The fiscal cliff battle has started with both sides launching their initial attacks on the other and floating trial balloons meant to energize their base.

Market Statistics

I am actually very pleased with the market reaction to the opening salvos from both sides in the fiscal cliff war. Both sides hurled ridicule, insults and calculated talking points at the other and instead of selling off the markets ignored them. The gang of four each took a potshot at the other side and the market jiggled a little bit when they did but then recovered as though nothing had happened. I view that as bullish but we are still in the early stages of the battle.

This was the first week of posturing and nobody really expected anything to be accomplished. In actuality we got what was expected. Proposals were floated that don't have a chance of being accepted and each side repeated daily their demands for compromise from the other side while holding firm to their own no compromise positions. It was true political theater and in this case the markets realized there was no substance and therefore no reason for buying or selling stocks.

One of the proposals floated by the democrats was to raise taxes $1.6 trillion and increase short term spending by $100 billion to stimulate the economy. The deal offered $400 in unspecified spending cuts to come later. The deal also required a "permanent" end to the congressional control of the debt ceiling so the president would not have to ask for another increase for the rest of his term. Since the spending is sure to increase that would be convenient and avoid a repeat of the August 2011 disaster. The republicans called the proposal "comical" and a "break from reality."

My guess for the real work to get done is still in the Dec 21-24th timeframe. That means we have at least one more week of posturing and then politicians will start to narrow their demands as they head for the holiday adjournment deadline of Dec 14th. I suspect that deadline will be extended but the lame ducks in Congress are not going to want to stick around over the holiday when their time in office is numbered in days. That brings up an interesting point. If some of the lame ducks go AWOL in the final days will that impact the number of votes needed to pass the controversial legislation when it finally comes to the floor? Could there be a strategy there in hoping the scales tip in one party's favor.

The indexes all finished the week with a gain and that is remarkable given the daily press conferences, verbal broadsides and campaign appearances. The S&P dip to the 200-day average on Wednesday was met with immediate buying as I predicted in my prior commentaries.

This hopefulness does not mean there is no volatility in our future since the politicians have failed to budge on a single issue so far. As the countdown clock heads towards the deadline there could be another August 2011-like volatility event but I view that as a less than 50% chance. Nearly everyone now believes, despite the speeches to the contrary, that there will be a substantive settlement and life will go on. Every dip that is bought will further solidify that sentiment in the market.

Just to recap the fiscal cliff details. The term fiscal cliff means the $607 billion in tax hikes and spending cuts that are scheduled to kick in on January 1st.

$221 billion - Expiration of Bush tax cuts
$105 billion - Other changes to spending and taxes
$95 billion - Expiration of the 2% Social Security tax holiday
$65 billion - Other expiring tax provisions
$65 billion - Spending cuts forced by debt ceiling sequestration
$26 billion - Expiration of unemployment insurance
$18 billion - Start of Obamacare taxes
$11 billion - Reduction in Medicare payments to doctors
$607 billion - Equal to 6,070 tons of $100 bills or 303.5 semi-truck loads

The economic calendar on Friday was light but positive. The ISM Chicago, formerly Chicago PMI, rose from 49.9 to 50.4. That is not a big move but that puts it back into expansion territory after two months of contraction. Since Hurricane Sandy destroyed thousands of cars the uptick in orders for automobile parts was thought to have lifted the Chicago economy. However, the internals don't really show that. The new orders component actually declined to 45.3 from 50.6 and it should have gone the other direction given the theory on Sandy. Order backlogs did rise slightly from 44.3 to 49.6 but remained in contraction territory.

The biggest improvement was in the employment component that rose from 50.3 to 55.2 and the supplier deliveries component rising from 50.4 to 57.3. The sharp rise in employment while the orders and backorders components remained in contraction was puzzling. Apparently manufacturers are expecting business to pickup now that the election is over and the fiscal cliff is about to be resolved.

