Fiscal Cliff: Nothing to Fear But Fear Itself

by Jim Woods | August 22, 2012 11:14 am

[1]There’s a new panic phrase on Wall Street, as well as on the presidential campaign trail, and that phrase is the “fiscal cliff.”

By now, you’ve no doubt heard this term being bandied about by analysts, money managers, congressmen, senators and even the principles in the fight for the White House.

This week, we heard another warning on the topic — this time from Wall Street titan Goldman Sachs (NYSE:GS[2]), which said that investors should dump stocks before the fiscal cliff hits[3].

In a note to clients, Goldman Sachs chief U.S. equity strategist David Kostin wrote that he thinks Congress will fail to grapple with the fiscal cliff issues before the election, and possibly before the end of the year. That, Kostin says, will cause massive uncertainty in the markets that could take the S&P 500 down substantially by year’s end.

Here’s the money quote from Kostin’s note:

“Political realities and last year’s precedent suggest the potential that Congress fails to reach agreement in addressing the fiscal cliff is greater than what most investors seem to believe based on our client conversations.”

The political realities Kostin is referring to is last year’s debt ceiling debate[4] that resulted in a stop-gap measure deal between the White House and Congress to lift the debt ceiling and cut the rate of growth of some federal spending. According to last year’s deal, if a new budget deal isn’t reached by Jan. 1, 2013, a bitter cocktail of automatic tax increases and spending cuts that could seize an estimated $500 billion from the economy in 2013 would take effect. That possibility is something Kostin thinks will exert a lot of pressure on the markets leading up to that fateful day, and beyond.

One reason Kostin is making this argument could be an attempt to defend his bearish thesis that the S&P 500 would finish the year at 1,250. On Monday, Aug. 20, the broad-based measure of the domestic market closed just above 1,418. To reach Kostin’s target, stocks would have to plunge nearly 12% by Dec. 31.

Here, Kostin points out that in the immediate aftermath of last year’s debt ceiling debate, stocks fell hard in a very short time, and the implication is they are susceptible to another similar plunge.

“Last year, the deadline for Congress to raise the federal debt ceiling was known months in advance … Nevertheless, Congress was unable to reach an agreement that satisfied all factions. Investors were stunned and the S&P 500 plunged 11 percent in 10 trading days,” Kostin writes.

What I think we need to keep in mind is that this is an election year, and that means the rhetoric over fiscal issues — by both political parties — will be on a massive dose of steroids. You can bet that the fiscal cliff is something both sides will demagogue all the way through Election Day, and well beyond.

In a recent article on the defense sector[5], I wrote that while our nation’s fiscal problems are very real, I don’t think Congress and the next president will let so much money flow out of the biggest area to be affected by automatic cuts — defense. I also wrote that there’s likely to be a whole lot of fear-mongering about those automatic cuts, as well as those automatic tax increases, in the weeks and months leading up to the fiscal cliff.

So far, those warnings about the fiscal cliff haven’t been successful at keeping money away from equities. The S&P 500 is up nearly 12% year-to-date, and since falling to its June low, the index has surged more than 11%. The S&P 500 now trades right at multi-year highs. The gains in stocks also have pushed down the level of fear in the market, which is at a minimum. The CBOE Volatility Index, or VIX, is the best measure of such sentiment, and it has fallen to multi-year lows[6]. This certainly suggests fear is not a factor for the markets.

Could Kostin be correct about the fiscal cliff eventually putting pressure on stocks? Possibly, but right now it seems more like a failed early prediction than a likely outcome.

Until we see the markets begin to react to fiscal cliff fears, I don’t think investors should be dumping stocks. In fact, if you’re not long equities now, the only fiscal cliff you’ll want to jump off is the one from your own rooftop after you see your account statement — and after you realize how much money you’ve left off the table because you feared the unknown.

As of this writing, Jim Woods did not hold a position in any of the aforementioned securities.

The opinions contained in this column are solely those of the writer.

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  4. last year’s debt ceiling debate:
  5. recent article on the defense sector:
  6. has fallen to multi-year lows:

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