So, will the US stock market break hard on Monday? Let’s analyze the pros and cons and try to figure out what is most likely to happen.

First of all, as I write this at 2 am EST / 11 pm PST Sunday night, global markets are down. Asia is down 2-4 percent across the board. Europe is about to open. S&P and NDX futures here in the US are indicating a 2.5% down opening. Let’s also realize that 2.5 percent on the Dow Jones is about 200 points. The breakers don’t shut down the market until 1000 points on the Dow. We’re not in that territory yet.

Factors in favor of a breakdown:

The S&P downgrade certainly has implications for US Treasuries and entities that hold US Treasuries. There will probably be long-term ramifications of the downgrade for months.

Margin calls. We’re in margin call territory in the US, although the Asia markets have much higher margin levels than the US stock markets. If this puts firms at risk due to margin, you won’t see it in the opening action. It will hit the most over midday lunch activity and the last hour.

Overvalued to begin with. A lot of people are making the argument that pricing in US stocks due to QE2 puts prices at beyond reasonable levels if you ignore the S&P downgrade, and even morese if the economy contracts.

Destructive behavior in Washington. If you read the S&P downgrade statement carefully, it doesn’t say that it feels like the US can’t pay its debts. It basically says that Washington is so irrational today that it has zero faith that it will take the proper steps to finish the business that it left on the table. It even goes as far as to say that the expiration of the high-end Bush tax cuts are necessary to stabilizing the markets, and that it no longer is certain that this will occur. In other words, the inmates are running the asylum, and here’s the penalty and extended punishment. Go back to what I wrote last week. Contracting an economy in the middle of 9% unemployment is just dumb.

That’s actually a fairly short list, to be honest.

Factors against a breakdown:

Two other ratings agencies DIDN’T agree with the downgrade. This is a key point that is being overlooked. Not everyone is sure about this.

We’re not close to August options expiration. The great crashes in stock market history occur when there is no options protection (including 1987, 1989, and 2000); INSERT INTO `wp_posts` (`ID`, `post_author`, `post_date`, `post_date_gmt`, `post_content`, `post_title`, `post_category`, `post_excerpt`, `post_status`, `comment_status`, `ping_status`, `post_password`, `post_name`, `to_ping`, `pinged`, `post_modified`, `post_modified_gmt`, `post_content_filtered`, `post_parent`, `guid`, `menu_order`, `post_type`, `post_mime_type`, `comment_count`) VALUES but this isn’t that point.

We sold off sharply last week, at least part of which was in anticipation of the downgrade. This doesn’t mean that Monday will be a bottom, but it suggests that Monday won’t be as bad as it could be.

The active sellers don’t own stocks anyway. Frankly, most of them got wiped late in 2008 at the end of the largest drop in market history when the VIX spiked to levels it had never seen. They’ve missed the run, they don’t believe in it to begin with, so they don’t have stocks to sell.

The US Dollar has been strong in the FX market since the open.

So what does that leave us with?

Never underestimate how much selling pressure gets factored into the markets before we get to the US session. My general view is that this does NOT lead to a sharp sell-off in the US markets after the open on Monday. Washington may have made a lot of mistakes in their efforts last week. Let me give you the version of how this should have worked. The stimulus back in 2009 should have been $1.5 trillion bigger (or more) and not in the form of greater tax cuts but in the form of job-creating spending like we did in the early 1930’s. When unemployment and the economy improved, it should have been a long-term debt/deficit agreement that included bigger commitments to debt reduction funded by 75% spending cuts and 25% tax increases, mostly on the rich, who haven’t felt any of this comparatively. But, we did the stimulus wrong, and we did the debt reduction too early and even more poorly. So are the markets going to punish us as I said they might last week if they felt that the spending contraction would lead to a recession in 6-9 months? And I think the answer is that the downgrade is probably factored in in the short term and the rich got short last week on the heavy volume that we saw, and there will be buyers Monday, but after that, the sky’s the limit.

And either way, we’ll trade it the way we see it, based on market direction, which is great since we’re giving a free webinar at noon EST tomorrow on that very subject that was already planned. Non-subscribers, access the Lab here for free with any username and password “august” without the quotes.

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