The Dow lost -158 as investors moved to the sidelines ahead of the fiscal cliff deadline.

Market Statistics

The markets opened lower and recovered only briefly at 10:30 when the White House announced there would be a meeting with congressional leaders at 3:00. The markets traded sideways on low volume ahead of that meeting. When news broke that the president was not making any new offers in the meeting but only repeating his prior position the bottom fell out of the market. The Dow closed down -158 at 12,938 but the news kept coming. When the meeting broke up and nobody stepped in front of the cameras to announce a plan the futures imploded in afterhours trading.

The Dow futures sank to 12,773 in afterhours, an additional -90 point decline, and the S&P futures fell to 1382, an additional loss of -14 points. There will be new headlines over the weekend but without a dramatic change in posture the market will open significantly lower on Monday.

Dow Futures Chart

S&P Futures Chart

The president reiterated his call for a tax hike on anyone making over $250,000. He also demanded another extension of unemployment insurance benefits for two million people. Those extended benefits from the last deal expire on January 1st. He wants to structure a framework for talks on spending and postpone the fiscal cliff spending cuts for 90 days until a compromise can be reached. Basically that is another can kicking exercise to get us past the December 31st deadline. He also wants the debt ceiling to be extended another year until a comprehensive balance between new taxes and spending can be reached. Since they have had more than a year to work on that since the last debt ceiling battle and nothing has happened I would be very doubtful it would happen in the next year.

The market wants to see the current tax cuts extended and some progress on spending cuts. Claiming a cut in spending for 2013 because the Iraqi war ended for us a year ago does not fly. Investors are smart enough to see that is just smoke to cloud the process.

The House has been told to be ready to vote on something at 6:30 Sunday night but as of Saturday afternoon there are no new proposals to vote on. The president asked congress to put his proposal to a vote but that was rejected by House leaders.

Without a miraculous turn of events over the weekend it appears we are going over the cliff on at least a technical basis. I am sure there will eventually be a resolution but nobody can predict a timeframe.

Treasury Secretary Tim Geithner warned congress on Wednesday the government would hit the debt ceiling on Monday. That means the Treasury Dept will have to start cutting back on payments to non critical things like retirement funds and state grants. They can come up with about $200 billion in petty cash from these "extraordinary measures" but that will only fund the remaining government operations until late February.

That means any fiscal cliff deal may now involve a debt ceiling component. Since the House is the only legislative branch that can raise the debt ceiling the leverage has shifted somewhat back in favor of Speaker Boehner and the republicans. The Speaker can use that trump card to offset the positions held by the president BUT the president has the bully pulpit. You can bet he will immediately begin blasting the republicans for threatening to shutdown the government.

The president started its barrage late Friday when he held a press conference at the White House saying "The American people are not going to have any patience for a politically self-inflicted wound to our economy." The rest of the press conference was spent dumping on Congress for allowing this stalemate to happen.

He also said, "The time for immediate action has come." Since nothing ever gets done until the last minute that means we could see a flurry of activity and a cobbled together stop-gap measure on Sunday that extends the tax cuts, puts more time on the clock and extends the cliff another few weeks.

The White House also said the president will be on "Meet the Press" on NBC on Sunday morning. You can bet he will be dumping on Congress and trying to increase the urgency of the moment.

The only thing we know for sure is that without a compromise deal sometime this weekend the tone of the debate will escalate sharply next week. This will be seriously market negative as we saw late Friday.

The economic reports on Friday were positive but not strong enough to overcome the fiscal cliff cloud over the market. The ISM Chicago, formerly the PMI, rose to 51.6 in December. That is up from 50.4 in November. This is the highest level since August but still only barely above the contraction territory below 50.

The new orders component rose from 45.3 to 54.0 and a decent rebound out of contraction territory. Order backlogs did not show the same improvement with a further decline from 49.6 to 46.9. Employment declined sharply from 55.2 to 45.9 and the first time under 50 in more than six months.

The improvement in the Chicago area is due mostly to the surge in auto production. Hurricane Sandy destroyed 250,000 cars and production is being accelerated to cover those replacements.

Chicago ISM Chart

The Pending Home Sales Index rose +1.7% from 104.6 to 106.4 for November. That is a new two-year high. Home sales for the entire nation are up +9.8% over the last 12 months and +30% over the recession lows. The gains in November came mostly from the Northeast (+5.2%) and the West (+4.2%). The South showed no gains and the Midwest squeaked out only a +0.1% gain.

The economic calendar for next week is headlined by the national ISM Manufacturing and the various payroll reports. The ISM is expected to come in at 50.0 and possibly move fractionally into expansion territory over 50. Without a major upside surprise the ISM report could be market negative because it is not showing a positive trend.

The ISM Nonmanufacturing Index is due out on Friday and the headline number is expected to decline slightly from 54.7 to 54.0.

