Dangerous Waters

UPDATE:  9:30 AM PDT

Despite generally better than expected economic and earnings news this morning, we formed most of a Head and Shoulders pattern in the futures prior to the cash market opening.  I decided to wait and see how it played out before scaling back my shorts.  We have since completed it, and a downside to 1283 is indicated.  I'll stay short to play this out, but lower stops in order to protect profits in the event of a debt ceiling breakthrough. VIX is trading at its highs for the day, so I'm not the only one expecting greater volatility ahead.  The OPEX gang will have their hands full trying to keep things in check.



ORIGINAL POST:  4:00 AM PDT

There is a dizzying array of cross-currents at work in the markets, now.  The sharks ripping into the Euro have finally noticed the Dollar's lifeboat is leaking.

Thanks to Bernanke's testimony (more today!) before Congress, the prospects for additional QE refuse to fade.  I believe the Fed would face a very difficult political battle in instituting an additional round unless markets were to take a serious tumble.  But, as we've learned on many occasions, just the hint of QE is often enough to accomplish the Fed's goals.

Equity markets, however, are at risk of decoupling from the dollar's fate.  In recent weeks, a bull run in the Dollar meant a risk-off environment.  Investors turned our cash as a safe haven (ludicrous, no?) from Euro concerns, for instance, dumping equities and other "riskier" assets such as commodities.  With the dollar increasingly suspect, will the inverse occur?

A dollar that's weaker due to the Fed's manipulation -- sure.  But, a dollar that's threatened by Congressional failure to address the debt ceiling, I have my doubts.  If the worst case scenario were to occur and the US actually did default, there would be immediate and catastrophic effects.  One obvious effect would be skyrocketing interest rates -- hardly positive for stocks, or for the economy from which US companies still derive half their earnings. 

I have little doubt that Congress will ultimately pull the trigger on the debt ceiling.  My concern is how much damage they'll do in the meantime, waving loaded guns around without the safetys on.  As markets grow increasingly alarmed about the possibility of a default, we could see a scenario where stocks, the Dollar and the Euro all tumble at the same time.

When a deal is reached, the relief could be immediate and powerful.  The Dollar would be "out of danger" and will soar -- at least relative to the Euro.  Equities would, too, but how much?  An immediate relief rally would be tempered by the realization that the forces threatening the US economy are still with us.  From a macroeconomic standpoint, of course, the risks are much greater as debt increases.  At some point, printing more money won't cure that ill.

The net outcome, as I see it, is that we experience a brief but dazzling relief rally in equities to accompany the Dollar's more sustained push.  But, as it dawns on investors that we're now heading for an even worse fall from a greater precipice, equities should resume their downward march.

Will the Bernanke put come to the rescue?  Of course he'll try, pulling out whatever stops are necessary.  But, it's possible the markets are finally on to him.  We had a hint of that during his testimony today, when the rally during his remarks faded as quickly as it arose.

As these cross-currents swirl about us, I expect markets to be exceptionally volatile.  In addition to the above factors, we have loads of important earnings and economic data coming today and tomorrow.  And, to add to the machinations, Friday is an options expiration day.

My personality is to try to anticipate each and every turn, reacting with cat-like reflexes and pouncing on opportunities nano-seconds before the markets catch on to my master plan.  The reality is that I'd likely make my broker a lot of money in commissions as I flail about, blindly reacting to headlines, always 5 minutes too late to avoid losing money.

Thus, I think this might be an excellent time to rein things in a bit.  I have been net short for several days, but will pull some money off the table and hedge the rest for the next week or two.  I'd rather miss some profit opportunities than lose a bundle when the futures move against me overnight or over a weekend.

As for today, I think it could go either way.  Indications are that stocks will drift lower today and tomorrow, possibly to 1295-1300.  At that point -- sooner if the debt ceiling impasse is resolved -- we should get a bounce.  If the impasse gets uglier and/or the earnings/economic news even worse, expect the plunge to get uglier.  Remember, we have the above scenario where everyone heads for the exits at once.  While I'm expecting cooler heads will prevail, it remains a distinct possibility.

A month from now, equity markets should be significantly lower.  But, I think it's going to be a wild ride.