Chicago ISM Chart

The Personal Income report for October showed zero growth in incomes and the slowest since April. Wage income fell -0.2% and the first decline since May after growing +0.3% in September. Consumer spending fell -0.2% on a sharp decline in durable goods spending of -1.9%. Real spending posted the largest decline since Sept 2009 at -0.3%. Analysts claim Hurricane Sandy was responsible for the majority of the decline. The government made an $18 billion deduction for lost wages due to Sandy. At the same time the savings rate rose +3.4% as more consumers put money away for rainy days ahead. This is the equivalent of investors moving money from stocks to bonds. They are preparing for hard times and higher taxes.

The calendar for next week is dominated by the national ISM reports and the three payroll reports. The national ISM Manufacturing on Monday is expected to have improved slightly from 51.7 to 52.1. Not a big move but still a gain. ISM Services on Wednesday is expected to decline from 54.2 to 53.5 because of Hurricane Sandy.

The ADP Employment report on Wednesday is expected to show new jobs declined from 158,000 in October to 125,000 in November. The Nonfarm Payrolls on Friday is expected to show a decline in new jobs from 171,000 to 100,000.

However, all the jobs reports could miss estimates by a mile as a result of Sandy and the disruption to business in the Northeast.

November economic reports released in December are all going to have a Sandy factor in them. There could be huge estimate misses in almost every area and because of the Sandy component they will all be ignored.

In reality the economics for December released in January will also be impacted. The quarterly earnings for Q4 will also be impacted by Sandy. Q4 will be the kitchen sink quarter where many companies will post lower earnings for a number of reasons but then blame it on Sandy. That means Q4 earnings will also be ignored to some extent. The Sandy ate my earnings excuse will be a common factor in the reports.

Economic Calendar

The calendar for the following week includes a Fed meeting and odds are very good they will announce QE4. The Operation Twist program is scheduled to terminate at year end. Twist was a program where the Fed sold $45 billion in short term treasuries each month and bought longer term treasuries to force long term rates lower and support the housing market. Twist has to end because the Fed has run out of short term treasuries. Because Twist was selling as much as they were buying it was not really a QE program. Twist was just moving money around.

The Fed has been sending signals to the market that they will announce a new QE program at the December meeting that will replace Operation Twist. Analysts believe the new QE program will buy treasuries and mortgage backed securities outright with a monthly target of about $40 billion. This would be a new QE program aimed not only at keeping rates low for a longer period of time but also at keeping the dollar low to offset the low value of the Chinese currency.

The Treasury Dept stopped short last week of calling China a currency manipulator but they again warned that the low value of the RMB has kept China's imports cheap and created an unfair advantage over U.S. companies. Keeping interest rates low also allows the government to continue running $100 billion monthly deficits at almost no cost. There is method to the Fed's madness but there is a limit to how far they can go. They can't continue to buy treasuries forever. The Fed can't finance the Federal government and eventually those treasuries will have to be resold on the open market. That will not be pretty and it will make the current fiscal cliff look like a kindergarten picnic.

Scotiabank economists believe the Fed will eventually purchase another $1 trillion in U.S. debt in 2013 with roughly half in mortgage backed securities. Scotiabank believes the Fed may be conservative in their December announcement and then add to it later. The reasoning is the uncertainty over the fiscal cliff and the assumption there will be no agreement before the Fed meeting. They believe the Fed will want to keep something in reserve just in case the cliff negotiations go horribly wrong.

Helping to push the markets higher is the rush to declare special dividends in December to capitalize on the low tax rates in 2012. Since the election more than 175 companies have either announced a special dividend or moved their payment dates from January into December. The total of the special dividends already announced is now more than $21 billion. That has provided a lot of incentive to keep money in stocks despite the turmoil developing in Washington.

Unfortunately there is a fuse on this trend. At some point the timing for announcing a special dividend, record date and pay date will run into a wall where the calendar no longer works. Analysts believe that is about Friday the 14th. Anything not announced before the 14th probably will not be announced. That gives companies two more weeks for deciding before the calendar window closes.

