Why smart money will sell the Senate’s budget

End of Day Analysis:

The S&P500 fell out of bed Thursday morning when it started the day with the biggest losses in over a month. But within an hour supply dried up and dip buyers rushed to our rescue. Not only did we finish off the early lows, we actually managed to close in the green. That said, volume was unremarkable given how dramatic the price-action was.

This was an impressive reversal and it leaves us wondering what it means. Decisive reversals are often strong buy signals when they follow multi-day selloffs and the rebound occurs following yet another piece of bad news. Selling capitulates when then the crowd is most uncertain and fearful. That is when the last of the nervous sellers bail out and moments later prices rebound when there is no one left to sell. Unfortunately that setup looks nothing like today’s dip and rebound.

Things got more interesting late Thursday evening when the Senate passed a budget. While it was nice to finally see something not crash and burn in the Senate, the budget is largely a procedural matter and really doesn’t count for anything. The only significant thing is it allows Republicans to avoid a Democrat filibuster when voting on their yet to be announced Tax Reform Bill. Overnight futures popped 0.3% on the encouraging developments.

So what is a trader to do on Friday? Thursday’s intraday rebound appears constructive. Then you have the good news coming out of the Senate. Most likely the best plan is to sell the news. There are a couple of reasons why.

The easiest to explain is politics. If anyone believes our leaders will have constructive dialogues, quickly arrive at consensus, and pass a great Tax Reform Bill clearly isn’t paying attention. Politics is messy and I have no doubt Tax Reform will stumble countless times before it has a chance of passing.

There are two key rules every politician learns when they get to Washington:
A) Throw a fit until you get what you want.
B) If you don’t get what you want, blow everything up.

That is how Healthcare Reform went down and if anyone thinks Tax Reform will be any different, there is a medical term for that, it’s called insanity.

There are several opposing forces in the Republican party that will make any compromise difficult. First are the pro-business Republicans who want aggressive business tax cuts to stimulate growth. Second are the fiscal conservatives who bristle at the thought of adding to the deficit. And third are the moderates who want to see most of the tax cuts benefit the middle class. Three very different factions whose ideas are in direct conflict with each other. Without a doubt we will see someone throw a fit and refuse to support the first draft of the bill. Get three of those someones and the whole thing goes down in flames.

There is a good chance a compromise will eventually be reached, but politics is ugly and most likely this process will teeter on the verge of collapse moments before it is salvaged at the last possible second. Expect a lot of bad news between now and then.

Next comes the market’s price-action. As I’ve been writing about for the last two-weeks, the market is extended and needs to consolidate recent gains. Everyone knows markets move in waves and we are near the upper end of the latest wave. I’m definitely not predicting a crash, but catching our breath is a normal and healthy thing to do following a 100-point move from last month’s lows.

The market is fatigued and this is easily seen in the lethargic breakouts to record highs. Gains of 0.18%, 0.07%, 0.07%, and 0.03% over the previous four days show how little interest there is in buying the record highs. If there was explosive upside left in this rally, we would have raced higher by now. Instead these insignificant “breakouts” tell us demand is drying up.

Don’t get me wrong, I’m not bearish, just realistically cautious. Consolidations are a normal and healthy part of moving higher. The quickest way to refresh a market is pulling back to support. The longer way is drifting sideways for an extended period and allowing the trend lines and moving averages to catch up. Either one will work for this market and only time will tell which one we get.

I’m most definitely not calling a top here, just warning that the upside is more limited than the downside. Long-term investors should stick with their favorite positions, but shorter-term traders need to think about locking-in profits and waiting for better prices.

Jani