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Will Markets See Santa Rally Driven by 'Staged In' Fiscal Cliff Solution? This Is the Key Week to Watch

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A pullback to the 1400-1410 level, with a concurrent oversold reading from the McClellan Oscillator, could act as a springboard for fabled Santa Rally.

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While last week, and this week, often see distortions in individual stock prices historically due to tax loss selling, Santa Claus tends to arrive the following week. Indeed, the last week of the year, into the first two days of January, has a pretty good track record on the upside with a rally coming about 65% of the time. As stated in previous missives, I expect the same Santa Rally this year driven by a "staged in" solution to the fiscal cliff. Most readers know that I have lived in the DC Beltway and have a good working knowledge of how our system works. And while this year's "rhythm" has a different feel to it, I still expect a last minute solution. That has been my stance for the past few weeks based on this reality. Speaker John Boehner is under intense personal pressure to cut a deal because if he doesn't he may not be reelected Speaker of the House when the new Congress convenes January 4. Therefore, he will likely accept the 39.6% tax bracket for high wage earners and then focus the conversation toward entitlements and the debt ceiling. Evidently, I am not the only one thinking this. As the Wall Street Journal's Kimberly Strassel writes:

Since the president has not sent budgets out (the only one he did send out was voted down 79 to nothing in his own Senate) and he said what would solve the nation's problems was taxing the rich, and we've said all along the amount of money that you get for this is just a few days of deficits. But since that's really the only thing that you've proposed to do and that you've got a mandate for doing it, and a majority of people say that this certainly is fair - we've got a gigantic deficit and the rich have benefitted (directly or indirectly) from the money that's been spent, so we'll say fine, you can have that - we'll concede, now the rest of the problems are yours. You've said that this will solve the nation's problems - fine, we'll sit tight and we've got the debt limit coming up and we will keep following along.

If the Washington Waltz does play out this way, then the Acapulco "cliff diving" exhibition will be off; but if not, the economy's destiny will hang on how the "contest" is finally resolved.

One sector that should not be affected either way is technology. According to the discerning Don Coxe, of BMO Capital fame:

They [technology companies] are self-financing, they have potent balance sheets, they have the patents, the visibility, and they are the best in the world at what they do pretty much, so this is a continuing source of strength for US stocks relative to other global stocks, and will help if we should fall over the fiscal cliff.

Those comments were particularly timely given Raymond James' Technology Conference last week. As one particularly keen-witted Wall Street wag wrote (as paraphrased by me):

The most significant takeaways from our tech conference yesterday were that while the broad tone seemed cautious, there were clearly signs of stability on the supply chain with a leading chip distributor calling for positive book-to-bill readings for October, November and the early part of December. Other companies with favorable ratings from our fundamental analysts, like Maxim (NASDAQ:MXIM) and Analog Devices (NASDAQ:ADI), also signaled stability versus existing expectations, while SDN (S4C Digital Network) fears and those surrounding Microsoft's (NASDAQ:MSFT) Surface products were calmed a few degrees [Microsoft is also favorably rated by our fundamental analyst)].

I like the technology sector for many of the reasons mentioned by Don Coxe.

Meanwhile, the equity markets struggled with only five of the 15 major indices I monitor closing positive for the week. Those five were the Dow Jones Transportation Average (INDEXDJX:DJT) (+1.15%), the S&P 500 Equal Weighted Composite (INDEXSP:SP500EW) (+0.09%), the two ValuLine Indexes (Arithmetic +0.37%; Geometric +0.30%), and the Russell 2000 (INDEXRUSSELL:RUT) (+0.18). The only three macro sectors that closed "up" on the week were: materials (+1.64%), telecommunications (+0.50%), and industrial (+0.30%). The strength in the materials sector is interesting because it is economically sensitive. Despite last week's waffling action, by my work the Dow Jones Industrial Average (INDEXDJX:.DJI), the Dow Jones Transportation Average, the Nasdaq Composite (INDEXNASDAQ:.IXIC), and S&P 500 (INDEXSP:.INX) all remain on short/intermediate-term "buy signals." However, the Utility Index has registered an intermediate-term "sell signal." Frustratingly, it has been difficult to surmount the SPX's overhead resistance zone of 1420 – 1430, but that has been anticipated numerous times in these reports. Nevertheless, this still looks like an upside "continuation pattern" to me unless the support level of 1390 – 1400 is decisively violated.

Speaking to the US Dollar Index (NYSEARCA:UUP) (NYSEARCA:UDN), the weakness anticipated in mid-November has left that index down 2.4% and in jeopardy of breaking below its recent reaction low of 79.36. As stated in November, "A weaker dollar should be bullish for stocks," and it has. I actually think the dollar's decline accelerates from here. Said decline should also have been bullish for gold, but that has not been the case. What it has been bullish for is lumber, which has traded out to new reaction "highs" as housing continues to strengthen. To me, all of this is suggestive of an economy that is not going to tilt back into recession. Even if we go over "the cliff," provided it is not for too long, the economy should be able to survive, as should the stock market. The more important question, at least in the short-term, is the overbought condition of the equity markets, a condition that is quickly being corrected. Also worth noting is that while some sectors are overbought, others are oversold, the most obvious of which is precious metals. Another sub-sector that is oversold is the coal sector. Both sectors provide investor friendly risk/reward ratios. For names, we point you to our fundamental analysts' research reports, or to Van Eck International Gold Investors Mutual Fund (MUTF:INIVX), as well as to Van Eck Coal Global Coal Market Vectors (NYSEARCA:KOL). I am also sticking with my bullish "call" on China of four weeks ago using the ETF of your choice.

The call for this week: If the Mayan calendar is right, and December 21, 2012 represents the end of the world, none of my ramblings matter; and this week's "call" should therefore be "Party on, Garth." But if the Earth doesn't implode, I still think the upside in stocks should be favored. The fact is that governmental spending "cuts" should prove positive for the various markets provided they are too large and do not come too quickly. And while it's true raising taxes is potentially short-term bearish, longer-term it is not; again provided it is not too much of a tax increase. This week is the key, a pullback to the 1400 – 1410 level, with a concurrent oversold reading from the McClellan Oscillator, could act as a springboard for fabled Santa Rally. But if 1390 is decisively violated, well, "If Santa fails to call, the bears will roam on Broad and Wall!"
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No positions in stocks mentioned.
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