The payroll reports are going to be of interest because they should show a rebound from Hurricane Sandy. If that rebound does not appear new jobs decline it would suggest the economy slowed ahead of the fiscal cliff deadline. The ADP report is expected to show a gain of +125,000 private sector jobs compared to +118,000 for November.

The Nonfarm payroll report is expected to show a gain of +143,000 jobs compared to a gain of +146,000 in November. Clearly neither if these reports is telegraphing any economic strength. If the result of the cliff negotiations is less than satisfactory the economy could quickly slip back into recession.

The FOMC minutes on Thursday are not expected to be earthshaking since Bernanke held a press conference after the FOMC meeting.

Economic Calendar

Another problem facing the economy is the Dairy Cliff. Milk now costs an average of $3.65 per gallon. If Congress does not act quickly and pass the Farm Bill we could see milk prices rocket to between $6 and $8 per gallon. The problem is the way the farm bill is constructed. In 1949 the government established some guidelines for farm product pricing. The Dept of Agriculture committed to buying milk and cheese from farmers if prices decline too far. This keeps a bottom under prices. The bill also contains subsidies for producers to insure a profit and keep dairy products flowing. If farmers can't make a profit they will sell their cows and milk production slows.

It seems like a contradiction of efforts with subsidies to keep prices low and guarantees to keep them from going too low. The Farm Bill renews every five years. If the bill was allowed to expire the laws governing farms, commodities and subsidies revert back to those in existence in 1949. Clearly farming and the economy has changed over the last 60 years.

Congress does not want to deal with the Farm Bill because of the subsidies. That is money paid out to guarantee farmers grow enough of the right kind of crops. The entire Farm Bill needs to be rewritten to fit the current environment but that would involve killing off some of the sacred cows in the subsidy program. The farm lobby is a powerful lobby and when you add to it the milk lobby, beef lobby, etc, it is tough for lawmakers to actually change the laws without making a lot of people mad.

Lawmakers also don't want to be seen voting for billions in new subsidies when every headline is screaming spending cuts. However, if they let milk prices rise to $7 a gallon there will be millions of mothers burning up the congressional switchboard.

There was one cliff averted on Friday. The container cliff as it is being called was postponed until February 6th. Dockworkers were poised to go on strike for the first time in 35 years at ports from Maine to Texas. A strike would have closed ports handling about 45% of the country's commerce. Talks had collapsed last week after a deadlock on container royalty fees. Those fees were instituted in 1960 when containers began shipping in volume. They were to offset job losses by dock workers no longer needed to unload ships. Containers are now almost exclusively the only method of shipping and dock workers are few. However, those royalty payments continue to rise and amounted to $211 million in November alone. The International Longshoremen Association gets 10% and their union members get the rest.

The average payment to ILA members is $15,500 and very few of those receiving the payments today were even alive in 1960 or at least not of working age back then. Only 168 of the 3,281 ILA workers in NY and NJ were working at the port in 1968 and the first year of payment. In the Savannah area members got $36,000 per worker in 2011. Royalty payments continue to increase but the number of union members continues to decrease. The contract deadlock is because those subject to container royalties are objecting to the constant increase in royalties. They want to cap them. These workers are already some of the highest paid union members in the country.

Moving from cliffs to mountains Bloomberg reported that corporations have sold a record amount of bonds in 2012. They raised a mountain of nearly $4 trillion in cash at record low interest rates. Corporate borrowing costs fell to a record 3.27% last week thanks to the Fed's QE programs. Corporations sold $1.19 trillion in debt in Q1, $721 billion in Q2, $996.8 billion in Q3 and $981.4 billion in Q4 for a total of $3.98 trillion.

Investors poured $475.3 billion into bond funds while U.S. equity mutual funds saw outflows of $154 billion YTD in 2012. These are astounding numbers and eventually the trends will reverse to some extent. The decline in mutual funds was brought about by the financial crisis, flash crash, etc. Baby boomers facing retirement can no longer risk another 50% drop in the equity market and corresponding 50% decline in their retirement accounts. As the boomers retire there will be an influx of new workers and new retirement accounts started. Unfortunately that is going to be a long process.

Fund Flow Chart

When all this money starts rotating out of bonds and back into equities there is going to be a monster rally. Some would say a "generational" rally. It may not be anytime soon but once the global economy begins accelerating the race back into stocks is going to be very strong. The key of course is picking the turning point where investors decide stocks are suddenly a buy again.

There was no stock news on Friday. It was a holiday week and volume was running at about 50% of normal until the afternoon crash. Everyone reporting stock news was on vacation and companies were not putting out press releases.

Next week that should change. We will get the last flurry of earnings warnings ahead of the Q4 earnings cycle that begins with Dow component Alcoa (AA) on January 8th. Earnings before Alcoa include Family Dollar (FDO) and Sonic (SONC) on the 3rd and Mosaic (MOS) and Finish Line (FINL) on the 4th.

