INVESTMENT POLICY COMMITTEE
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Cliff Diving, or Not

December 7, 2012

The debates about the so-called fiscal cliff – the year-end expiration of multiple tax rate reductions, government spending levels, and unemployment benefit extensions – have dominated recent news coverage.  So far, the stock market hasn’t reacted much to the daily headlines that alternately predict a solution is or is not likely prior to December 31. 

Given the prophecies from many economists that a failure to act on the fiscal cliff by Congress will bring economic doom, and given how sensitive the market has been to headlines over the past three years, the stock market’s recent even keel has surprised many observers, including us.

Regardless of the market’s seeming indifference to the cliff, we still believe that a failure by Congress to agree on a solution prior to year-end would result in a sizeable drop in stock market prices.  How sizeable?  Let’s use earlier failures by Congress as reference points:

  1. On September 29, 2008, Congress rejected the Troubled Asset Relief Program (TARP).  This major piece of bail-out legislation came at a time when the U.S. economy was in chaos: the banks were drowning is a sea of bad loans, monthly job losses had reached 800,000, and GDP had just entered a recession.   In the week following that “No” vote by Congress, the Dow Jones Industrial Average (DJIA) dropped almost 11%.  As economic conditions continued to worsen and serious talk of the need to nationalize all banks began to surface, the market dropped another 18% - a total decline of nearly 30%.
  2. In the summer of 2011, Congress appeared to be stalemated again over raising the debt ceiling.   (Which, ironically enough, began a series of events that has landed us where we are today, 24 days away from the fiscal cliff).  On July 21, 2011, the DJIA was at 12,724.  As Congress flailed around in public and practiced brinksmanship in the press, public confidence fell.  The DJIA also fell, by 16% to 10,719 on August 10.  (Note, the decline was about half that of 2008.)  Unlike 2008, by the summer of 2011, the economy was adding roughly 200,000 jobs per month and GDP was growing in the 2% range.  In August 2011, the stalemate was broken when Congress, bowing to public indignation, raised the country’s debt ceiling before any government shutdown was triggered.  Within three weeks, the DJIA rose 8% to 11,613, and has continued to rise another 12% to today’s level of around 13,000.

In light of these recent precedents, we believe a failure by the politicians to reach any agreement prior to December 31 could push the Dow down by about 10%.   There are arguments on both sides of the question as to whether or not some risk of going over the cliff is already priced into the market, but, let’s assume it hasn’t.  We’ll explain later why we believe the risk of a big market selloff is less today than in the earlier stalemates.

A 10% selloff would be a problem, but not a catastrophe, since bear markets, by definition, don’t start until the market drops 20% or more.  However, the cliché about going over a cliff definitely applies here: It isn’t the fall that’s dangerous, it’s the landing.   Almost all of the media discussions about Congress, the fiscal cliff, and the economy seem to end with the stroke of midnight, December 31.  Will we go over the cliff or won’t we?  End of story.  Some have taken it a bit farther to list the various tax increases or spending cuts that will be triggered.  Even fewer go so far as to try to put a timeline to exactly when each element will hit.  

What nearly all pundits seem to miss is that the U.S. economy, the banking system, and Congress will all continue functioning beyond year-end.  And even though, we believe stocks will sell off, we firmly believe they are not headed for the trash heap such as in 2008.  For that to happen, the economy would have to be in far worse shape than it is today.  Therefore, it’s critical to include in our investment planning how the economy, Congress, and the elements of the fiscal cliff will interact after December 31, 2012.

In our view, the economic and stock market risks we face in 2013 and beyond are nowhere near as bad as they were in the two previous Congressional stalemates.  Here’s a list of reasons why we say that:   

  1. The U.S. banking system is dramatically stronger than it was in 2008.
  2. The U.S. economy is adding jobs every month, not hemorrhaging them as it was in 2008.
  3. Third-quarter GDP growth reached 2.8%, which was the highest rate of growth of any quarter this year.
  4. Housing starts are 50% higher than a year ago, and home prices have recently turned higher.  
  5. Finally, we are not facing a government shutdown or a massive bailout of the banks.  Instead, we are facing – in the worst case – higher individual income tax rates, reduced unemployment benefits, and automatic spending cuts of just over $100 billion per year, or less than 1% of GDP. 

Left unaddressed, these tax increases and spending cuts would be felt, but they would not send the economy into a death spiral.  In short, the U.S. has positive and growing economic momentum. 