Another factor holding the market up on Friday was the rebalance of the MSCI indexes. The MSCI indexes are widely tracked global equity benchmarks and serve as the basis for more than 500 ETFs. They were rebalanced on Friday and that added significant volume to the market. On the NYSE alone there was $3.6 billion in market on close buy orders. On a typical day the market on close orders would be in the $100 million range.

Volume on Friday rose to 7.0 billion shares after trading 6.1 billion on Wednesday and Thursday in anticipation of the rebalance. Active traders and hedge funds were gaming the event and they sold into the volume spike. Typically $3.6 billion in buy orders would cause a significant market spike. Because the changes were telegraphed the sellers were waiting. Also, in an index rebalance the total weight of the index remains the same. If the index represented $1 billion in equities before the rebalance it would still represent $1 billion after the event. Only the weighting of the stocks in the index would have changed. That means for every $1 of stocks bought there was $1 in stocks sold to adjust the ratios. If managers had to add $100,000 in a particular stock then they had to sell $100,000 total in one or more stocks to complete the adjustment.

Most rebalances simply add volume to the market and rarely provide direction. Friday was no exception. The S&P traded sideways between 1412-1418 all day and ended at 1416. If anything the rebalance distracted traders from the political theater making headlines.

The markets were so focused on the rebalance and the war of words over the cliff that they did not notice Moody's downgraded the European bailout funds from AAA rated. Moody's cut the European Stability Mechanism (ESM) and European Financial Stability Fund (SFSF) from AAA to Aa1 "because of a high correlation in credit risk." Moody's said their downgrade was driven by the recent downgrade of France from AAA to Aa1 and the risk to the largest supporters of the bailout funds. France was the second largest backer of these funds behind Germany. Moody's noted that France was responsible for 20.4% of the ESM callable collateral or $164 billion. Germany is responsible for 27.1%. France is liable for 21.8% of the EFSF or $205 billion. Given the downgrade to France Moody's said the country was "very unlikely" to be able to uphold its obligations to the funds. The news of the downgrade hit the wires about 2:PM and the markets didn't even blink.

Problems with the Greek debt deal also failed to derail the market. The IMF, one third of the Troika that negotiated the deal, said it would pull out of the deal if Greece could not organize a debt buyback program. That would halt the release of the 44 billion euros in bailout funds due to Greece later this month.

The IMF is demanding that Greece buy back 30 billion euros of debt at the current market value of 30%. That is another 70% haircut for private investors, banks, insurers and pension funds. Under the proposed plan Greece would borrow money from the Troika and buy the bonds back at a discount. The problem is that private investors don't want to sell and there is no vehicle to force them to sell. If the private investors are forced to sell now they have to recognize their losses now rather than years from now when the debt matures. Those investors are hoping Greece will be better off 7-10 years from now and the debts will be paid at 100%. These same private investors have already taken a 53% haircut when their debt was restructured last year. In theory Greece could cut its outstanding debt by 30 billion euros, about 10% of their 309 billion total but then add back about 10 billion in Troika loans to buy that discounted debt.

Documents leaked since the announcement of the Greek deal have already caused analysts to doubt it will work. The numbers from Greece are still proving to be false guesstimates and reality is worse than what was shown to the Troika and the EU Finance Ministers. Early last week the deal was heralded as the end to the Greek problem but as each day passes the deal seems less sure and future problems with Greece seem more likely. The markets ignored the entire topic on Friday.

There was very little stock news with the cliff headlines pushing everything else out of the news flow.

YUM Brands (YUM) shares fell -10% to $67.08 after saying same store sales in China would decline -4% in Q4. China accounted for 44% of YUM's revenue in 2011. The -4% same store sales decline compares to a +21% gain in the year ago quarter.

Analysts claim the softness is related to the change in government leaders in China and the tough sales comparable from 2011. How do you improve on a +21% sales gain? YUM said it will open 700 stores in China in 2013, compared to 800 in 2012. YUM has more than 38,000 stores globally.

YUM Chart

Verisign (VRSN) fell -13% after the Dept of Commerce approved the company to manage the .com domain name registry. However, the company will not be able to raise prices as it did in the last licensing period.

