Bullish investors have a hair-trigger regarding any deal relating to the fiscal cliff. They presume a deal will be had around terms including higher taxes on “the rich” (loosely defined by $250K-$1M in income) and a concession to include entitlement spending reductions probably focused on social security. If agreed to this should provide a “relief rally” that may last through the holidays. Given this deal really only fixes deficit and debt conditions around the edges perhaps in early 2013 the rally will be undone. In other words, after year-end bonuses are paid to portfolio managers reality may bite after a brief honeymoon.

Lingering under cliff news economic data remains poor. Monday the Empire State Mfg Survey laid an egg (-8.1 vs 0 expected & prior -5.5) as manufacturing ex-autos remains weak. A quick look at a combination of economic data below makes a weak economic picture more believable.

Beyond all of this is what the Fed wants you to do—buy stocks. After all, they’re providing nearly $100 billion a month in QE activity. This money will find its way into markets and will force you to buy stocks even if you don’t want to. Why? Because the alternatives are negative yields in bonds and sideline cash.

The same holds true with other central banks in Europe and Asia as its raining fiat currencies.

Not to be outdone, Japan’s election provided a large win for the LDP led by the conservative Shinzo Abe where “economic recovery and overcoming deflation” are top priorities. This means more stimulus and a much weaker yen as John Mauldin explains well-enough in this video and article. Yet there’s one thing Abe or anyone can do anything about and that’s poor demographics with an aging population and massive debt. Perhaps the investment strategy will evolve to a short yen/long EWJ position. We’ve already gone through one round of profitable trading short yen (YCS). But, now the yen is much oversold and short positions are now at record levels. A sharp short squeeze could occur at any moment.

What could go wrong with this scenario? Markets and bond vigilantes could balk at buying more debt even as central banks print money to support deficits thru QE. The disaster scenario for all developed countries would be if interest rates rose given massive debt levels.

Stocks rallied sharply once the WH agreed to consider some changes to social security and/or other entitlement changes giving investors the idea a deal is close. Even if a handshake deal is made Boehner and Obama must sell the deal to their respective base. Financials (XLF) led the charge higher along with real estate sectors (IYR) (ITB) (RWX) as they’re perceived as beneficiaries of the Fed liquidity deluge.

Bonds (TLT) saw selling as stocks rose and Treasury auctions were weakly received. Meanwhile as stocks were gaining strength gold (GLD) was unresponsive in a “risk on” environment. The dollar (UUP) was flat and commodities (DBC) overall were flat.

Volume was modest and only picked-up after a more conciliatory WH response on cliff. Breadth per the WSJ was quite positive.

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