Stocks And The Fiscal Cliff: What Really Matters Today

by: Eric Parnell, CFA

Much is being made in the financial news about the pending U.S. fiscal cliff at the end of the year. Such attention is certainly warranted, for going over the cliff on January 1, 2013 would strip roughly $500 billion, or 3.5% of GDP, out of the U.S. economy and almost certainly plunge us into recession. And many point to the poor performance of stocks around the time of the debt ceiling debate in the summer of 2011 as proof that we could once again see a spike lower in stocks as the fiscal cliff negotiations unfold in the coming weeks. But such references are largely misguided, as the stock market did not plunge last year due to the debt ceiling debate.

A detailed look back at the stock market during the summer of 2011 shows that it was other factors, not the debt ceiling debate, that caused stocks to plunge lower.

It is worthwhile to first take a daily walk through the timeline. The debt ceiling debate had been ongoing for months heading into the summer of 2011. And the August 2, 2011 line in the sand to get a deal done had been drawn by Treasury Secretary Tim Geithner back on May 16, 2011 in his letter to Congress when he stated that the borrowing authority of the United States would be exhausted past this date. But most on Wall Street are well aware of the sausage making process in Washington, knowing that both sides would take the debate down to the final hour before reaching some sort of deal. And so it came to pass on the evening of Sunday, July 31, when congressional leaders and President Obama reached an agreement that included delaying many of the cuts until 2013. This, of course, helped lead us to the fiscal cliff debate we are now having today.

The stock market was largely complacent if not sanguine in the days leading up to the August 2 deadline. Stocks had been in rally mode up until a week before. And on the last trading day before a deal was announced on Friday, July 29, stocks as measured by the S&P 500 were still trading above June 2011 levels and were holding support both at 1295 and the 200-day moving average. And once a debt ceiling deal was announced on Sunday, July 31, the S&P 500 futures initially spiked higher by +17 points.

It was only after the debt ceiling debate was completed that the stock market began to plunge lower and downside volume spiked higher. Some might contend that this post agreement downturn was driven by Standard & Poor's downgrading the United States credit rating from AAA. But this occurred on August 5, 2011 long after the spike lower was already underway. And if the markets truly took this downgrade seriously, we would have likely seen an accompanying spike higher in Treasury yields and not the strong rally that included a 16 basis point drop in the 30-year Treasury yield on the first trading day after the announcement.

Thus, despite what we might hear today, the debt ceiling debate likely had little if anything to do with the stock market plunge during the summer of 2011.

The more things stay the same, the more they stay the same

So if it wasn't the debt ceiling debate, why exactly did markets plunge in the summer of 2011? Three far more significant factors were at work. And since policy makers have done nothing to fix the underlying problems facing the global economy other than to put the hard decisions off until a later date, we find ourselves facing these same three problems along with the fiscal cliff as we move toward the end of 2012.

The three key challenges for both the summer of 2011 as well as today as first cited in my article on Seeking Alpha from August 1, 2011 are as follows:

1. The global economy is slowing

2. Additional fiscal and monetary stimulus will be limited going forward

3. The European sovereign debt crisis keeps getting worse

So what does this all suggest for the market as we move toward the fiscal cliff and beyond into 2013?

First, stocks movement between now and the end of the year will likely have little to do with the fiscal cliff. Just as with the debt ceiling debate from the summer of 2011, the consensus market view remains that some sort of deal will be worked out before the end of the year. The process in Washington will once again likely be ugly to watch along the way and will probably involve postponing the difficult decisions until after the President has been inaugurated for his second term and the new Congress has been seated, but this plan actually makes sense as most major legislation and compromise have historically occurred more toward the middle of presidential terms in office and not during a lame duck session. The surprise for the market at this point would be if we actually plunged over the cliff in a sustainable way.

Instead, the three forces listed above will likely determine the path for stocks in the weeks ahead. Just as it was in the summer of 2011, the crisis in Europe remains the most important issue to watch for the stock market between now and the end of the year. If markets get the sense that the situation can stabilize, at least for the moment, stocks have the ability to rally even in the face of the fiscal cliff uncertainty.

The significance of the Fed's influence on the stock market should also not be overlooked. After all, it was the Fed's initial hints about more stimulus on August 8, 2011 that first help set a bottom under the stock market at that time. Today, the Fed is already engaged in full-blown balance sheet expanding monetary stimulus at the rate of $40 billion per month. And Chairman Bernanke has already been out on the streets in recent days hinting that he will up the ante even more on monetary stimulus if necessary.

Market risks may continue to seem tenuous in the coming weeks. Amid such an uncertain environment, it is as important as ever to remain focused on the key issues driving the market. And given the inclination for policy makers to intervene at the first signs of any stock market instability, the risks to the upside (being short) are just as profound as they are to the downside (being long). Moreover, any market views, particularly as they relate to stocks, should be held with a short-term focus and evaluated carefully as events unfold between now and the end of the year.

As a result, a hedged approach remains the best strategy for navigating the current market environment. This includes allocations to low volatility (NYSEARCA:SPLV) and mid-cap (NYSEARCA:MDY) U.S. stocks as well as selected non-U.S. markets such as China (NYSEARCA:FXI) and Brazil (NYSEARCA:EWZ) that are better positioned for growth and have greater scope to apply additional stimulus if necessary. And in an environment marked by seemingly boundless money printing, maintaining core holdings in store of value precious metals such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) through instruments such as the Central GoldTrust (NYSEMKT:GTU) and the Central Fund of Canada (NYSEMKT:CEF) remains prudent.

So when monitoring market performance in the coming weeks, beware revisionist history. For the reasons you may be hearing as to why the stock market is moving in one direction or another may actually have nothing to do with the actual cause.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long MDY, SPLV, FXI, EWZ, CEF, GTU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.