Deal or No Deal? A Contrarian's Guide to the 'Cliff' Trade

The technical levels we're watching as stocks march into December

by 12/1/2012 10:22:41 AM
Stocks quoted in this article:

It was a mixed bag for stocks in the month of November, as the Nasdaq Composite's solid win contrasted with the Dow's minor dip and the S&P 500's flattish finish. Last week's lack of clarity from Capitol Hill contributed to the directionless trend, as our nation's top leaders duked it out in the Great Fiscal Cliff Debates of 2012. While Wednesday brought us heartwarming tales of bipartisan optimism, the talks had devolved into all-too-familiar political bickering by Friday. With just one calendar month left until we collectively dive over that proverbial cliff, Todd Salamone and Rocky White are here to prepare you for a December to remember.

  • Crucial round numbers to watch for the blue chips, tech stocks, and mid-caps
  • Why we're tracking rolling five-year returns for the SPX and other major indexes
  • How investor sentiment and year-to-date returns impact December seasonality

Finally, we wrap up with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: Watch Those Rolling Five-Year Returns
By Todd Salamone, Senior V.P. of Research

"Turning to the charts, while the SPX turned in an impressive performance in last week's holiday-shortened trading, there is still work that needs to be done. For example, technicians will have their eyes set on the 1,420 area, which acted as resistance for the first nine months of this year. The 80-day moving average, which acted as short-term resistance in mid-June and as short-term support in late-October/early November is coincidentally situated in this region. Also worth mentioning -- with the SPX closing at 1,409 on Friday -- is that the 50% retracement of the September high and this month's low is parked at 1,410."
-Monday Morning Outlook, November 24, 2012

"Three out of four global investors expect President Barack Obama and congressional leaders to reach a short-term agreement to avert more than $600 billion in spending cuts and tax increases scheduled to begin on Jan. 1. Only 6 percent of investors anticipate a political impasse that would send the U.S. economy over the so-called fiscal cliff and into a recession, according to a Bloomberg Global Poll conducted on Nov. 27. The survey of 862 Bloomberg customers who are investors, traders or analysts found that 40 percent expect financial markets to rise after a short-term tax-and-spending deal. An additional 28 percent forecast no significant market reaction while 26 percent say markets would fall, seeing a short-term deal as delaying an unavoidable day of reckoning with the country's finances."
-Bloomberg, November 29, 2012

Next week, we turn to the last trading month of the year, a month with historically positive returns (see Rocky White's dissection of sentiment and December seasonality on the next page). As we progress through the month and the deadline to the "fiscal cliff," we are likely to see the typical political jockeying between the president and congressional leaders as negotiations take place -- with each hint of progress, or lack thereof, moving markets along the way. In case you're wondering how much attention is being devoted to the potential fiscal cliff, you can tune into CNBC for its "countdown" in the lower right-hand corner of the screen.

The market's price action seems to support the expectation that something might get done. For example, we have tracked how the market has reacted between various utterances from Washington, D.C., in terms of "progress" in fiscal cliff negotiations to the next utterance of "no progress" since mid-November.

While we did this primarily for entertainment purposes, the fact that the market has traded about 95 points higher after "progress" was hinted at and lost roughly only 25 points when a "lack of progress" was indicated supports the Bloomberg excerpt above, in which expectations are said to be high that a short-term agreement will occur before we fall off the proverbial cliff. A takeaway is that if absolutely nothing (whether a short-term or long-term deal) is done, the market is vulnerable to a setback. If a short-term or long-term deal gets done, the contrarian play would hint at going long, as a majority of participants would expect a neutral-to-bearish reaction.

30-Minute Intraday Chart of SPX since Nov. 14, 2012

As markets react to various headlines, we find it interesting that major benchmarks are trading around key round-number millennium levels simultaneously, perhaps keeping a lid on rally attempts. For example:

  1. The S&P MidCap 400 Index (MID - 1,000.15) is once again bumping into the 1,000 level, an area it has failed at numerous times since early 2011, when it tested this region for the first time ever.

  2. The Nasdaq Composite (COMP - 3,010.24) is toying around with the 3,000 level. In March, the COMP touched the 3,000 mark for the first time since early 2000, and has traded 200 points above and below this area ever since.

  3. The Dow Jones Industrial Average (DJI - 13,025.58) is trading around 13,000, which it touched back in February. It has been a sideways grind since, mostly between 12,500 and 13,500.

30-Minute Intraday Chart of MID since Oct. 24, 2012

While round millennium levels are not coming into play for the S&P 500 Index (SPX - 1,416.18) or Russell 2000 Index (RUT - 821.92), there is visible resistance above.

  1. SPX - The 1,420 level, as mentioned in one of the beginning excerpts, is significant, as it marked a top earlier in the year and is the site of a key moving average.

  2. RUT - The 820-830 area marks a peak in July and a 61.8% Fibonacci retracement of the September high and mid-November low.

What if we break out above resistance if a new deal is made? We have a few levels for you to watch on the SPX, DJI, RUT and MID throughout December, in the event that the market advances on such news.

Per the Google Finance chart below, note how the SPX and DJI have struggled to overtake their respective rolling five-year breakeven marks. As of the end of December, these five-year breakeven points will be:

  1. Dow Jones Industrial Average - 13,264

  2. S&P 500 Index - 1,468, which coincidentally is around the September closing high
5-Year Returns for SPX and DJI

Since early 2011, the RUT has struggled to overtake its rolling five-year return of 10%, after numerous attempts to do so. Moreover, the MID has peaked at rolling five-year 20% returns on multiple occasions since early 2011. Based on this information, the critical levels to watch for this month are:

  1. RUT - 842 marks a 10% 5-year return and, coincidentally, is the site of a short-term top in March.

  2. MID - 1,030 marks a 20% 5-year return and, coincidentally. is the site of its September peak.
5-Year Returns for MID and RUT

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