Fiscal Cliff Dead Ahead For U.S. Stock Market

Includes: DIA, GLD, SHY, SPY
by: Wall Street Sector Selector

Fiscal cliff lies dead ahead for U.S. stock market with max danger just after next week’s election.

fiscal cliff, spy, dia, gldAfter facing Hurricane Sandy, a Presidential election and an upcoming lame duck session of Congress, the U.S. economy will soon have to face the “fiscal cliff” that is due to arrive at the end of the year.

Times have been nothing, if not exciting, but the most excitement might still lay ahead as the fiscal cliff approaches. See: US Markets Face A Huge Week

The fiscal cliff is the combination of expiring tax cuts coupled with mandatory spending reductions by the Federal government totaling some $600 billion. This all started with the Budget Control Act of 2011 when Congress couldn’t come to any other agreement for keeping the government operating. In a nutshell, at the stroke of midnight on New Year’s Eve, the temporary payroll tax cuts will turn into a pumpkin, along with changes to business tax breaks, changes to alternative minimum tax and new taxes to fund ObamaCare. Simultaneously, the Federal government will be subjected to automatic spending cuts in big ticket areas like defense and Medicare.

Everybody has been assuming that the lame duck session of Congress will “punt” the problem into 2013 for the new Congress to handle, but this is growing more dicey as partisan politics will likely grow more shrill when the outcome of next week’s election is known.

Just recently, CEOs of 80 major U.S. corporations called on Congress to fix the problem as they’re getting nervous, and the impact of the fiscal cliff is already being felt as businesses postpone hiring and capital investment until they learn what kind of tax and spending environment they’ll face in the new year. See: CEOs Press Washington To Cut Deficit

If Congress let’s all of the tax and spending cuts take place, the deficit will be cut, but almost certainly we will enter another recession as the sum total of these items are roughly 4% of GDP and would trigger an immediate cut in growth to a contraction mode. This discussion and deadlock has been in progress for about three years and so now we’re definitely coming down to the last minutes of this drama as just two months remain until we go over the cliff with its instant recession, higher unemployment and the loss of roughly two million jobs.

While Dr. Bernanke and the Federal Reserve have been major players in the financial recovery thus far, even they will be helpless to mitigate the impact of the approaching fiscal cliff

Both Chairman Bernanke and the Congressional Budget Office have given warnings about the “fiscal cliff” – the consequences of abruptly-imposed, draconian austerity measures while the economy remains in a state of sluggish growth in the wake of the 2008 financial crisis.

Chairman Bernanke has warned that the Fed would be unable to offset the negative effects from a fall off the fiscal cliff which are forecast to generate an instant recession in the United States.

The most likely course going forward will see the election come and go next week and then the fiscal cliff will explode back onto the front pages of the business press. Global stock markets will likely react in a negative fashion as the lame duck Congress wrestles with this problem until ultimately they “punt” the fiscal cliff into 2013 for the new Congress to deal with in the New Year.

As far as investment strategies go, investors can take several approaches.

The most conservative is to move to cash in anticipation that action in the S&P 500 (SPY) and Dow Jones Industrial Average (DIA) will be negative in response to any possible fiscal cliff scenario. Just remember back to the last Congressional budget showdown and the resultant stock market decline.

Another option would be to move to the safety of government bonds (NYSEARCA:SHY) because, perversely, in spite of our unbalanced budget and fiscal problems, US Treasuries are still viewed as the ultimate safe haven. See: When A 10 Year Treasury Yield Just Isn’t Enough

A third approach that many investors have taken is a move to gold (GLD) which is widely seen as a reasonable alternative to financial crises and meltdowns.

Bottom line: Uncertainty and volatility will abound and investors will have to continue being flexible and tactical in their approach to seeking profits in this environment. The next weeks and months will present unprecedented opportunities to investors who have a strategic and tactical plan, while investors who hope that the “Bernanke Put” will continue into the New Year will face enormous danger. We are heading for the fiscal cliff. Will you be ready?

Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds, and positions can change at any time.

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