How much of the potential upside from a solution to the fiscal cliff has already been priced into the market? Answering this question necessarily requires a number of assumptions, however, one strategy is to envision the best and worst case scenarios and estimate the expected upside or downside in each case. Once this is finished an approximation of the likelihood of the two scenarios will enable an investor to calculate the 'pot odds' that are presently priced into the market.
For the downside scenario: assume the Democrats and Republicans fail to reach a deal by the end of the year. According to the Congressional Budget Office:
If the fiscal cliff were to unfold beginning in January 2013 "it would reduce federal spending by $103 billion and increase tax revenues by $399 billion (and another $105 billion "mostly in revenue") through September 2013 (the end of FY2013). This would amount to a net total of $560 billion, roughly half the $1.2 trillion FY2011 deficit."
To put $560B in perspective it represents approximately 3% of the GDP of the United States. Even under a reasonably optimistic 2% growth scenario this would be expected to push the economy either into recession or at best a zero growth environment. It seems highly unlikely that the market would continue to rally into the face of this uncertainty if a deal is not reached and quickly.
Under more optimistic assumptions let us assume that a deal is reached. The market would certainly rally upon this news, however, the question is: how much room remains for the market to rally? The S&P 500 currently trades at 13x forward earnings (Figure 1). While 13x forward earnings is hardly a state of overvaluation, it bears remembering that this is close to the maximum earnings multiple that the S&P 500 has enjoyed during the course of this bull market. In order for the market to enjoy further upside, one of two things must happen. Either P/E multiples must expand or earnings must increase. Expecting multiples to expand is not unreasonable, however, an environment favoring multiple expansion is somewhat difficult to envision without earnings growth and improving economic conditions. While this could certainly happen, I would hesitate to describe the market as less than fully valued at the present time.
Based on these two scenarios, my earlier price target of 1500 for the S&P 500 seems reasonable if one expects the more optimistic scenario to play out. However, in the pessimistic case it is expected that the market would quickly retest the lows of the post-election correction (approximately 1330 on the S&P 500). If a recessionary environment becomes the expectation of the market the post-summer crash earnings multiple of 11x is the ultimate downside target (approximately 1200 on the S&P500 - a full blown recession could bring 1000 into play). The lower targets would take longer to play out and seem unlikely since neither party would benefit from inviting a recession. Therefore, an approximately 3.4% return has been left on the table with immediate downside of about 8.3% (the S&P500 trades at 1450 at the time of this writing). This implies a breakeven probability for avoiding the pessimistic scenario of 72%.
The gambling site In-Trade allows speculators to put up money in a similar manner to betting on a sporting event. The market pushes the wager up and down based on how likely members feel the outcome of an event is. The odds that this market has placed on an optimistic resolution of the fiscal cliff by the end of December have ranged between 10% and slightly above 50% during the course of December. The official bet is whether the debt ceiling will be raised, however, as this goes hand in hand with the fiscal cliff resolution thus the odds should be more or less the same. The question to ask yourself is: while the market has continued to rally have the odds of a resolution actually increased? It is argued here that the odds are actually diminishing by the day. While not having a resolution by the end of the year may not be the end of the world, it is expected that the market will not react positively to such an occurrence.
I have long thought that the largest danger for the market is normalization of the large account deficits that the United States government has run since the end of the financial crisis. Forward stock market returns are positively correlated with high government deficits. In other words, the larger the current account deficit of the United States, the more you should want to buy stocks. This strategy works because the multiplier effect spurs the economy and buying at times of high government deficits is a good way of timing the economic cycle. If the government balances the budget the stock market will likely be in for a bumpy ride.
The current rally may have a greater than average likelihood of disappointment for the reasons described above. If a grand bargain is announced the market may quickly ascend to 1500, however, a rally beyond that level is difficult to envision without stronger earnings growth. Therefore, downside risk is beginning to outweigh upside potential and ironically as the market has rallied there is probably less upside remaining to capture if events play out in a positive manner. Therefore, it is advocated that the current rally is an opportunity to raise cash and rotate toward lower beta less cyclical sectors for the portion of your portfolio that is held in stocks. Stocks such as Altria (NYSE:MO), Johnson and Johnson (NYSE:JNJ) and McDonald's (NYSE:MCD) fit this defensive strategy nicely and do not look overbought at the present time. Also it may be instructive to create a Christmas shopping list and a plan to deploy cash in your portfolio should we encounter another market swoon. Several stocks that appear to be overbought in the short term, but may prove to be interesting ideas should a pullback emerge are: AFLAC(NYSE:AFL), Mylan (NASDAQ:MYL), Rio Tinto (NYSE:RIO) and Wells Fargo (NYSE:WFC).
Disclosure: I am long MCD, MO, JNJ, RIO, WFC. 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.
Additional disclosure: The article above should not be interpreted as a solicitation to purchase any of the mentioned securities. Please do proper due diligence before taking a long position in any stock. Furthermore, remember that markets move quickly. During the time between my submission, editing of this article and when the market opens tomorrow significant price changes could occur shifting the conclusions contained in this article.