The Fiscal Cliff and Traders: What to Know

John Netto Founder, The Protean Trader, LLC

What does the "fiscal cliff" mean for traders? John Netto explains what he's watching to determine how to trade the reaction.

My guest today is John Netto; we’re talking about the fiscal cliff, we’ve heard a lot about this in the news, but how is it affecting trading decisions?  John, I know you follow a lot of the news; how is this fiscal cliff affecting your decisions of making trading right now?

Sure.  What’s important about the fiscal cliff is to understand the market perception behind the fiscal cliff, and a lot of people say oh, we don’t want to go to total sequestration because it can be damaging for the economy, and ultimately will these two parties reconcile themselves, but I take a trader’s perspective and I want to understand what does the market anticipate will happen, and what we saw post-election as the market was concerned that with the status quo being ratified, i.e. President Obama being re-elected, and then House of Representatives also coming back into power, more or less the same profile and composition, that it would set up an environment for gridlock, and some of the early dialog we saw out of The White House and even in some regards out of John Boehner was that maybe the decisions wouldn’t reconcile, so the market began to become more negative in terms of expecting a resolution to happen, so that gives you insight into how you might want to play that market. So if there is a resolution to it, I think the market could rally rather strongly to the upside.  If there’s not, we’ll continue to sell as real money funds and pension funds unwind some of their positions.

Alright.  Let’s talk about how you make those trades.  Let’s say they do come to a compromise and we have some tax increases or we have at least a budget.  How will you trade that; is it as simple as going long the SPYs or what will you be doing?

Well, there’s two aspects of this, and you need to define the time frame behind how you want to trade this market.  The first is how will you trade in the hours and days that followed the decision?  The next is how will you trade it in the weeks and months that follow the decision?  The bigger issue, longer term is global growth; growth from developing nations and growth from emerging markets, and as I look at the hours and days that follow, we’re probably going to see a bit of a buttress in the overall equity markets, but we also want to understand that when the decision is put into place, where are the markets at, at that point in time?  Did the market anticipate the decision would happen, like had it rallied three or four days leading up to the release of the decision?  If so, you have to take on more of a cautious tone because the market had already priced that in, juxtaposed to if it comes as a surprise.  If it comes as a surprise there’s a real potential to play that move in the coming days and weeks of the upside.

What do you think is influencing the market most right now; is it earnings or is it the fiscal cliff and that uncertainty there?

I think it’s a combination of higher capital gains taxes; we have a couple of precedents going back to 1986, when Regan was in The White House and raised capital gains from 20% to 28%; we thought that was one of the five Decembers since 1950 where the market’s been down in December as people prepare for those capital gains increases, and wanted to sell the things that they had a high stake in, and what’s funny is we look at stocks like Apple right now, which is obviously very capital gains intensive, and looking at other aspects of the market, just the kind of impression that puts in place for companies that are widely held, have a lot of gains, and then the people want to realize those gains early, and as a result of that you have an aspect where people are coming in and being structurally short, understand that people are going to want to sell those holdings.

Alright, and then finally, will this have an effect on a Santa Claus rally?  Do you think we’ll have one at all knowing all this is happening?

I think it puts a damper on a Santa Claus rally.  Understanding that there’s a structure in place here, that we’re seeing a major catalyst take place in this market from a macro perspective, all right, I think we’re going to be much harder pressed to rally in December, but I am positive for 2013, but what’s on the horizon for Q1 and the Q4 economically, it’s very suggestive to me it’s going to be very difficult for this market to rally, and being long Treasuries and being very tactical with equities is the way to play this.