All these mitigating factors are why we believe that going over the cliff might hit stocks prices by 10%, not 16% or 30%.  Indeed, the Congressional Budget Office estimates that going over the cliff would cause the U.S. economy to dip early in the year, but GDP would show positive growth for the second half of the year and for 2013 as a whole.

Importantly, however, going over the cliff is not the only possibility in the current stalemate.  There are two other major possible outcomes:

  1. Congress could “kick the can down the road.” That is, they could agree to postpone the cliff without a comprehensive long-term fix, yet agree on the level and mix of tax hikes and deficit reduction to be worked out over the coming months.
  2. They could enact a massive re-write of the tax code, raise major revenues and substantially reform entitlement spending – the so-called “Grand Plan”.   Yeah, we don’t think so either.  But given the current widespread pessimism about Congress’ ability to function, we believe that either of the two alternative outcomes would result in significant stock market increases.  In fact, we think the upsides of the positive outcomes are greater than the downside of going over the cliff, maybe by as much as 2:1.

The probabilities of the three major outcomes are certainly debatable.  Our Investment Policy Committee has spent literally hundreds of hours thinking, debating, and researching the three most likely outcomes.  The table below offers our probability analysis of each outcome on stock market prices, their individual risk-weighted impacts, and the overall weighted expected average return

Event

Probability

Stock Market Impact

Weighted Average

  Kick the Can

50%

+10%

+5.0%

  Go Over the Cliff

40%

-10%

-4.0%

  Grand Plan

10%

+20%

+2.0%

  Total Weighted Average

 

 

+3.0%

As you can see, the risk adjusted impact of the three outcomes is a positive 3%. That is not a probability profile that you run from. 

For these reasons and our hours of discussion, it is our plan to remain invested as we are today through the end of the year and beyond. Additionally, an important consideration in our decision is the reality that the American people are fed up with a government that cannot function.  Thus, in our way of thinking, even if Congress allows us to go over the cliff, we don’t think it will last long. As a model, think here of the National Football League’s stalemate with their referees.  No deal was in sight until the American people felt like they were being cheated with an inferior product.  After both parties stated unequivocally that they remained far apart, a deal was struck within 24 hours after the ineptitude of the substitute refs was made clear to all. 

Congress can talk tough all they want, but we believe they have shown they will buckle to extreme public pressure, and that is exactly what they will get if they can’t cut a deal by year-end.   

A final reason that we believe we should not significantly alter our investment strategy is the reality of how markets work.  If the stock market falls because the current stalemate persists beyond December 31, we believe it will soar perhaps as much as several hundred points in the new year when a deal is reached.  That might seem like a big “if,” but we think it is the safest bet of all those we have discussed here. 

In our minds, there will be a deal, we just don’t know when.  There is no precedent in history when legislators chose to destroy the country for purely ideological reasons.

We believe no matter what happens stocks will be higher in six months than they are today.  Trying to duck a worrisome event just because it is full of unknowns and lots of emotions is one sure way to irreparably damage long-term returns.  We have seen it over and over again:  A client goes to cash in the face of falling stocks and gloomy headlines and economic data, only to kick him or herself weeks or even months later when the stock markets dramatically recover.

The discussion up to now may sound like we are just going to give the fiscal cliff a pass, and we aren’t going to make any changes in our portfolios.  Nothing could be farther from the truth.  Indeed, we were hoping that as the fiscal cliff drew near it would produce big swings in stock prices.  Our strategy was and is to add to many of our terrific rising dividend stocks during these market sell offs.  We still believe we will have some buying opportunities, even though the markets have been reasonably tame so far. 

For regular readers of our blogs and quarterly letters, you know that we have been moderately optimistic all year.  The average stock market gain prediction among our Investment Policy Committee in January 2012 was for total return gains of slightly above 15% for the year.  Over the past year, we have been shifting the mix of companies in our clients’ portfolios away from such a heavy emphasis on defensive issues and toward those that will do best in a growing economy – Consumer Cyclicals, Energy, Financial Services, and Real Estate.  It continues to be our view that the U.S. economy is strengthening every day. 

So, there you have it.  We have been thinking, planning, and acting in anticipation of the fiscal cliff since February.  And in our view, our clients are well positioned to ride safely even through the turbulence of actually going over the cliff, if that comes to pass.  Better yet, we believe our clients will benefit from the net positive outcome we expect from the entire mix of possibilities.

Respectfully,
The Investment Policy Committee

Randy Alsman, VP
Rick Roop, VP       
Joe Zabratanski, VP
Mike Hull, President
Greg Donaldson, Chairman