Catching the falling knife

With the S&P's downgrade of US debt a reality, the question now is finding and trading the bottom on the market.

The S&P 500, as well as nearly every other stock index, was devastated last week. Fortunes were made and lost, and the careers of many amateur traders likely came to an abrupt end. It still remains to be seen, however, exactly how much more downside is left.

It's very likely that a large part of the selling we saw last week was insider trading based on advanced knowledge that the downgrade would occur. This could mean that the majority of downside is already priced into the market. It's also possible that this is just the beginning and we have a long way to fall yet.

Personally, I believe the most severe selling has already happened. I think it's likely that Monday sees an additional reflex selling flush that possibly even lasts into Tuesday. From there, I think it's possible a short term bottom on the market is in.

Alternatively, fear and panic, as well as hedge funds liquidating their holdings, could drive the markets substantially lower. I think this is the least likely scenario as it assumes that large financial institutions have not yet begun to sell.

In any case, I will be trading carefully. I mentioned several times last week that I would not be holding any large positions into this kind of uncertainty and that continues to be the case. I will be looking mostly at short term scalp trades and closely watching for signs of a low in the market. Once the market bottoms, we should see a substantial relief rally.

S&P US downgrade--highlights

Below are some highlights from the S&P's recent downgrade of the US's debt rating. Also, be sure read my thoughts on the circumstances that lead to the downgrade here.

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"We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade."

"The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year's wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability."

"Standard & Poor's takes no position on the mix of spending and revenue measures that Congress and the Administration might conclude is appropriate for putting the U.S.'s finances on a sustainable footing."

                       

"The [Budget Control] act further provides that if Congress does not enact the committee's recommendations, cuts of $1.2 trillion will be implemented over the same time period. The reductions would mainly affect outlays for civilian discretionary spending, defense, and Medicare. We understand that this fall-back mechanism is designed to encourage Congress to embrace a more balanced mix of expenditure savings, as the committee might recommend.

"We view the act's measures as a step toward fiscal consolidation. However, this is within the framework of a legislative mechanism that leaves open the details of what is finally agreed to until the end of 2011, and Congress and the Administration could modify any agreement in the future. Even assuming that at least $2.1 trillion of the spending reductions the act envisages are implemented, we maintain our view that the U.S. net general government debt burden (all levels of government combined, excluding liquid financial assets) will likely continue to grow. Under our revised base case fiscal scenario--which we consider to be consistent with a 'AA+' long-term rating and a negative outlook--we now project that net general government debt would rise from an estimated 74% of GDP by the end of 2011 to 79% in 2015 and 85% by 2021. Even the projected 2015 ratio of sovereign indebtedness is high in relation to those of peer credits and, as noted, would continue to rise under the act's revised policy settings."

"Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act. Key macroeconomic assumptions in the base case scenario include trend real GDP growth of 3% and consumer price inflation near 2% annually over the decade."

"When comparing the U.S. to sovereigns with 'AAA' long-term ratings that we view as relevant peers--Canada, France, Germany, and the U.K.--we also observe, based on our base case scenarios for each, that the trajectory of the U.S.'s net public debt is diverging from the others. Including the U.S., we estimate that these five sovereigns will have net general government debt to GDP ratios this year ranging from 34% (Canada) to 80% (the U.K.), with the U.S. debt burden at 74%. By 2015, we project that their net public debt to GDP ratios will range between 30% (lowest, Canada) and 83% (highest, France), with the U.S. debt burden at 79%. However, in contrast with the U.S., we project that the net public debt burdens of these other sovereigns will begin to decline, either before or by 2015."

"The outlook on the long-term rating is negative. As our downside alternate fiscal scenario illustrates, a higher public debt trajectory than we currently assume could lead us to lower the long-term rating again. On the other hand, as our upside scenario highlights, if the recommendations of the Congressional Joint Select Committee on Deficit Reduction--independently or coupled with other initiatives, such as the lapsing of the 2001 and 2003 tax cuts for high earners--lead to fiscal consolidation measures beyond the minimum mandated, and we believe they are likely to slow the deterioration of the government's debt dynamics, the long-term rating could stabilize at 'AA+'."

