Stocks Set to Bungee from Fiscal Cliff

NEW YORK (TheStreet) -- During Thanksgiving week stocks should rebound in what I call the first rise of the bungee after stocks hit a pre-holiday bottom at Friday's lows. The turnaround was caused by optimism from House and Senate leaders following a meeting with President Obama discussing how to resolve the fiscal cliff.

Last Friday I wrote Go Over the Cliff? May Be Best Thing fully aware that Congressional leaders would be meeting with President Obama to see if they could reach a consensus that both sides of the aisle can compromise on increasing revenue with higher taxes and spending cuts.

The promising words from the four Congressional leaders were received positively by the stock market. I believe that Friday's lows will not be breached this week, even though the longer term downside risks of QE fatigue remain.

What could be an appropriate fiscal cliff compromise?

On the revenue side, President Obama wants to let the Bush-era tax cuts expire at the end of 2012 for families earning $250,000 or more ($200,000 for individuals). Republicans say that this would hurt small businesses structured as an S-corp, where corporate profits flow to the owners' individual tax returns.

My suggested compromise is to keep the tax rate unchanged for all income identified from S-Corp earnings. I would also agree to allow capital gains and dividend income be taxed at the same rate as ordinary income. With regard to loopholes, I would table them until details can be established in 2013 for 2014 implementation.

On the spending side, the starting point should be what is already set by the Budget Control Act to begin in 2013. There should be no deductions in retirement benefits keeping Medicare and Social Security as is. If one party wants to spend more money than the law allows, such as defense spending, they must identify equivalent cuts elsewhere. The markets will not like the lack of discipline on the spending side of the ledger. No compromise means the cuts in the Budget Control Act should stand.

Reviewing the technical damage to the major equity averages since QE3 and the election:

Analysis of the Dow Industrial Average (12,588): Is up just 3.0% year-to-date, is down 8.5% since its QE3 reaction high, is down 5.2% since the election and rebounded 0.9% on Friday after the fiscal cliff meeting with the president. My annual value level is 12,312 with weekly and monthly pivots at 12,623 and 13,143.

Analysis of the S&P 500 (1359.9): Is still up 8.1% year-to-date, is down 8.4% since its QE3 reaction high, is down 5.0% since the election and rebounded 1.2% on Friday after the fiscal cliff meeting. If SPX moves above weekly and annual pivots at 1359.6 and 1363.2 the upside is to my monthly pivot at 1418.7.

Analysis of the Nasdaq (2853): Is still up 9.5% year-to-date, is down 12.0% since its QE3 reaction high, is down 5.6% since the election and rebounded 1.5% on Friday after the fiscal cliff meeting. My weekly value level is 2794 with this month's risky level at 3028.

Analysis of the Dow Transportation Average (4891): Down 2.6% year-to-date, is down 6.9% since its QE3 reaction high, is down 6.4% since the election and rebounded 1.1% on Friday after the fiscal cliff meeting.

A Dow Theory Sell Signal occurs given a daily close below the June 4 closing low at 4847.73. Dow transports traded below that level intra-day on Friday before the fiscal cliff meeting ended. Monthly and weekly pivots are 5056 and 5096.

Analysis of the Russell 2000 (776.31): Up 4.8% year-to-date, is down 11.9% since its QE3 reaction high, is down 6.4% since the election and rebounded 1.7% on Friday after the fiscal cliff meeting.

The daily chart shows a potential key reversal.

This index of small cap stocks set a post-QE3 low at 763.55 on Friday then closed at 776.28 above Thursday's high at 775.08, which is a "Key Reversal Day."

Higher closes today and Tuesday confirm the key reversal signaling a Thanksgiving rally, which could be the start of a Santa Claus Rally.

You can observe the key reversal day on the daily bar at the far right of the daily chart below. Also note that the momentum (12x3x3 daily slow stochastic) reading at 11.09 is well below 20.00 and thus is extremely oversold. There is a potential rebound to the 200-day simple moving average at 806.83.

Such a rally would still have the Russell 2000 below the five-week modified moving average at 809.43, which would keep the weekly chart profile negative. This week's value level is 766.63 with a monthly pivot at 807.15.

Chart Courtesy of Thomson/Reuters

While investors know that Congressional leaders are striving for a compromise to resolve the fiscal cliff, they also worry about higher tax rates on capital gains and dividend income.

Market strength off last Friday's lows should continue at least through the quiet trading of Thanksgiving week. This could be the beginning of a Santa Claus Rally if favorable fiscal cliff negotiations hit the tape.

However, if increased taxes on capital gains and dividend income become part of a Congressional deal, investors will likely sell before year end, to buy back in January.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Suttmeier has an engineering degree from Georgia Tech and a master of science from Brooklyn Poly. He began his career in the financial services industry in 1972 trading U.S. Treasury securities in the primary dealer community. In 1981 he formed the Government Bond Department at LF Rothschild and helped establish that firm as a primary dealer in 1986. Richard began writing market research in 1984 and held positions as market strategist at firms such as Smith Barney, William R Hough, Joseph Stevens, and Rightside Advisors. He joined www.ValuEngine.com in 2008 producing newsletters covering the U.S. capital markets, and a universe of more than 7,000 stocks. Richard employs a "buy and trade" investment strategy and can be reached at RSuttmeier@Gmail.com.

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