Last Tuesday Americans voted with their ballots. The next day the global equity markets voted with their money and the outcome was ugly. The markets sold off as we had predicted in last week's column.
Obama supporters say he got the American people's mandate. Republican supporters disagree pointing to the win in House of Representatives. Putting partisan hysteria aside let's agree that nothing changed with the election. Obama is still the President, the Democrats still control the Senate and the Republicans still control the House. But let us look at the equity markets.
Given the high unemployment, anemic economic growth and massive deficits under the Obama administration the markets anticipated a Romney win. But when that did not happen we saw sell off across the globe with the Dow Jones Industrial Average selling off more than 4% in three days.
We had mentioned in last week's article that an Obama win would lead to a fall in the equity markets and that's exactly what happened. The President's plan to let the tax cuts passed in 2003 to expire will lead to an increase in dividend and long term capital gain tax rises. This directly hits the stock market investor. Given that taxes would go up next year if the President and Congress do not act, investors want to book profits this year with a lower tax rate. The consequent selling led to a drop in the US markets and the global equity markets reacted.
Along with the expiration of the tax the US faces something called sequestration and the whole conundrum has been called the fiscal cliff. This is A situation where there will be automatic spending cuts and tax increases if the president and Congress don't act. The result is higher taxes and spending cuts automatically take effect to reduce the deficit by an estimated $560 billion.
According to the Congressional Budget Office (CBO), the sudden tax increase and spending reductions would cut gross domestic product (GDP) by four percentage points in 2013, leading to a recession along with a job loss of two million.
The sell off in the markets have focused the attention of politicians on the issue. But one can never be sure what will come out of the political discussions.
After all it was the same set of politicians that failed to deal with cliff before the elections. Probably the rapidly approaching year-end deadline would do the trick.
Given the uncertainty of the political outcome, it's best to focus on the charts.
As objective investors we should not be emotional about the political situation when buying, selling or shorting financial assets. Remember it does not matter if the markets are going up or down, what matters is the whether the size of your trading and investment portfolio is going up or down. As long as you are willing to go long and also short the market, volatility is a good thing.
The structure of the indexes in India and US right now are different. While the Indian indexes such as the Nifty and Sensex are caught in a range, the US indicies such as the S&P 500 and Dow are close to support levels.
This essentially means that while the Nifty and Sensex can continue to be volatile, the downtrend in the S&P 500 and Dow may be close to an end.
Let us first look at the Sensex (Click here for the Sensex chart).
Notice that the Sensex is forming a chart pattern called broadening formation. This is an extremely difficult pattern to trade. It is a pattern where price makes lower lows and higher highs, making it difficult to decide where to sell and where to buy without being stopped out.
For instance if one buys at a previous low, the market goes and makes a lower low before going higher, thereby stopping you out. If one buys at the previous high, the market rallies higher before falling, but one gets stopped out again.
Notice that the Sensex was in a decent downtrend as shown by the green arrows. They show a series of lower lows. A lower low is made when latest low in price is lower than the previous low. Also notice that the two red arrows on the left show lower highs. A lower high is made when the latest high in price is lower than the previous high. A series of lower highs and lower lows show a downtrend. In addition, note that the latest low in price was made after a long period of consolidation, which gave a signal that the downtrend was set to continue.
Then the market made a surprising move and rallied to make a higher high as shown by the third red arrow. A higher high is made when the latest high in price is higher than the previous high. The new high negated the downtrend. It is possible that the market could make a lower low and higher high again and continue the broadening formation. Also notice that the last bounce from the latest low was from a gap
A gap happens when the price closes at a certain level and opens the next day at a different level. A higher opening as in the case of the Sensex shows strong areas of support where demand exceeds supply leading to a rally in price. The gap is shown by a blue arrow. Now look at the price at which the index closed on Friday. It is near another gap, which is support making a down move tougher. Now if the market breaks the last low, you will notice that there is another strong gap support a little below.
Now let us look at the US markets. We will look at SPY, which is the exchange traded fund that follows the S&P 500 index. (Click here for the chart)
Notice that prices are now in a gap area as shown by the horizontal green lines. And there is another gap area below too. Hence now is not the time to buy as prices could rally from this level or the lower level.
A rally in the US markets can be a positive for the Indian markets. Aggressive S&P 500 traders can buy the S&P futures traded on NSE to take advantage of a potential bounce.
However, keep in mind that the fluid political discussions on the fiscal cliff can make the S&P 500 very volatile with a bearish bias.