Choosing is not a choice

Friday night Standard & Poor's downgraded America's debt rating from AAA to AA+. The "bipartisan" budget deal worked out by US lawmakers last week apparently doesn't pass muster.

This should come as no surprise. The deal is the concoction of a government in gridlock and political parties without the will to make tough choices and risk alienating their most vocal and influential backers. Faced with the option of raising taxes or cutting spending--two very sacred cows--lawmakers chose none of the above.

The situation in the US is unsustainable because neither side of the debate is willing to concede anything, but now something has to give. Spending must be matched with revenue. When the two are out of sequence, the former must be cut or the latter raised--or better yet, both. A business can't survive without this careful balance and neither can a country.

In abandoning this basic principle, the US is now downgraded--and rightly so. Plans that appease everyone serve no one, and so it is with recent American fiscal policy. US lawmakers must prepare to make unpopular decisions or risk worsening an already grave budgetary tailspin.

Americans can either pay more for the services they receive or cut those services and pay less. Both options are valid, but a choice must be made as no combination of the two will work.

To be sure, the coming days and weeks will be crucial ones. Lawmakers and economists will be working hard to assess the damage that has been done and determine a way forward. Traders like myself will be looking to understand this changing dynamic of the global markets and identify opportunities therein.

As this situation unfolds, follow my latest thoughts both here and on Twitter @thetsxpert.

--Read the S&P's downgrade report here--

Debt fears drive markets sharply lower

Today the S&P 500 gapped lower and continued to sell for the majority of the trading session. Traders and investors are clearly nervous that members of the US House and Senate will not be able to reach an agreement in the short term.

As I posted yesterday, I expected increased volatility as we near the August 2 deadline--and volatility usually means selling. However, even I was surprised by the ferociousness of today's sell-off.

Technically, the daily $SPX chart suffered a lot of damage. Both the 61.8 fib and the 50 moving average support levels were broken and prices closed near the lows of the day. However, it's difficult to put much meaning into this sell-off as it was driven purely by fear and not technical factors.

Fear drives the SPX daily below several key support levels

Whatever the reasons, I'll continue to use the charts as my guide. The markets are now very oversold and due for at least a short term bounce, but when that will happen is anyone's guess. My suspicion, as I've written about previously, is that once a debt agreement is made in the US the markets will rally.

Irregardless of an agreement, the SPY filled a key intraday gap today and that alone may be indicative of a bounce in the coming days. I personally took a small long position close to this level as I believe the markets are due for some short term relief. If we continue to fall tomorrow, I will re-evaluate this position based on several factors such as decline velocity and volume.

Gap filled after near continuous selling on SPY 10 min

Please note that even though today's sell-off surprised me, I did not expose myself heavily to the long side--instead opting to slowly accumulate on the way down. The advantages to this approach are minimal losses and the opportunity to buy stocks at lower levels. It is especially important to remain prudent when there are so many political and economic unknowns looming in the near future.

Going forward into the last half of this week, remain cautious and do not weigh yourself too heavily on the short side. The market is incredibly fearful right now and that usually signals that a turning point is near.

For my latest thoughts throughout the day, be sure check here regularly and follow me on twitter.

Markets continue to whip as debt negotiations stall

By this point it is cliched, but also accurate, to say that US debt ceiling negotiations are driving the markets. Events in the European Union, such as Greece's downgrade by Moody's last night, are now merely an afterthought to global traders--at least for the time being.

This morning the S&P 500 opened sharply lower as "bi-partisan" negotiations seemingly broke down over the weekend. But within 20 minutes of the opening bell, the S&P 500 easily started its climb back up to Friday's close at approximately 1345 on the SPX.

Market whips continue on the SPY 10 min chart

The day's rally lasted until midday, when the market topped at the gap-fill and started to decline, this time accelerated as US Republicans and Democrats traded barbs and publicly rejected each other's proposal. The drop continued for the rest of the session, with the SPX closing at 1337.43--more or less flat on the day.

