How far will the market fall if we go over the cliff?

Disappointment over a lack of an agreement by Christmas could result in an immediate selloff.

By InvestorPlace Dec 14, 2012 1:09PM

Arrow Down copyright ImageSource, PictureQuestiplogoBy Sam Collins


Stocks slipped for most of the day Thursday following House Speaker John Boehner's negative comments on the lack of progress on averting the fiscal cliff. He even suggested that President Obama was willing to go over the cliff in order to push ahead with his position on tax cuts for the wealthy. 


A late-day announcement that the president and speaker would meet at 5:00 p.m. caused a minor rally, but even most of that was taken back before the close.


At Thursday's close, the Dow Jones Industrial Average was off 75 points at 13,171, the S&P 500 fell 9 points to 1,419, and the Nasdaq lost 22 points at 2,992. The NYSE traded 662 million shares and the Nasdaq crossed 398 million. On the Big Board, decliners outpaced advancers by 2.3-to-1, and on the Nasdaq, decliners were ahead by 1.7-to-1.


UUP Chart
Click to Enlarge


Trade of the Day Chart Key


While investors' attention has been focused on the fiscal cliff, the U.S. dollar has been strengthening. As illustrated by the PowerShares DB US Dollar Index Bullish Fund (UUP), the dollar appears to be putting in a bottom at current levels after falling from its 200-day moving average in November. MACD is positive as support is forming at the support line of a long-term bull channel.


NYSE Chart
Click to Enlarge


The NYSE Composite is an index of all stocks listed on the New York Stock Exchange. Therefore, it is often more representative of what the "stock market" is doing than other indices. Here we see that while the Dow and Nasdaq, and even the S&P 500, have been trapped in a narrow trading range, the NYSE Composite is just shy of a massive bullish breakout.


In November, it reversed from its intermediate support line, and for three weeks has been racking up gains. It is currently overbought as shown by the MACD indicator, and thus will likely pull back to support at its 50-day moving average. But the overall pattern is bullish and could even evolve into a massive reverse head-and-shoulders. We'll continue to focus on the chart during the next month.


Conclusion

The two charts shown today, UUP and the NYSE Composite Index, appear to be incompatible. But are they? If the dollar rallies, then stocks should drop; however, UUP has considerable resistance at its 200-day moving average, and the NYSE Composite has support at its 50-day moving average. A near-term correction in stocks resulting from going over the cliff could set up stocks for an immediate correction and then a strong move up and a breakout in late January.


This week’s AAII sentiment survey appears to support this view. Bearish sentiment -- expectations that stock prices will fall over the next six months -- dropped by 4.5 percentage points to 30.1%. This was the lowest level of pessimism registered by the survey since Aug. 23. Bullish sentiment rose to 43.2%, up 1 percentage point. Since this survey is a contra-indicator, it supports the view that we should expect a correction to occur shortly.


Disappointment over the lack of an agreement on the fiscal cliff by Christmas could result in an immediate sell-off. But there appears to be enough support to hold a decline to no more than 5% to 8%. The New Year may very well bring new highs despite the near-term malaise.


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