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Paulo Santos, Think Finance (377 clicks)
Long/short equity, arbitrage, event-driven, research analyst
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Wikipedia defines the fiscal cliff as:

… the effect of a series of enacted legislation which, if unchanged, will result in tax increases, spending cuts, and a corresponding reduction in the budget deficit. These laws include tax increases due to the expiration of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 and the spending reductions ("sequestrations") under the Budget Control Act of 2011.

So basically if politicians do nothing, a huge set of revenue increases and spending cuts go into effect at the end of 2012, with the stated objective of bringing the fiscal deficit into control.

Why is it a cliff?

Controlling the budget deficit doesn't seem like a horrible thing to do, so why are the measures needed to do so referred to as a cliff, implying negativity?

This happens because both the tax increases and the spending cuts are expected to have a large economic impact. If they are enacted, a recession is to be expected, profits will contract, and the stock market will go down together with the economy. Indeed, if the fiscal cliff happens, the resulting impact wouldn't be too different from what we're seeing in Portugal, Spain or - God forbid - Greece. And the stock markets in all those places didn't fare all too well.

So why is there a paradox here?

The paradox resides in the fact that "solving" the fiscal cliff implies delaying (and making worse) an unsustainable situation, by not solving the budget deficit which will mean adding to the public debt mountain until it collapses or requires wholesale monetarization (something which we could argue has already started). And not "solving" it, by letting the measures come into effect, will have profound economic impact, destroying earnings and leading to a much lower stock market.

So we stand here with the market basically begging that the unsustainable situation be fed a little longer. It's a situation much like the one faced by Saint Augustine and his famous prayer, "Grant me chastity and continence, but not yet".

But can't an economic recovery ultimately solve the problem?

Well, an economic recovery could solve an "excess of debt" problem if the economy was coming from an unsustainably low activity level, for example, such as what happened after the Great Depression and World War II, where a huge amount of consumption, home building and family-making were unleashed. The trouble presently is that quite the contrary, the economy is being held at an unsustainably high level of activity through the tune of 10%/GBP budget deficits and the associated debt-taking. So it's quite unlikely that such a boom takes place from that elevated plateau.

This situation has huge implications

For one, it transforms a market in which investors might be tempted to apply the usual "buy & hold" due to supposedly reasonable fundamentals/valuation, into a hugely speculative bet. The "buy & hold" bet turns speculative because it's essentially a bet on an unsustainable situation lasting long enough for the investor to collect. It's also a bet on there being no action to contain the unsustainability - that is, no "fiscal cliff".

On the other hand, recognizing the existence of an unsustainable situation helps very little. Monetization is bound to help the market higher. Continuous deficit spending is bound to keep the economy and earnings stable enough for the unsustainability not to become evident. Staying out of the market with the 10 year bond yielding 1.6% and cash yielding close to zero can have tremendous opportunity costs.

So what's an investor to do? In my own view, an investor should turn into a trader: he should exploit evident effects without committing his capital on a long-term basis. The objective will be to eliminate the opportunity cost of being out of a monetarily-goosed market by generating alpha wherever he can find it, but not running the risk of having a stable investment portfolio when either a fiscal cliff or the unsustainability of not having a fiscal cliff, hits.

This can be achieved by either playing the market through short term trades motivated by clear insights, or by keeping a rather balanced long-short portfolio, which can be based off both insights and valuation. In my case, I do both.

An example

Regarding specific insights, an investor reading Seeking Alpha regularly will come across many of those.

As for a balanced long-short portfolio, an investor can marry shorts in clearly overvalued stocks with negative fundamental trends, such as Amazon.com (AMZN), Angie's List (ANGI) or Neonode (NEON) with longs in reasonable stocks, such as Apple (AAPL) or even an entire index through ETFs, such as the S&P 500 (SPY) or the Nasdaq 100 (QQQ). Care should be taken in keeping each short position small enough that no squeeze can happen, especially in those companies where the market capitalization is smaller and thus more vulnerable to large movements.

Conclusion

The fiscal cliff presents a paradox for the stock market. In one hand "solving" the fiscal cliff just means prolonging an unsustainable situation. In the other, not "solving" it exposes the market to huge downside from the economic impact of austerity.

This means that the present market is basically artificial and is carrying substantial implicit downside, but that downside can be held at bay for years through political/fiscal and monetary measures. As such, betting on the upside through a common "buy & hold" approach is as speculative as trading wildly as the winds shift.

Source: The Fiscal Cliff Paradox

Additional disclosure: I might also short ANGI in the next 72 hours (actually, I was short today and covered). I am also long the Nasdaq 100 through NQ futures bought today.