Right now, the pattern on the daily SPX chart is the beginnings of bullish consolidation--a move up followed by several days of sideways trading within the range of the initial up-move. The longer we see sideways trading, the more likely that we eventually trade higher and approach the daily double top at 1370. This pattern confirms my suspicion that if a a debt resolution manages to pass the House and the Senate, the markets will rally as a sign of relief. And please note that the market does not care if it's a Republican or Democratic plan that passes, as long as this uncertainty comes to a timely end.

I have every confidence that a deal will pass by the deadline--to do otherwise without a contingency plan would be political suicide for all parties involved, not to mention the collateral damage to financial markets.

Going into the rest of the week, continue to follow the charts and consider news events only as a means of understanding the intraday whips of the market. We're still in an uptrend, though admittedly extended on the charts, and will remain so until we either hit resistance on the way up or break back to the downside. In the meantime, expect the whips and saws to continue until there is some sort of resolution.

Market Surges on QE3 Suggestion

Today Fed Chairman Ben Bernanke indicated that fiscal stimulus programs would be available in the future as needed, ala QE3. The SPY spiked sharply on this news as the US dollar dropped.

The Bernanke Effect

This should come as no surprise and is clearly the cause of yesterday's short-lived spike on the SPY at around 2pm ET. From my perspective, there is no way Ben Bernanke would ever say something the markets could interpret negatively. Fiscal stimulus comes in the form of soothing words just as often as it's monetary, and it's an area where the Fed has unlimited ammunition.

Prolonging the Fed's quantitative easing program means a weakened US dollar, and that will inflate the markets--just what we're seeing on the SPY intraday. It's unclear if this rally will hold, but a continually devalued US dollar will continue to push the markets up.

Despite all this seemingly bullish news, it's important to remember that Europe is still in trouble and those issues will not go away overnight. Any developments on this front (downgrades, defaults, etc...) will hit the Euro hard and therefore the markets.

In the event of a falling Euro and a rising US dollar, Ben Bernanke and his team at the Fed will have almost insurmountable task ahead of them in supporting this market. But until then, it's up up and away (for equities and commodities)!

Tuesday Market Summary

Today was very much the kind of day you'd expect after a big move up or down in the markets. Trading on the $SPY was interesting due to a few surprises, but was ultimately muted and confined to a range.

As a contrarian trader, I expect days like this. After yesterday's sharp drop, lots of amateur traders who read about it the night before piled on the short side this morning expecting to drop further. This is a perfect opportunity for the big financial players to whip the market around and stop these traders out. Also, keep in mind that this week is options expiration and erratic trading during this time is somewhat the norm.

Another reason why I expected this market pause is because of the technical support we hit at the daily 50 moving average on the SPY. Whenever you hit a major moving average or support level, you have to expect at least a small pause or bounce--just as I explained yesterday.

From an intraday perspective, the SPY opened the day down slightly at 131.69 and chopped sideways from there. The only surprise move came at 2pm ET when it was revealed that QE3 had been discussed as per the FOMC minutes. The SPY spiked almost 1 dollar on this news but shortly after it was announced that Ireland had been downgraded by Moody's to junk status and this brought the market all the way back in, going as low as 131.36. The SPY closed the day around the lows at 131.45--basically flat.

News whips market up then right back down

This is a good example of why I trade technicals and not fundamentals. Traders who bought the FOMC QE3 spike ended up giving back all their gains shortly after when Ireland was downgraded. For this reason, it's very important to follow the charts and only look to trade the best support and resistance levels. This strategy is crucial to avoiding the whips and saws of the market as much as possible.

Tomorrow is more of an unknown to me. Since we've satisfied the small pause/bounce requirement after yesterday's big move, Wednesday could either resume the down move or have another small up-day. The only scenario that would surprise me is a big move up. And of course, this assumes we don't get any other surprise news out of Europe overnight or pre-market.

Keep following this blog and my twitter feed for my latest thoughts. It will be interesting to see how the market digests Ireland's downgrade overnight. In the next few days I expect to have more long and short ideas on the market and in stocks. I just need