We have officially entered the silly season where all the major analysts publish their price targets for the coming year. As of Friday's close only one target is below the S&P close at 1403. Quite a few are well above the current level and that suggests the market is too bullish about 2013. I am assuming everyone is expecting the cliff to be resolved and our economic growth to continue.

The economic growth part may not be a valid assumption. The U.S. typically falls back into recession every 3-5 years. That means we could be close to another dip and that makes a positive resolution to the fiscal cliff even more important. On the bright side another recession now would be the normal kind that is typically followed by a strong rebound.

2013 S&P Forecasts

I updated the 2012 forecast table using Friday's close at 1403 to show how far away each analyst was for 2012. These were the year end targets as of March 1st, 2012.

2012 S&P Forecasts

I could spend a lot of time dissecting charts but we are still hostage to the headlines and whatever happens next week will be related to what happens in Washington over the next two days. Monday is the deadline for the tax cuts and they have to do something or taxes will go up on everyone. The Alternative Minimum Tax or AMT will hit an additional 20-25 million people if they don't extend the tax cuts and include the AMT. The AMT alone will remove around $80 billion from the economy AND it is retroactive. It will be for 2012 taxes and due in the first quarter. Nobody withheld for this increase in AMT so it will be a very painful cliff result.

This is one reason the market will be so reactive on Monday and Wednesday to what happens over the next couple of days. The impact could be traumatic to individuals and the economy.

There is also the potential impact of tax selling on January 2nd. Investors that exhausted deductions or refrained from selling until the new tax year arrives will be free to do that in January.

Couple that with the potential for a post cliff sell the news event and the market could remain very volatile. Most investors have been pricing in a post cliff rally for the last two months. If that rally does not appear we could see a rush to the exits.

Determining market direction in this environment is a fool's errand.

The S&P closed just above 1400 with critical support at the 200-day at 1390 and the November 28th low at 1385. A break under those levels would be very bearish. Resistance is 1450 and that would require several days of strong gains to reach.

Remember, the S&P futures dipped to 1382 after the close on Friday. Unless something positive happens in Washington on Sunday night that decline could continue.

S&P Chart

The Dow sank to close at a three week low and right on light support at 12,935. This level has no specific significance and but any further decline suggests a target of 12,500.

The chart has little bearing on market direction for next week. It is all dependent on the fiscal cliff headlines. However, because the blue chips have been used as a safe deposit box for cash heading into yearend we could see a dip late in the week unless a favorable resolution is achieved.

Dow Chart

The Nasdaq clung to the last thread of support with the 2960 close on Friday. That was a four week low and the internals are terrible. Apple is on the verge of breaking below $500 and Google missed closing under $700 by only two cents. Amazon closed at a four week low after retail sales for the holiday period came in weak.

It is very possible there are a large number of investors clinging to hope in these stocks and just waiting for a new tax year to take profits.

If the Nasdaq moves below 2960 the next target would be 2900 and then 2800.

Apple Chart

Google Chart

Nasdaq Chart

The Russell 2000 remains the best performing index. Apparently fund managers are still betting on the January Effect even though that rally started back around Thanksgiving. That is where fund managers shift into small caps at the beginning of the year in hopes of getting a better return on their investment dollar. A $10 gain in a $50 stock is +20% but a $10 gain in a $10 stock is 100%. Many investors try to front run the funds by purchasing small caps after Thanksgiving.

Unless the Russell breaks below support at 820 I would still be in buy the dip mode.

Russell 2000 Chart

Tis the season for window dressing. Actually that season ended last week but you can bet there will be a few stocks that get bought on Monday to dress up portfolios. Normally funds receive large inflows of retirement cash at the end of December and the first few days of January. For those funds that get money this year I would expect them to hold the cash until the fiscal cliff resolution appears. I can't see them rushing to put that cash in the market ahead of what could be extreme volatility. I do expect them to buy the dip.

As an example of the uncertainty surrounding the cliff negotiations and deadline Jon Najarian, a major market maker in the options market and frequent quest commentator on CNBC said he was totally in cash. "For the first time in 31 years in the market, I am completely out of everything. I see no reason to stick with longs and no reason to get short either."

That sums up my feelings as well. The potential for some strong volatility is nearing a 100% probability. Even if they get a fiscal cliff deal the debt ceiling is next in the hopper and it will prove to be much more disastrous to the markets than the fiscal cliff. We will be just trading one problem for another.

Conversely there would also be a good chance of a rally if they suddenly announced a solution that kicked that can down the road along with the fiscal cliff. The trouble is we just don't know how to position our trades. When in doubt, stay out.

Informed investors know that an opportunity lost is far less damaging than money lost. You can miss a good trade and feel bad but making a bad trade will make you feel worse.

I think we are very close to a tradable period in the markets once the cliff headlines fade and the focus returns to Q4 earnings. Wait for the opportunity.

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Jim Brown

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