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Judging by low implied volatility and S&P 500 breaking five year highs, the market seems unconcerned with upcoming fiscal cliff (see below).


(Click to enlarge)

The automatic $606 billion tax expirations and spending cuts will become reality if Congress fails to act by year-end. The Congressional Budget Office (CBO) estimates the automatic cuts/expirations will reduce GDP by about four percent and drag the U.S. into recession in 2013. With a potential recession hanging over our heads, the performance of the S&P 500 illuminates a different story as it continues to defy gravity and outperform Europe, China and Japan (see chart below).


(Click to enlarge) SPDR S&P 500 Index: iShares MSCI EAFE Index (NYSEARCA:EFA), iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI), iShares MSCI Japan Index (NYSEARCA:EWJ)

With Fed Chairman Ben Bernanke's resolve to fight unemployment and the sluggish economy with open-ended QE3, it is now up to the Congress to keep the Keynesian stimulus going. Keynesian theory is a macroeconomic school of thought arguing that private sector decisions sometimes lead to inefficient macroeconomic outcomes which require active policy responses by the public sector, particularly monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle. In other words, Keynesian economics advocates a mixed economy - predominantly private sector, but with a role of government intervention during recessions.

Scenario A: Congress does nothing and economy contracts by about four percent with higher unemployment and bouts of deflation. Investors should prepare for declines in their stock and commodity positions. Bonds should do fine.

Scenario B: Congress over-delivers with robust stimulus (i.e., more trillion-dollar-plus deficit spending). Under this scenario, stocks and commodities should take off, but underlying economy must grow faster than present in order to support higher debt levels and additional jobs.

Scenario C: Congress compromises and delivers a balanced approach to deal with fiscal cliff. Investors might expect a slow to no growth economy and equivalent performance in stock, commodity and bond markets. This may provide little to no help in the job market, but should alleviate overall debt burdens.

Conclusion

It behooves investors to prepare for the upcoming fiscal cliff. With no way to predict the future, make sure you put on your seat belt, and maybe have some hedges set up for a bumpy ride. Economist Marc Faber, editor of Gloom, Boom & Doom Report predicts a 100% chance the world heads into recession in 2013. Because strains in our economy pose significant downside global risks, it is hard to believe Congress will not act. In this vein, it is reasonable to expect Congress to cushion the fall through extending some of the tax and spending initiatives or adopting all or parts of the National Commission on Fiscal Responsibility and Reform plan (often called Simpson-Bowles from the names of co-chairs Alan Simpson and Erskine Bowles). A balanced deficit reduction plan over the long-term, coupled with open-ended QE3 and debt restructuring, is conducive to a sustainable public sector and a growing (albeit slowly) private sector. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it doesn't produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. This right mix is referred by hedge fund manager Ray Dalio of Bridgewater Associates as a "beautiful deleveraging".

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Source: How To Prepare For Upcoming Fiscal Cliff