Investor reaction to the U.S. election last week was worse than expected. I cautioned readers to expect some volatility on Wednesday but stocks sold off hard with a two-day plunge. It was the worst week for stocks since June with the S&P 500 index falling -2.4%. The NASDAQ composite was hit harder with a -2.59% decline. Believe it or not the U.S. dollar has continued to climb over the last few days but the dollar's rise has not stopped a rebound in precious metals as well. Bonds rallied as investors looked for safety and the yield on the 10-year U.S. bond fell to 1.6% and looks headed for the 2012 low near 1.4%.

As expected any economic data was completely overshadowed by the U.S. presidential election. The ISM services index saw a drop from 55.1 to 54.2 in October. That was slightly worse than expected. The real surprise was the University of Michigan preliminary reading on consumer sentiment, which rose again from 82.6 to 84.9. This is a new multi-year high for sentiment. It would seem that consumers are not concerned with the fast approaching fiscal cliff or what that might mean for their personal finances.

Europe was back in the news. Germany is the strongest economy in the Eurozone. The latest data showed that German factory orders and exports declined in September. Plus Germany's industrial production fell -1.8% in September, which was much worse than expected. The Eurozone's Autumn Forecast is suggesting the German economy will continue to slow down. The European Central Bank President Mario Draghi admitted that Europe's financial crisis was having an impact on Germany. A significant chunk of Europe is already in recession and if Germany falls into recession it's going to make things that much worse.

Speaking of "worse" the German Chancellor Angela Merkel uttered a depressing statement. Merkel confessed that solving the Eurozone crisis would take "five years or more". It's already been two years. I'm starting to wonder if the Eurozone is facing its own lost decade. The ECB and the Eurozone officials have promised a lot of solutions and very little action. Granted, I'm sure trying to get Eurozone members to agree on anything is like herding cats. Yet the lack of political will to tackle the hard issues and the "we have to look out for ourselves first" attitude could fuel more and more protests and civil unrest.

Greece was making headlines again. The country is teetering on the brink of chaos. Most analysts are still expecting Greece to leave or get kicked out of the Eurozone in the next six to twelve months. If that happens then there is no hope of the EU/IMF/ECB of getting its 240 billion bailout money back. Greece has a debt payment due this week of 4.0 billion euros (about $5 billion). They don't have the money. They are going to try and sell new debt to pay on the old debt. Now who is going to buy Greek bonds when nearly everyone thinks they will default? If the debt auction is successful it will likely be the ECB throwing more good money after bad. If the Greece situation isn't bad enough there are rumors that Spain is going to ask for a bailout soon. A year ago that was unthinkable. Spain is several times larger than Greece and it was considered too big to be bailed out. We have seen two years of pain as the EU struggles with the Greece bailout. What will a Spanish bailout do to the region?

Right now everyone is blaming the fiscal cliff for the stock market sell-off. Of course we've known about the cliff for months but with Obama's reelection on Tuesday there is suddenly a greater worry that Washington will not remedy this problem in time. We have less than 50 days before the "cliff" gets here on January 1st, 2013. The problem is that President Obama has already said that while he and congress would likely work something out it could take months. By that time we would already be over the cliff and falling into recession.

There are analysts who argue with the term "cliff" and suggest it will be more like a "slope". That may be true for the impact on the government and its citizens but the perception of going over the cliff by investors is all the reality we need to spark a major market sell-off?

Let me back up for a moment. You may have heard the term "fiscal cliff" but you don't really know what it means. It all started back in summer 2011. The U.S. was approaching its debt ceiling and a showdown between Democrats and Republicans actually pushed the U.S. to the edge of a credit default when they could not reach a compromise. The final deal was the Budget Control Act of 2011, which allowed the government to raise the U.S. debt ceiling by more than $2 trillion to about $16.3 trillion.

This 11th hour deal created a joint democratic and republican committee to agree on over a trillion in budget cuts spread out over ten years. If they did not agree by the end of 2011 then there would be a "fiscal cliff", the term was coined by Federal Reserve President Ben Bernanke, scheduled for January 2013. If no deal was reached by 2013 then the U.S. would suffer $1.2 trillion in across the board budget cuts with half coming from the defense spending and half non-defense (entitlements). To pay for this $1.2 trillion in spending cuts, taxes shoot up across the board for almost everyone. What Wall Street realizes is that one of the taxes the fiscal cliff creates is a higher tax on financial transactions, higher taxes on dividends and capital gains.

Washington's failure to solve the U.S. debt ceiling issue on time back in July 2011 sparked a 250-point sell off in the S&P 500 index (a -18% plunge) in less than a month. A few days later the Standard & Poor's rating agency downgraded the U.S. rating for the first time in history. Now we are facing the potent combination of both the fiscal cliff deadline on January 1st, 2013 and another battle over raising the U.S. debt ceiling again.

FYI: Curious about the "fiscal cliff"? Check out this Wall Street Journal video on the fiscal cliff (click here).

