Friday, December 28, 2012

Will Congress sabotage the economy in 2013?

The lack of a budget deal weighed heavily on investors’ minds on Friday.  There’s a growing sense that Congress may do the unthinkable and allow the U.S. to careen over the edge of the fiscal precipice.  If this happens, the initial shock would have a decidedly negative impact on equity prices, at least in the short term.  A defensive posture is important when the major indices are below the 15-day moving average and internal momentum readings are mostly negative, which is now the case.

With Monday’s deadline for reaching a fiscal agreement imminent, Congress convened a late-night session on Friday in the hope of hammering out a compromise.  Failure to do so would result in automatic tax increases and spending cuts.  I have no inside connections in Washington, so I can only speculate like everyone else what the outcome will be.  Recently I had the privilege of interviewing the venerable investment analyst Bert Dohmen, whose work I’ve long admired.  (FYI, you can read the entire interview by clicking here.)

Mr. Dohmen told me, “Nobody knows if there’s going to be an agreement among the Democrats and Republicans.  The popular view is that there will be a compromise by year end.  But as you know, the popular view is usually wrong.  I can see a situation where there’s a lot to be gained by Democrats by letting the country go over the cliff and then blaming the Republicans.  ‘The Republicans made us do it’ will be the excuse.”

We can only hope that Dohmen’s fearful scenario doesn’t happen.  Regardless of the outcome, the immediate-term trend for equities is bearish based on a reading of the indicators.  We’ll review some of these indications in tonight’s report….

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Now let’s turn our attention to market volatility.  Last week I cautioned that we’d need to be on our toes from here on out in anticipation of increased volatility.  Along those lines is the disturbing pattern visible in the daily chart of the CBOE Volatility Index (VIX), shown below. 

VIX has since spiked to its highest level of the last six months, which shows us just how worried investors have become in the face of the forthcoming Congressional deadline for averting the fiscal precipice.  A conspicuous rally in the VIX typically means the immediate-term market trend is in its final critical stages and often precedes a short-term market bottom.  But as of Friday, Dec. 28, there’s no indication that a bottom has been made.  Therefore we should be prepared for more potential downside next week.

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