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Fiscal Cliff 2: The Sequestration Sequel
By: Martin Tillier
Here we go again! Once again it seems that U.S. politicians are intent on ruining an economy that, despite their worst efforts, is grinding its way through a recovery. It is hard to escape the conclusion that this particular spat will end the same way; brinkmanship until something has to be done, and then, to use an overworked phrase, more can kicking. Whichever side you blame it is frustrating for investors to say the least.
As we approach the deadline for sequestration it is logical to expect the market to falter a little, but there has been no sign of that so far. Major indices are continuing to edge up, hitting multi-year highs in the process. Overall the best advice is to stay the course, as hard as it may be to put trust in the ability of Washington to solve the problem. The doomsayers were wrong at the end of last year and will be again. That said, I believe we will see some volatility over the coming weeks as each side doubles down on intransigence as a negotiating tactic. For those looking for short term opportunities, I am sure they will present themselves.
To me, the difference this time around is that a downward move sparked by posturing politicians is more likely to be sustained. The moves up to these highs have been mostly incremental and on low volume, leading to the conclusion that buyers are getting a little nervous and any correction could well be quite sharp. A sustained drop of around 10% would come as no surprise. Last time my advice was to buy into weakness in defense stocks. That generally worked out well, but this time around market dynamics lead me to conclude that the correction, when it comes, will be more general.
The fear of the effects of huge cuts in the defense budget is still real, but the across the board nature of sequestration is the focus now, along with the possible impact on employment and thus the risk of sinking back into recession. A more general play on indices may well be a better option this time.
Shorting both major indices by way of the ETFs DIA and SPY may seem like a brave thing to do looking at the charts, but given the seeming inevitability of some bad news over the next couple of weeks, now is the time.
I should make it clear that this is a fairly short-term trade, designed to enable you to buy back and go long at a good average when the drop comes. In this case I would break one of my basic rules and set levels to turn around or cut the position at about the same distance away from the entry point, say 7.5% away. At the time of writing that would mean, in the case of DIA, an order to buy twice as much as you sell at around 129 and a stop-loss to buy at around 150. For SPY the levels would be 141 and 164.
In the markets, nothing is ever certain. In politics, however, you can be sure that Washington types from both side of the aisle will open their mouths and say something, probably something stupid. When they do, it
Martin Tillier has been dragged, kicking and screaming, into the 21st century and can now be followed on Twitter @MartinTillier.