Although yesterday's move left many investors scratching their heads, the reason for the joyride to the upside can be summed up in one simple phrase: A path forward is developing.
After finishing lower almost daily for the last three weeks, stocks were clearly oversold. As such, a bounce was certainly to be expected at some point. However, Thursday's blast wasn't the prototypical oversold bounce. No, this one had some oomph behind it as shorts scrambled for cover, dip-buyers did their thing, and all those opportunistic fast-money types that had been looking for a sign that it was safe to get back into the pool dove in as well.
There are two question from here, of course. First, why did stocks suddenly and without warning reverse course? And second, will the rally hold up given that there is still no deal in sight and the deadline remains a long way off?
The short answer to the first question is that traders have been implementing the government-crisis trading play book developed in 2011. Here's the way it works.
The Play Book
First, stocks are sold off in earnest on the fear that the government might default on its debt and create a recession/depression along the way.
This fear causes sellers to become more active and buyers to simply stand aside. The thinking on the buy side of the equation is simple; why buy now when stocks are likely to go lower until the deadline occurs? The combination of emboldened sellers and buyers sitting on their hands creates a vacuum. Whoosh, down they go.
Stocks then continue to head lower due to the fact that a deal to save the day won't occur until right before (or right after) the well-publicized deadline. Each passing day creates more tension, more uncertainty, and more doubt. And while logic dictates that Congress wouldn't do anything to actually harm the country or the economy, as the debate becomes more acrimonious, doubt on this topic continues to creep in.
But then, just when it looks like the deadline clock will expire and the economic calamity being predicted by the bears will actually occur, Congress pulls a rabbit out of their hat and somehow, some way, makes a deal. Stocks soar in response as traders breathe a sigh of relief. Short-covering ensues and before you know it, the entire worry-induced decline is erased.
But This Time Around...
However, this time around the game was played a little differently. In the beginning, traders didn't want to buy into the game. The bottom line is nobody wanted to get fooled again. After buying into the doom and gloom being espoused at the end of 2012, traders didn't appear interested in biting on the idea that Congress might actually cause the sky to fall this time. But as this drama has unfolded and neither side has appeared willing to budge, the fear of what might happen clearly took hold.
Just as the play book calls for, a vacuum was created and stocks then started to tank. With the President doing nothing, the Tea Party making unreasonable demands and the Democrats sitting on their winning position, it became clear that nothing was going to get done before the Oct. 17 deadline. Therefore, the fast-money types thought they had a no-brainer trade to the short side.
However, what short-sellers didn't count on was the idea that the Republicans might not want to take the blame for this thing going south. So, with plenty of time left on the clock, the negotiations began again. And as the saying goes, as long as the two sides are talking, nothing bad is going to happen. Suddenly the doom and gloom scenario has been removed. Boom, the bulls look to be back in business.
Will It Stick?
The next question investors face is whether or not the Thursday move will stick. The bears contend that there are many twists and turns left in this drama/debate and that there is still no guarantee that a deal will get done.
In fact, the headlines came fast and furious out of Washington Thursday evening. First, the White House announced that Obama had rejected the GOP debt limit plan (because they didn't do exactly what he wanted). Then House Majority Leader Eric Cantor said that talks are expected to continue into the night. So, to say that this remains a fluid situation is an understatement.
The key however, is that the two sides are indeed talking. They are clearly not talking nicely and there is no Kumbaya moment at hand. But given that the GOP has backed away from the early demands related to ObamaCare, it does appear that there is a possible path forward to an eventual deal. So, even if a deal doesn't get done until the very last minute, as long as there is hope for a deal, stocks could easily remain buoyant.
Mr. David Moenning is a full-time professional money manager and is the President and Chief Investment Strategist at Heritage Capital Management. He focuses on stock market risk management, stock analysis, stock trading, market news and research. Click here to claim a free copy of Dave's Special Report on changes in the current market.