Navigating the Fiscal Cliff

Beware the “Fiscal Cliff.”  Absent legislative action, a $600 billion cocktail of tax hikes and spending cuts effective January 1 is predicted to throw the US economy into recession.  Consumer spending would slump, unemployment could rise to over 9%, and corporate profits would sink.  That could trigger a bear market.  Already, significant economic and investment activity has been iced, awaiting clarity on tax rates and government spending.  The Nasdaq and Russell 2000 are in correction territory, down over 10% from recent highs.

What to Do?

Check your objectives and risk tolerance.  If long term, confirm you’re diversified.  Then, stay the course.  Use any deep sell offs as buying opportunities.

That seems counterintuitive.  Why wouldn’t you raise cash, and await more clarity?  First, markets already have priced in the risk. The Dow is already at a three month low and Treasury yields are retreating to multi-decade lows; every report on the markets leads with this issue.  Investors don’t get run over by
the bus they see coming.

Stocks anticipate the news so quickly that it’s nearly impossible to trade ahead.  Even if you’re able to get a jump you may not predict properly other investors’ response. By the time present uncertainties clear up, the market could be 10%
higher. More conservative is to stick with proven franchise stocks whose earnings are projected to be much higher over the next 5 to 10 years.  The strategy of moving to the sidelines becomes even less attractive when money market yields are nil.

To trade short term you need to decide if the market is responding to the politicians or the politicians are responding to the markets.  That’s not easy. Expect compromise and cooperation the more poorly the markets are acting.  Conversely, if the economic data is positive, there will be more talk of principles and mandates. 

Finally, even if the Fiscal Cliff occurs, longer term that may well benefit the economy and the markets. While going over the Fiscal Cliff is likely to cause a recessionary first half of  2013, economists expect a second half rebound.  Longer term, going over the Fiscal Cliff would reduce our indebtedness, diminishing the risk of higher interest rates and a credit rating downgrade.

Most Likely Scenario

The most probable outcome is an agreement to suspend for as long as four years the combination of tax hikes and spending cuts that would otherwise occur on January 1.  This is consistent with the widely held view that unemployment is our greatest near term concern, and any increase in taxes or reduction in Government spending would exacerbate that problem.  This would also provide more time to negotiate solutions that address our long term financial health. 

Backers of a postponement of the Fiscal Cliff point to the ultra-low interest rates now prevailing.  The yield on the 10 year US Treasury is under 1.6%, not much above the recent low last summer of 1.4%.  Quite simply, there’s no evidence that investors are skeptical of our debt.  Further, inflation remains quite low, and the dollar remains strong on foreign exchange markets.

Other Risks Remain      

Investors’ second biggest risk is Europe; namely, the fear that the Southern European countries will default on their sovereign debt due to weakening economies and extraordinary debt loads relative to the size of their economies.  Help from the Euro central bank and the stronger countries, primarily Germany, is available, but it’s contingent on the troubled countries exercising austerity. The debate rages as to whether the austerity demands are excessive, providing plenty of uncertainty for investors, and plunging Europe as whole into recession.  Leadership may be on hold pending Angela Merkel, Germany’s chancellor, surviving elections next year.

Corporate earnings have for the first quarter in nearly 3 years slipped relative to year ago figures.  There’s been a recent softening of demand, partly due to Chinese and Euro weakness, plus tougher year over year comparables.   Corporate leaders cite uncertainty amid the looming Fiscal Cliff, as well.

Positives, However, Abound

Stock valuations remain non-demanding, at 13.5 times earnings, with dividend yields half a point above the 10 year Treasury.  That type of yield disparity in favor of stocks generally hasn’t prevailed since the 1950s.

Those low interest rates, in addition to making fixed income less appealing to investors, provides big stimulus to the all-important housing and vehicle markets.  It also reduces financing costs for consumers and business.

The housing market seems to be making a bottom, with most regions seeing year over year price increases.  This is critical for consumer confidence.  Very low mortgage rates and relatively high rents continue to support a recovery.  The final stimulus required would be an improving jobs market.  While unemployment is still too high, it appears to be moving in the right direction.

Of course, the markets benefit from the unqualified support of policy makers.  The two most important economic players in Washington are Federal Reserve Chairman Bernanke and President Obama.  This is their economy, and it will make their legacy.  Expect them to support market friendly policies to address unemployment and near term economic weakness.

Finally, China, after seeing weakness in its economy, appears to be rebounding.  Given the low levels of inflation, policymakers there have more room to stimulate economic growth.

Where To Invest

Tilt to equities over fixed income, as rock bottom interest rates provide little return plus entail risk should rates rise.  But, bonds still must be included in balanced portfolios, serving as an insurance policy against Armageddon and dry powder to take advantage of volatility bouts.

Medium to high quality corporate bonds provide a nice yield pick up over Treasuries, but could be vulnerable nevertheless to changes in attitudes on fixed income should rates rise and or extreme recessionary conditions emerge.

Sectors

Financials offer opportunity.  Valuations remain low, in many cases below book value.   Asset quality, particularly real estate backed, is rising.  Ability to return money to shareholders via stock buy backs and dividends is improving. 
A favorite is American International Group (AIG), one of the country’s largest insurance companies, trading at a 40% discount to book value, but having a commanding market share in the property and casualty market.  The stock has been held back by concerns about future share sales by the government, which took shares in connection with its bailout of AIG.  However, we see that exit coming sooner rather than later now that elections are past; government ownership is now down to 22%.  AIG is also buying back its shares at what we think are favorable prices.

The Japanese market, too, may be a safe haven:  Valuations are quite low,
sentiment poor, and investors fret about recessionary conditions and
demographic structural problems.  But, policymakers there are poised to provide extreme monetary and fiscal accommodation, particularly to engineer a decline in the value of the Yen.  This would boost exports and drive shareholder value for exporters. 

A favorite is Honda (HMC).  It boasts one of the world’s most recognized brands and offers not only exposure to the emerging markets but also to the US.  While
depressed due to the scorn shown Japanese companies, this company is actually more North American than Coke based on its worldwide sales.  US auto sales
are revving up just like home sales, driven by low interest rates and a deferred replacement cycle.  It’s trading at just 10 times earnings and sports a strong balance sheet.

Finally, energy companies offer opportunity.  Their valuations are depressed as commodity prices have retreated over concerns of a global economic slowdown.  The upside looks bright if in fact China stabilizes and the US dodges the Fiscal Cliff.  Because of low valuations, your downside should China/Fiscal Cliff be worse than expected is less than the upside should these clouds dissipate.  A favorite is Chevron (CVX), the second largest US energy company. This diversified energy concern has low debt, a solid and growing dividend (3.23%), and shareholder friendly management.  It trades at just 6 times cash flow, 0.9 times sales.  CEO John Watson is given high marks for his stewardship and capital allocation policies.