Diary of a Financier

The fiscal cliff mini deal & tactical recalibrations

In Capital Markets, Politics on Wed 2 Jan 2013 at 22:35

Beyond the 11th hour, the US House of Representatives passed the Senate’s draft of a fiscal cliff resolution last night, and President Barack Obama signed the bill in the early morning. The mini deal resolves the tax/revenue portion of negotiations, deferring the deadline for government spending sequestration and debt ceiling increases until late February or early March. Far lighter than Street expectations, the tax deal in isolation will only trim an estimated 1% from 2013 GDP vs. 2.75% worst case or 2% best case projections. It will also raise 20% less revenue than feared over 10 years.

Republicans are largely framing this as a Pyrrhic loss (sic) for their caucus—a compromise that they hesitantly conceded out of concern for the greater good. (The actual vote fell neatly in accordance with partisan lines, with Majority Leader Eric Cantor predictably voting “nay”; the most public acts of concession were on behalf of Speaker John Boehner and former VP candidate Paul Ryan, who both voted “yea.”)

There’s a quid pro quo here, apparently, and the GOP’s spreading the word that they now have leverage in the spending debate. That’s delusional for a few reasons. Mr. Obama asserted that there would be no debate regarding the debt ceiling—he’ll exercise unilateral powers to increase the Treasury’s budget, which may or may not be within his authority. Regardless, the Republicans have no leverage on spending because Democrats hold the same trumps they did coming into YE12:

  1. Two more Democrats are being sworn into Congress January 20, and
  2. Sequestration’s deepest cuts would hit military/defense

So, the White House can now refuse any compromise, either extracting its own desired terms or leaving Republicans with the blood of their own sacred lambs (like 800,000 Pentagon jobs furloughed).

~~~~

At the end of the day, we’ll revisit these shenanigans all too soon. The highest stakes battle remains, with $600B in cuts being demanded at the starting line. When I peer across asset classes today, I see some markets acknowledging the fiscal contraction just ahead… and others willfully ignoring it.

For example, equities rallied in blissful exuberance: SPX +2.54%, COMPQ +3.07%, and DJIA +2.35%. The Dow printed its biggest gain in history to open a year (+308 points).

PIMCO’s Bill Gross did an interview on CNBC today, and he attributed the risk-on rally to central bank printing, not last night’s fiscal cliff resolution-lite, which he said is actually a barb to GDP growth. Increasingly a raging Cassandra, he’s bearish, and he ended his interview by saying:

‘The economy and markets are being affected negatively by this deal… Someone needs to start asking where are the bond market vigilantes? Where are the stock market and foreign exchange vigilantes?… We have a $60T forward entitlement that isn’t being address, and at some point, that AAA rating has to be addressed.’

For something like 3 years now, Mr. Gross has mistakenly conflated the economy and capital markets—specifically stocks. Indeed, this mini tax deal is negative for the economy. Any spending cuts that emerge from February’s fuzzy deadline are negative too. Bottom line is that markets rallied because markets expected worse. A good deal of uncertainty remains, but a great deal of certainty has returned. Capital formation and investment projects now have the tax rates necessary for inclusion in their discounted cash flow analyses. (Thank gawd. Now our valuation models can predict the future with certainty. It’s so scary when you don’t know exactly what the world will look like in 10 years. /sarcasm )

Seriously though, I can’t call equities wrong. What’s really happened here? Tax rates for most incomes, capital gains, inheritance, etc. are increasing, but they’re increasing far less than the Street expected. That’s bullish. The market rarely discounts such information in one session alone; momentum usually drives the trend for days or weeks thereafter; pent up demand can push it for weeks or months. These are technicals, the collective psychology of the market, which trumps fundamentals over the short term. Stocks have always been the dumb money, as is widely acknowledged. It seems the stock market’s short term-ism increases every year, and as a consequence, a failure to see beyond the quarter, the month, or the daily close has made equities more susceptible to missing crises. Eventually, SPX will look up and see fundamentals on the horizon, but indices are busy digesting this bit of certainty right now.

Bonds are the smart money, the rulers of the universe. They’re the first to catch crises, partially because of market dynamics (e.g. spreads and liquidity) that force buyers into a long term orientation. Bill Gross is a bond guy. He’s more of an investor than a trader, so I understand that he approaches these discussions from a long term focus. He’s been around capital markets for a long time—too long to suggest stocks have it wrong in the short term, too long to challenge the causality between this fiscal cliff mini deal and the risk-on rally. For a while now, I’ve challenged Mr. Gross’ understanding of the economic machine; now I’m questioning his objectivity. If he has such conviction in a long term, bearish thesis that he chooses to forgo a risk-on rally, why pretend to ascribe the origins of such a rally? After all, his research efforts make him an expert in the long term, not the short term. Thus, his condemnation of the rally exposes a couple cognitive biases: Mr. Gross is either anchoring to his thesis or CNBC’s asking him to capitalize on an illusion of validity (i.e. an expert bias).