Many economists have estimated the impact of the fiscal cliff on the U.S. economy to be about -3% to -4.5% on the U.S. GDP in 2013. There does seem to be a growing camp of analysts who believe that some sort of compromise will be reached and the adjusted fiscal "slope" will only cut -1.5% off the U.S. economy in 2013. Unfortunately the U.S. economy only grew at +2% in the third quarter of 2012. If there is no compromise then we are guaranteed to fall into a recession next year. Even if there is a compromise then we are still at risk of seeing the U.S. slip toward a new recession. If the U.S. hits a recession it impacts the entire globe. A few market watchers are already predicting that Washington's gridlock on the fiscal cliff will push stocks lower and we could see the S&P 500 index trading back under 1250 by year end.

Major Indices:

Technically last week was bearish for the S&P 500 index. The -2.4% drop produced a bearish breakdown below what should have been support at the 1400 level and its 100-dma and 200-dma. I warned readers that if the S&P 500 broke down under 1400 it was headed for 1380 or its 200-dma. That's exactly what happened.

Stocks are arguably short-term oversold here. Yet if equities do see a bounce the broken support at 1400 is now new resistance. If the sell-off continues then the next likely support level is the 1350 area.

chart of the S&P 500 index:

The tech-heavy NASDAQ continues to underperform with a -2.59% decline last week. The breakdown under support at the simple 200-dma, the exponential 200-dma and the 2950 level is definitely bearish. The NASDAQ managed to end the week hugging the 2900 level. This index is short-term oversold with a five-week decline. Yet any oversold bounce could encounter new resistance at 2950, 3000, and all of its major moving averages. If this sell-off continues then the next support levels to watch are probably the 2850 level and the 2800 level.

FYI: The NASDAQ is about -9% off its 2012 highs.

chart of the NASDAQ Composite index:

Side note: Last week I warned readers that Apple Inc.'s (AAPL) sell-off was probably not over yet. I suggested readers look for a drop towards the $530-528 area. The stock hit a low near $535 on Thursday and traded under $534 on Friday. Shares are definitely looking oversold here but there is no guarantee the correction lower is over. Honestly I would not be surprised to see AAPL spike down to $525 before bouncing.

The small cap Russell 2000 index ($RUT) also looks pretty ugly with a sharp bearish breakdown through several major moving averages (100-dma, 200-dma, 200-ema, 150-dma) and round-number support at the 800 level. Aside from a couple of oversold bounces the $RUT has fallen over the last eight weeks with a -8% correction from its closing high.

Can the $RUT see another oversold bounce? Absolutely! Yet now broken support should be new resistance. If the selling continues the next likely support area is probably 780.

Daily chart of the Russell 2000 index

Now that the U.S. election is over the market's attention will focus on the fast approaching fiscal cliff and the deteriorating situation in Europe. We have less than 50 days left before 2012 ends and the U.S. economy runs off the cliff. Stocks could react to headlines out of Europe this week over the health of the Eurozone economy. Plus, we'll also get another look at the U.S. economy with the New York and Philadelphia Fed surveys.

Economic and Event Calendar

- Monday, November 12 -
(nothing significant)

- Tuesday, November 13 -
Eurozone jobs data
Italy debt auction

- Wednesday, November 14 -
U.S. retail sales (for October)
PPI (for October)
FOMC minutes
Eurozone Industrial Production
Eurozone CPI data
Eurozone GDP

- Thursday, November 15 -
Weekly Initial Jobless Claims
CPI for October
New York Empire State manufacturing survey
Philly Fed survey

- Friday, November 16 -
Industrial Production and Capacity Utilization
Debt deadline for Greece to make a $5 billion payment

Additional Events to be aware of:

Nov. 22nd - U.S. markets closed for Thanksgiving holiday
Dec. 12th - FOMC meeting

The Week Ahead:

Looking ahead I suspect we are in for a bumpy ride lower. You could argue that the U.S. market major indices are short-term overbought. My concern is that any bounce is going to be used as an opportunity to sell. What reason do investors have to buy stocks? There will be more pressure to sell stocks now before we hit 2013 to avoid higher taxes on capital gains and dividends.

Corporate guidance has been less than inspiring. Of those companies that issued guidance with their Q3 earnings results over 70% have warned on the fourth quarter. Right now analysts estimates on fourth quarter earnings growth have fallen from +11.1% to +5.6%. The uncertainty over the fiscal cliff, the U.S. debt ceiling, and how Obamacare might impact their bottom line in addition to weakness in Europe is likely to keep businesses cautious on guidance, spending, and hiring.

I mentioned earlier how the debt ceiling battle in Washington back in 2011 produced a -18% drop in the S&P 500. We're about to see another battle over the debt ceiling. The democrats are going to feel empowered by the election while republicans are likely to dig in deeper in an effort to hold on. Thus we're likely to see another brutal fight that could fuel more weakness for stocks.

Meanwhile issues overseas continue to simmer. Greece is marching closer to another default. Spain could be on the verge of asking for a bailout. The Syrian civil war is escalating. Syria just fired mortars into Israel this weekend and Israel retaliated. It wasn't that long ago that Syria was firing into Turkey. The situation there could get a lot worse really quick. The tension in Iran remains. There was a news story this weekend that Iran was shooting at a U.S. drone. Thankfully that is an unmanned aircraft but if they are shooting at U.S. vehicles it underscores the tense emotions in Iran as they suffer skyrocketing inflation and the U.N.'s current economic sanctions.

James