This preoccupation with the fiscal cliff is, frankly, driving me nuts.
I thought I was over it a few weeks ago. But it’s gotten much, much worse. You can't go anywhere without reading or hearing about the doomsday deadline when taxes increase and spending cuts kick in, potentially delivering a $500 billion double-whammy to the economy.
Markets move up and down based on the Washington rumor mill. On Tuesday, the Dow Jones Industrial Average closed down 89 points after Senate Majority Harry Reid (D-Nev.) said lawmakers were making "little progress" on negotiations to avoid going over the cliff by year-end. On Wednesday and early Thursday, stocks rallied after some hopeful statements by President Obama.
But for all of Wall Street's moaning and groaning, the market has hardly corrected at all over the past few weeks and the key VIX volatility index has barely budged. Maybe investors are venting their anxieties but voting with their wallets: Ultimately, they expect a deal. Only nervous traders are reacting to every twist and turn of this Beltway soap opera, and they'll pay the price.
If a deal gets done, it will most likely happen just before Christmas, so congressmen and women can enjoy a cushy holiday of eggnog and fund raising back home. They won't work out all the details, but there may well be some kind of framework of a final resolution by then, as the president suggested Wednesday.
I say this with all due humility -- because, as I wrote here, when it comes to the cliff, "nobody knows anything" about what's going to happen, including me (although two years of writing a political blog has made it clear to me that markets and politics operate by different rules).
But this is my best guess based on what the market is doing:
From its recent closing peak of 1,465.77 on Sept. 14, the S&P 500 fell to a closing low of 1,353.33 on Nov. 15 in the post-election sell-off. That's a decline of only 7.7%, barely in correction territory. (We saw an almost identical 7.8% pullback from early April to early June.)
By contrast, there was nearly a 16% drop from late April to July 2010 and a 20% correction from early May to early October 2011. In both cases, worries about Greece and Europe helped drive stocks down, and last year, the debt limit fiasco and Standard & Poor's downgrading of the U.S. credit rating to AA+ from AAA took their toll. But in neither case did stocks enter a bear market; in fact, they eventually moved much higher.
And then there's the widely followed VIX, the Chicago Board Options Exchange Market Volatility Index. In the sharp corrections of 2010 and 2011, the VIX topped 40. It even approached 27 in June. But in the current pullback, the VIX edged above 19 only once, on Nov. 7, the day after the election. Not much of a panic there.
In fact, Craig Johnson, who heads up technical research at Piper Jaffray, sees many positive signs in the charts, especially good relative strength in financials, industrials, and consumer cyclical stocks. If a bigger correction were in the cards, he told me, cyclicals wouldn’t be doing so well, 10-year Treasuries would be rallying big time, and housing-related stocks wouldn’t be tearing up the charts.
The latter reflects what looks increasingly like the long-term housing recovery I wrote about a couple of weeks ago as the forces behind housing's comeback -- low interest rates, much improved affordability, rising rents, and pent-up demand for household formation -- kick in.
Auto sales remain strong, and consumer confidence reached its highest level in over four years (although as Mark Hulbert pointed out on MarketWatch, that's often a lagging indicator). Still, it suggests that consumers continue to spend while businesses wait for more clarity about the fiscal cliff. If they get it, they have a lot of money on the sidelines to invest. Jeremy Siegel of The Wharton School predicts a budget deal would send the Dow Jones Industrial Average 1,000 points higher.
Right now, Johnson says, the S&P is in a narrow trading range between 1,380 and 1,425 as we wait for a resolution. If negotiations collapse, the S&P could fall back to deeper support level in the 1,200s, which "would probably be the last great buying opportunity of this bull market," he said. And if we get a deal, the sky’s the limit: Johnson thinks the S&P will hit 2,000 in two years.
So, there you have it -- risk vs. reward. I think the potential upside is much greater than the downside. I’m sticking with the reduced stock allocation I recommended back in August, but I may buy a little on the dips as rumors and speculation drive the market up and down. And if a deal collapses and stocks sell off to support levels again, I'll be buying with both hands, fiscal cliff be damned.