VRSN Chart

Zynga (ZNGA) shares declined -6% after SEC filings showed that Facebook was no longer in an exclusive relationship with the game developer. That caused worries that Zynga could find itself in greater competition with other developers on the Facebook platform. Facebook shares rallied again to close at $28 as shorts continue to cover.

Apple (AAPL) continued to move sideways for the fourth day despite receiving approval from Chinese regulators for the latest iPhone version. The company will release the iPhone in China later this month.

Apple Chart

The S&P closed fractionally positive on Friday but gained +7 points for the week. As I said earlier I think that shows some bullish sentiment although there may still be some decent volatility in our future.

The S&P declined to the 200-day average on Wednesday and the rebound was immediate. The buying continued at the open on Thursday to push the index back over the 100-day average at 1409 to close at 1416 on Friday.

Some of the gains were a result of end of month fund flows into stock funds. Some of the gains were the result of investors chasing special dividends. Other gains were probably related to the MSCI rebalance and investors front running that event. I am also sure there were quite a few traders covering shorts ahead of the weekend just in case a miracle happened and a compromise was reached on the cliff.

For next week we can expect the cliff conflict to escalate to a higher level. That could produce some stronger volatility with current resistance at 1420-1430. The path of least resistance is down intraday but barring some dramatic conflict in the political arena I still believe the dips will be bought.

However, the distance to support at the 200-day average at 1385 is farther than it was last week so any dip could be a little more painful than the last one. Be prepared.

S&P Chart

The Dow continues to battle resistance at 13,000 but closed just over that level on Friday. The big caps are special dividend candidates so nobody is in any rush to sell them. The next material resistance if 13,279 and well above us so any move higher could wander for a couple days before running into trouble.

If negativity reappears the most likely initial support is 12,800 followed by strong support at 12,500.

Dow Chart

Without Apple leading the way the Nasdaq still turned in a respectable +43 point gain for the week. There was a dead stop just below the 100-day average at 3019 but it appears poised for a breakout if the cliff news fails to roil the market.

Support at 2950 was tested twice last week and was immediately bought both times.

Nasdaq Chart

We should expect further posturing by lawmakers next week and the tone is likely to increase in hostility. That will probably produce some market volatility but we all know they are just playing a high stakes game of chicken as the countdown clock heads toward zero. Nothing will get done until the last minute and we are at least two weeks away from that window of opportunity.

Politicians never lead with their best offer when negotiating with the other side. The items producing the most negative response are toned down and the items in the proposal getting the least response are enhanced. Eventually both sides have a list of bullet points that are not deal killers and they will horse trade those points until they have a deal they can sell to the rank and file in the House and the Senate.

Investors need to remember that going over the cliff is not terminal and it could easily occur. The $607 billion cliff is the annual impact and assumes nothing happens for a full year. The $607 billion equates to just over $50 billion a month. That is not small change but it is also not a cliff. The $50 billion a month is the equivalent of a minor slope, not a cliff. In this case the constant news hype is worse than the actual impact although it would knock the economy back into a recession.

The odds are very good that there will be a compromise on several items that will be sold to the public as a major accomplishment while the rest is either kicked well into 2013 or is allowed to actually become reality. Instead of a $607 billion cliff maybe we end up with a $200 billion hit but remember that is spread over 12 months.

The market was helped by end of month inflows to funds and those flows will dry up by midweek. That makes Wednesday's ADP report the potential pivot point for the week with the Friday Nonfarm Payrolls the most critical report for the week.

Definitely, enter passively and exit aggressively over the next few weeks!

Annual End of Year Renewal Special

It is that time of year again when we offer the best prices of the year on a package of our top newsletters. If you have been a subscriber for several years you know this is the best price and best deal of the year.

Please follow the link below to see for yourself the EOY subscription special for 2013. You will not be disappointed!

Definitely, enter passively and exit aggressively over the next few weeks!

Jim Brown

Send Jim an email

"I have been impressed with the urgency of doing. Knowing is not enough; we must apply. Being willing is not enough; we must do."
Leonardo Da Vinci