Fiscal Cliff Ahead, Beep! Beep!

Includes: DIA, QQQ, SPY
by: Ingrid Hendershot, CFA

Without congressional action, Americans will experience one of the largest tax increases in history and massive spending cuts beginning Jan. 1, 2013, which has been dutifully dubbed the fiscal cliff. With Congress acting like a bunch of Looney Tunes characters, the U.S. economy is threatened with falling off the fiscal cliff with a big SPLAT, much like Wile E. Coyote in a Roadrunner cartoon. Potentially diving off the fiscal cliff, however, is no laughing matter, as another severe recession would undoubtedly ensue.

The mounting national debt is one of the biggest challenges facing the United States. While both comprehensive tax reform and significant spending cuts will be needed to close the growing deficit, we all know that Congress is as reluctant to cut pork from the budget as Porky Pig is to undergo liposuction. Yet not only will pork need to be pulled, but sacrosanct entitlement programs will also need to be placed on a diet.

Given the upcoming U.S. presidential election, it is unlikely that Congress will agree to compromise on any actions prior to the election. However, expecting Congress to solve all the issues during the lame-duck session is daffy. Washington's inability to deal with the country's fiscal problems is taking a big toll on business and consumer confidence, hindering economic growth. Other concerns include healthcare reform, which has everyone asking, "What's Up, Doc?" In Europe, the debt situation may best be described as Pepe Le Pew. Given all these challenges, many investors are selling their stocks and saying, "That's all folks!"

We believe giving up on stocks is a big mistake. The stock market has been rallying, with the S&P 500 Index up 12% so far this year, as stocks exceed four-year highs. The reason for the rally is due to attractive stock valuations, which have been as depressed as Elmer F.U.D.D (fear, uncertainty, doubt and despair). Once F.U.D.D. retreats after the election, we believe stock prices will hop even higher.

We also expect the U.S. economy will behave more like the Roadrunner than Wile E. Coyote by making a sharp U-turn before heading over the fiscal cliff. It is highly doubtful that all the tax hikes and spending cuts will be allowed to occur all at once, as significant bi-partisan support exists for the extension and renewal of many provisions. The House has already passed legislation to extend current individual tax rates for all individuals, while the Senate has passed a bill to extend rates for individuals earning less than $200,000 and couples earnings less than $250,000. A compromise will likely be reached after the election on tax rates and spending cuts, even if the proverbial can is just kicked down the road for further debate in 2013.

Before making rash changes to investment plans, long-term investors should remain focused on HI-quality business fundamentals. Keep in mind that the world is generally in a much better place than in 2008, as significant deleveraging has already occurred. The U.S. banking sector is much stronger, corporate balance sheets are flush with cash, the housing market is improving, and Mr. Market is applauding progress made on sovereign debt issues on both sides of the Atlantic. Happy endings can occur outside of cartoons!

Disclosure: Hendershot Investments holds a long position in each stock presented. The content in this article should not be taken as investment advice or construed as a recommendation to buy or sell any security. Ideas expressed may not be suitable for every account, depending on an individual’s investment objective, risk-tolerance and financial situation. Information presented here was obtained from sources believed to be reliable but accuracy and completeness and opinions based on this information are not guaranteed. It should not be assumed that investments discussed will be profitable or will equal the performance of securities listed here or recommended in the past. All data, information and opinions expressed are subject to change without notice. Further information on companies mentioned is available upon request.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.