Repeating History With the Fiscal Cliff

When the can has been kicked down the road before, it's meant a downside correction and V-reversal

   

The market action this week smells more and more like July and August of 2011. We hate to draw too many parallels to that period but the similarities are striking. There have been fast corrections to the downside followed by V-reversals back to resistance all while the actual issues facing the U.S. economy are postponed rather than solved. This kind of price action is actually a little bearish despite the upward trend. V-reversals happen when traders are uncertain and are changing their positioning very quickly.

Consider that much of the decline in August of 2011 was due to the debt ceiling debate of that year’s “Fiscal Cliff”, which is an issue for the U.S. again this time. The debt ceiling is the most important part of the 2012 cliff and it was not resolved or even addressed by this week’s votes in Congress. This should be an urgent issue for traders because the ceiling has already been breached and the clock is ticking. Another downgrade to U.S. debt could occur if a resolution isn’t found quickly, which would spoil this week’s rally.

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Consider the chain of events in July of 2011: On July 19th, the so-called Gang of Six prepared a proposed solution for the debt ceiling crisis. It was not attractive to Republicans or Democrats, but it was progress towards a resolution and the market rallied. On July 21st, Speaker Boehner and President Obama were said to be very close to a compromise to raise the debt ceiling after meetings between the two camps. The market rallied that day on speculation that a solution could be reached. However, by the time the debt ceiling was raised on July 31, the market was just about to fall off its own cliff. This all sounds very familiar.

So why are traders buying so much right now? There could be a number of factors that are driving the buying – not the least of which is momentum from high frequency traders who tend to dominate market volume on a day to day basis anyway. Traders are also back from vacation and may also be doing some catch-up buying that they would have done last week if not for the holidays. Because traders are back to the work the market action this week and next should be informative as volume rises and either confirms or disrupts the rally.

It is also important to note that there are differences between now and then including European fiscal machinations and bailouts that were headlines in July of 2011. However, the similarities are striking enough to give us pause as the S&P 500 reaches resistance again. This shouldn’t be construed as a guarantee that prices will fall in the short term. It’s possible that all the stars will align and fourth-quarter earnings season – which kicks off later in January – will be rosier than expected. In the meantime we prefer to hedge our bets a little and stay balanced in our trades.

John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.


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