinning volume and the resulting increased volatility.  Decision strategies for Democrats and Republicans have begun to emerge with  both sides claiming they are restricted to an all or nothing outcome and unable to compromise.  Of course, the rule here is to never press the other side with what you think is a dominant strategy unless you absolutely know your own worse case outcome.   Many fools over the years have increased their own exposure by pressing a strategy they believe will absolutely motivate the other side.   More to come.....

Preparing For Cliff

Fed shifted the qualitative and quantitative asset rules a bit today when they decided to use an economic outcome as a benchmark for continued accommodation; 6.5% unemployment rate.   In a news conference later, Bernanke seem to be preparing for what the Fed sees as a long drawn out battle for economic recovery, one that is threatened by a likely over the fiscal cliff event.  Equities seem to be convinced of a just in time end of year positive outcome to negotiations which may confirm the contrary. 

The Bad News If There Is Good News

Regardless of the outcome of the fiscal cliff, lets look at where the equity markets are in terms of value.

Conventional wisdom apparently reasons any decent resolution to the fiscal cliff problem will send equity markets higher and interest rate markets lower (higher rates).  Various reasons are applied most notably is the uncertainty element shall be removed and thus release the upside horde in large part because of the forever anecdotal "cash on the sidelines".  

However, many are looking at the equity markets only in terms of its current price being as high as it can get  without more good news.  So it has a set point bias. The fiscal cliff has set up this line in the sand reference point where resolution is good and non resolution is bad.  But since the market sits at a price location much higher than its 2008 lows, it needs to rationalize the best possible outcome to maintain value.  Thus, to slightly modify the disposition effect, the market is less willing to recognize potentially downside market moves and more willing to accept positive upside moves. 

To understand the bulls; real estate, technology growth, and greater economic expansion will be positively influence by fiscal cliff resolution.  But the market may want to concern itself more with some of the least positive potential outcomes.  One of these is that large advances in equity prices over the last several years and certainly advances this year have led to a potential over subscribed market.  That does not mean there are not reasonable explanations to explain valuations, but there are simply fewer participants to take the markets higher.  And if the cash on the sidelines is the only hope, be aware most of investor reserves represent a generational cash stockpile reflecting loss aversion;  people would prefer avoiding losses than acquiring gains.   Thus the greatest potential outcome for the market may be down whether the fiscal cliff crisis is resolved or not.

QRiskValue Over/Under

Monthly QRiskValue Over/Under

AAPL   Over
BAC     Over
GOOG  Over
GS        Under
IBM     Under
MSFT  Over
F           Over
PFE      Over

Cliff or Not to Cliff

It is much easier to win an election than it is to redistribute wealth.   Since any deal before the Fiscal Cliff deadline is unlikely to be truly effective over much more than short term period, it is clear there is limited leverage in the deadline.  Though we are dealing with economic issues facing the country, the real story is about political gains and losses.  Thus there are two different dimensions here.  One economic; jobs and growth.  The other is political; using the Fiscal Cliff to get party control in Washington.

The Democrats have just emerged from a general election with a limited momentum they believe has some sort of mandate to drive a deal favorable to their agenda.  The Republicans, having been humbled by a changing political demographic, are trying to walk a fine line between looking reasonable without alienating their only real constituency, a sort of Ayn Rand meritocracy which blends fundamentalism with general accounting.

Now the Democrats may believe the last election gives them the upper hand but that trade is over.   And since Obama  had a  sort of non confrontational bargaining approach in his first administration, they are hard pressed to deliver before the deadline.

So the choice for both parties is clear.  Go over the cliff.  And indeed it may be the right decision for both.   But since this battle is a political one and not economic, the winner will ultimately be the party with the greatest ability to play the outcome and not have the outcome play them.  Going into that event the Democrats have Obama and the Republicans have nobody.    

Bear Side

Presenting the Bear Side, lets go to numbers. 