~~~~

So, where’s my head at, tactically and strategically? I must admit, I acknowledged the [small] probability of a deal, but I didn’t expect a deal this dovish. I had considered it as an upside tail risk, but I’m surprised tax hikes undershot the Street’s best case scenario. Analogues across multiple asset classes had led me to a bearish skew before the New Year. Yet, for lack of conviction and recognition of the magnanimous, binary risk at hand, I came in only slightly underweight my benchmark,¹ as mentioned. I did nothing today except close my VXX exposure, bringing me up to market weight.

I’ve recalibrated many of the analogues I’ve been following. Some are still tracking as planned, others have faded into the footnotes in my gameplan. (A good reminder that, as in other complex systems, there’s no panacea in capital markets. Evidence that history rhymes, but its never the same twice.)

First, the SPY 2007 vs. QQQ 2013 analogue, which has served as a worthy guide for months, has been laid to waste. Today’s gap up on the open adds asymmetry to the comparison that can’t be explained away. The daily chart shows this development under a microscope:

SPY 07 v QQQ 13 analogue (daily)

SPY 07 v QQQ 13 analogue (daily)

In being a little more long-term, weekly charts usually send stronger, more reliable signals. This analogue’s weekly gives a little more leeway, but were the downside not to reassert itself immediately next week, this one goes into the recycling bin:

SPY 07 v QQQ 13 analogue (weekly)

SPY 07 v QQQ 13 analogue (weekly)

As ever, I’ll keep this self-similarity in the back of my mind until then, because it warns of a major market top–albeit a diminishingly small likelihood now. In the meantime I’ve transitioned to following the indices in their own right. To wit, today’s spike in SPY was a breakout above a short term symmetrical wedge. SPY is maintaining that long term rising wedge pattern, trying to rally up to trendline resistance ~$151 (+3.5%). The only reason I wouldn’t start selling at that target is if SPY reverses out of its 3x bear divergence:

SPY daily

SPY daily

QQQ still has to contend with its own bear divergence, plus a classic Head & Shoulders, wherein right shoulder resistance lay between $68.15-68.75 (23.6% Fibonacci retracement):

QQQ daily

QQQ daily

I see little in way of positive posture from the NASDAQ, and I care not to mess with it.  I expect tech–specifically Qs–to underperform in the forseeable future.

A false rally in VIX has to occur later this week to keep me following its 2011 analogue. I’ll follow the intraday technicals for an objective vote, but I can’t imagine vol peeking higher amidst this risk-on backdrop. Regardless, VIX’s lows in the mid-teens will return in the coming weeks, then we should see a lift higher by the end of January, before a spike into 30s.:

VIX 2011 v 2013 analogue (daily)

VIX 2011 v 2013 analogue (daily)

I’m a bit more confident that this 2011 analogue will recouple in the intermediate term, because the indicators, the chart construction, the futures’ term structure, and the story around the sequestration descend upon the same hypothesis. In fact, the rally in equities makes it all the more palatable, since everyone’s starting to look the other way. VIX is an equity-linked derivative (specifically a derivative of a derivative), so equity sentiment matters.

The precious metals were along for the ride last night into this morning. Silver was up 3.5%; gold about half of that. Their gains eroded as the day wore on, closing +1.87% and 0.71%, respectively. I look at this as a good example of different asset classes’ different time horizons. GLD & SLV are looking further ahead than equities. They see political gridlock and spending cuts just ahead, and the latter is a threat to the notion of fiat debasement.

The continued appreciation in the SPX/Gold ratio (S&P 500 priced in Gold) is a wonderful development, and I’ll reiterate, it’s a clear signal that there’s organic growth underway–growth devoid of the exogenous, artificial stimulus of reflationary monetary policy. I’m not sure if it will continue, but I’ll be watching Gold’s 2009 precedent as a guide to see if the analogue breaks down. Right now, GC is still tracking tightly, and it should bottom by next week and start a long term reversal higher. Monthly indicators align as well, lending the analogue more credibility²:

GC 09 v 13 analogue (daily)

GC 09 v 13 analogue (daily)

–Romeo

¹Portfolio beta at 74 bps vs. 76 benchmark after Monday, when I opened an Emerging Markets pair trade that I’ll likely keep on the book for the intermediate term, and I added to the little SPY position I had remaining for a quick trade on bullish intraday signals.

²Updated chart 1/4/13.

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  1. […] continue the 2013 New Year outlooks I presented earlier this week, I had to quickly mention developments in macro asset classes like the 10y US […]

  2. […] within the S&P 500 (SPX).  Since SPX gapped up on January 2 in the wake of the fiscal cliff mini-deal, this pattern is like an island floating above everything else on the 30-minute chart.  The […]

  3. […] Back in August 2012, I discussed the second test of SPY’s weekly bear divergence. It was an attempt at a bull reversal, but it failed [predictably] in September, and SPY corrected for the 4th time since 2009. Sequentially, these corrections have arrived with increasing frequency, but also decreasing severity. Such a coiling rally embodies a classic rising wedge, a bearish pattern I’ll keep in mind as SPY finds its trendline resistance >$151: […]

  4. […] I raised cash in preparation for the fall, in accordance with intermediate term targets that were premeditated. In retrospect, that conservatism feels ill-conceived–why sell into a 3% rally to avoid a […]

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