Deja Vu All Over Again?

As I write this today, I’m looking at my computer telling me that from 11:30 AM to 12:30PM, the S&P500 has risen almost 1.5%, from 1340 to 1360 (Dow up 126 points) in one hour! All because of a statement from John Boehner, that his meeting today with President Obama and others was “constructive”.  

One should keep in mind that the Fiscal Cliff is not 2008 all over again---it is more like 2011 all over again.  A review of events last year leading up to the deadlock regarding the debt ceiling and resulting credit downgrade provides some possible insight into the present situation.  Remarkably it involves all the same players—the major difference being that today, we are not in a pre-election year. Keep in mind, the uncertainty regarding Europe’s economic problems remains about the same now as it was last year. Between May and the end of June in 2011, the S&P500 fell about 7% as it appeared that there was major disagreement between the House and the President. Then, once it was clear that negotiations had failed and the unexpected worst case (credit downgrade) in fact occurred, the S&P500 fell another 11% to 1123.  Seven months later, it had risen 25% to 1408.

Between September 2012 and now, the S&P500 has fallen about 7% as it became clear there was a possibility that the Fiscal Cliff would not be resolved---especially after Obama’s unproductive “dig in his heels” speech/press conference on Wednesday of this week. Most probably, worst case is the remote possibility of another 11% drop, like in August-October 2011. Some investors will attempt to avoid this drop and time the market by selling good investments. This is a very dangerous strategy because they would likely be caught flat footed when/if a settlement is reached with markets rising rapidly. Wharton’s Jeremy Siegel has predicted the possibility of a 1000 point gain in the DOW in one day!

Another major difference between 2011 and now, is that the VIX index, a proxy for “fear” in the markets was an elevated 40+ last year and has remained a relatively low 18 or so over the past few weeks.  Importantly, the another difference is that last year, no significant fiscal tightening occurred--fears about the Fiscal Cliff have to do with substantial fiscal tightening. What history teaches us is that the “players” in this drama, have probably learned that deadlock is not a good outcome for them.  Also, they have never shown a willingness to allow higher taxes on lower income citizens or to knowingly allow circumstances to increase unemployment in the short term. For this reason, the likelihood of some form of negotiated settlement is high. (They are not prone to committing political suicide.)

The reality is that the settlement most probably will involve significantly higher taxes on higher income investors.  Hence, we have seen selling of even good quality stocks over the past two weeks—mostly to harvest capital gains but with some foolish attempts to avoid paying higher taxes on dividends.  Polls indicate that more than 74% of investors plan on buying in the dip or holding. Still the small percentage that have been selling into a market with few buyers has caused the market to fall. When sellers outnumber buyers, markets fall—and few, even the most optimistic investors, have been buying recently.  The “stay the course” strategy is what the vast majority of investors are following.

As I mentioned in my last post—long term investors should focus on the long term, and in this case, other than some “temporary” risk in the short term—the most likely outcome 6 months out is a substantial rise from here. Best guess—an S&P500 level likely above 1500 before March 30.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.