October marked the end of the attempt to test the highs made five years ago in 2007.  Market should decline for 60 months some 800 to 900 points in the S&P and then, if that is not bad enough, test those lows in 2022.  I guess that is another lost decade but at least interest rates will be low.  Refi at 0 with no points and the bank will throw in a vacant home in another state.

Looking back; October 1997 had a low 844 and 2.5 years later market made all time high of 1574 in 2000.  Market then declined to 767 in October of 2002 completing the 5 year cycle.  To speed this up, the market made a high of 1587 in October of 2007 and  made a low of 666 in March of 2009  and then we are right back up at the top of the previous paragraph.

But the Bears believe not just in cycle dirt, but in potential world class screw ups.  Bears believe any multiple combination of hits behind the four doors of the Apocalypse will send equities into a serious down.  Door one; Fiscal cliff.  Door two; Europe.  Door three; Middle East.  And door number four;  Chinese Recession.

 

Downside Hope vs Upside Cash

Markets are rarely obvious.  Apparently either are elections.  Though one might postulate the Wall Street brains may have been convinced Romney would win and sold off the market the days following the election, but that is too obvious.  The probable cause is more of a battle between those who truly believe we have higher prices on hope, and those who are sure the cost of carry is going continue to pay.   After all, in the search for returns,  its not whether one can find value, but where one can play the spread between the cost of money and the speculation on companies for modest returns over zero borrowing costs. 

But there is the fiscal cliff.  Everyone is talking about it so you know its over hyped and part of a self fulfilling temporary flagellation with an eventual hindsight view deserving an even greater upside narrative.    The markets are almost always wrong about the future but always right about the past. 

QRiskValue Over/Under Valued Eight

AAPL   Under
BAC     Under
GOOG  Over
GS        Under
IBM      Under
MSFT   Over
F           Under
PFE      Under

Electorate, Bettors, and Investors

Folks on the Romney side are upset with data coming from Nate Silver and his Fivethirtyeight blog.   Over the last few days Obama has ticked up in his chances to be re-elected according to the models Silver uses to predict the probable outcome.  Now there is now need to fully understand the make up of the methodology used to arrive at these projections but it is interesting how vitriolic the response has been to the blog's conclusions.  Republicans loved Silver when he was predicting their prior victories in various races but have attacked his conclusions of late due to the nature of their conservative bias. 

Silver is not a partisan but merely revealing the probability of Obama defeating Romney using the information he gleans from data mining certain criteria.  He is not telling you what is going to happen but what the models say is most likely to happen.  Vegas does not tell you if the Chicago Bears will win the Superbowl but only the chance of them winning; between 1/10  and 1/12 right now.   Silver says there is roughly an 8 in 10 chance Obama will win the electoral college and a 50/50 chance he will win the popular vote.

Now Vegas is a bit different in the fact that it does not try to predict the winner as much as putting up a line which will encourage the most betting on both sides.   Predicting the path of where the electorate, bettors, and investors with travel are correspondingly determined by votes, bets, and price movement.  Building models on how to capture a probable path is what many of us have successfully done.  But everyday is different and probabilities are not realities.  

Free Market Carny

The last of the political spin cycles will be going on over the next few days as the talking heads move to elect their man.  Business channels such as CNBC are trying to move Romney cheering to a new level as evening hosts  Kudlow and his sidekick, Lisa Something,  try to connect concepts of a fee market America with own ability to reason.  It might be interesting if it were not so pathetically shilled.  But I like watching Kudlow because its like watching a carny trying so sell you a product based on sincere nonsense.   You'd never by the crap but its fun to watch.

So markets have two more months to make everyone happy.  The moves have been anything but exciting and the bulls still dominate.  Fed forced feeding keeps rates down and balloons asset prices while sellers standing in front of the Bernanke equity train are thinning.  Bears know the action requires quick feet and if there are any downside victories ahead they will come out of nowhere.