Afraid of the Fiscal Cliff ?

Go to Turner Classic Movies--click on this link.

The phrase "FISCAL CLIFF" was coined in early 2012 by Fed Chairman Ben Bernanke.  One would not have expected an economist to be so artful in his presentation, but it shows just how masterful Mr. Bernanke is as a politician.

The video clip above is from the classic 1951 film, African Queen. Specifically the scene as the boat is approaching and navigating the first set of rapids.  It is a useful metaphor as the true risks of the fiscal cliff are more like shooting river rapids than falling off a cliff. (Video courtesy of TCM for non-commercial use. (http://www.tcm.turner.com/mediaroom/) Plays well on your smart phone.)

For the record, although the explanation wasn’t reported or repeated as much as the catchphrase itself, Bernanke actually said the fiscal cliff was about the large spending cuts and tax increases already scheduled to occur being far too big for the current U.S. economy to handle at one time. “I hope that Congress will look at [the spending cuts and revenue increases] and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date,” he told the committee.

Bernanke indicated that all of the upcoming taxes and spending cuts were probably good for the country and the economy (i.e. "long-run fiscal improvement") in the long run, but he was concerned about the changes all happening "at one date".

There is in fact many moving parts of this issue.  Politicians have procrastinated and put off decisions for so long, the list has become quite long.  Changes to Federal Estate Taxes could have big effects on those with estates greater than $1 million.  Changes to Alternative Income Tax rules could subject a surprisingly large number of people to much higher income tax rates.  Going back to the 2010 payroll tax rates would reduce take home pay of nearly the entire population and probably would reduce consumer spending.  Expiration of the Bush Tax Rates could significantly raise taxes on dividends and capital gains.  And, then the new taxes related to Obamacare take effect.  On the spending side, there are big cuts in Defense Spending--large enough that a lot of people employed by government contractors will lose their jobs.

If Congress does nothing and everything scheduled to change, does in fact change all at once, the effect on the economy would be large and potentially dangerous--sort of like shooting the rapids.   Nobody and I mean NOBODY knows the actual effects or outcome, for sure.  So this is an event made for the media. Who needs the Mayan 2012 end of the world story when we have the Fiscal Cliff to scare everyone who shakes at the thought of potential danger!  What you are hearing on TV and reading about now is like the movie trailer for African Queen---intentionally sensational to get your attention.

I use the term potentially dangerous in that even though it would definitely cause a short term slowdown, it would definitely move us toward the dramatic "long-run fiscal improvement" that we all know must happen, sooner or later.  So don't be surprised if some very intelligent people seem to be quite nonchalant about the possibility of complete deadlock in Washington.  It is the "long-run fiscal improvement" that is the most important to our future economic prosperity.  Sort of like going on a diet to lose weight---the benefits of the weight loss are known---the discomfort from being hungry and doing without will simply determine the length of time it takes to achieve the goal.

Having lived through many election and economic cycles, I've learned that usually the actual outcome is never as bad as feared by the pessimists and never as good as hoped by the optimists.  I've also learned that politicians seldom will intentionally approve an action that is generally feared and unpopular with their "constituents".  So, the most prudent expectation is that some sort of compromise will be found and the Fiscal Cliff will be more like a Fiscal Step.

On the other hand, this is a very divided country. President Obama was re-elected by only a 51% majority and he LOST 24 of the 50 states. Despite claims of great victory and a "mandate", this one was a very close election and the politicians' "constituents" still have very different opinions about tax and spending policy.  A "deadlock" like the 2011 debt ceiling debacle is unlikely, but possible.

Then, one must remember that even though January 1 is a "deadline", there is a long history of tax policy being changed "retroactively".  So a "deadlock" might be followed by a "compromise".

As markets wrestle with that possibility of "deadlock" and "compromise", they will fluctuate significantly.  Hence, the next 60-90 days is full of short term risk and opportunity. 

One example is the discussion about changes in taxes on dividends--a very large portion of stocks are held in IRA's and 401K's where a change in the tax rate on dividends will have not effect at all.  And, the "alternative" to dividends is interest that is already taxed at a high rate.  Any drop in prices because of people selling dividend paying stocks should be seen as a buying opportunity. Another example is the effect of changes in Capital Gains and Health Care Excise tax rates. For the most part, this change will most effect those with incomes over $250,000 and securities like Apple where capital gains have been and are likely to be a large part of the total return.  Prices on these stocks may fall more than others.

Should one be a buyer or a seller in this environment?   I think gambling and trying to predict the outcome and timing of complex political negotiations in the short run is unwise for a true long term investor.

On the other hand, there is almost universal agreement that whatever the outcome, economic growth and prosperity at some higher level than now is coming--sooner or later. Higher taxes will slow down consumer and business spending--but a lower deficit may make the climate for long term investment more attractive.  Keeping taxes low may force lower levels of government spending,  but will encourage higher levels of consumer and business spending and may also reduce the deficit, making the climate for long term investment more attractive.  One should remember that while consumer spending is 70% of the economy, much that is spent drives up imports without really improving our economic long term welfare and domestic employment.

The worst possible outcome--not expected by many--would be some sort of compromise where the deficit does not get smaller any time in the near future.  A bad outcome for investors would be where taxes don't go up and spending does not go down over time.  This would make the general public happy in the short term, but the likelihood of high levels of inflation would be almost inevitable.

We can argue about whether we would be better off with one outcome than another.  I have personal convictions that big government will generally make most investors less wealthy. So for my own sake and the sake of my investor clients, I am an advocate for government being as "small" as possible. (Sort of "A government big enough to do things for you is big enough to take things from you" philosophy.)  But, I also have strong convictions that wise, patient and prudent people can do well over the long run, even in less than optimum situations.  Good quality investments, chosen because of their ability to prosper in a given environment will do well. Wherever there is risk, there is opportunity, and whenever a trend is identified, you can make it your friend. Because of the election, government over the next two years will get bigger. But do not forget that we still have a divided government, so government growth will be constrained.

So for long term investors already invested--staying the course makes sense. For long term investors with new funds--entering the market as a buyer when the market dips may be wise.  When the outcome is known with certainty in January or February, it may then be wise to make adjustments to be sure your investment strategy is optimum given the known landscape--not exiting the market but rather a consideration toward changing the allocation. All of this of course depends on your tolerance for risk---investing is never an activity whose outcome can be predicted with 100% certainty.

Be sure you have sufficient liquidity to ride out these storms and stay focused on investing for the long term. Be diversified.

Most likely, like in the movie, we'll make it thru the rapids just fine---I'm sure that for most of us, unlike Rose (Katherine Hepburn in the movie), we will not find the experience and drama to be "invigorating".  Times like these are very difficult for investors and I for one am looking forward to less drama.

This paper is for non-commercial 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.