Why I Want A Fiscal Cliff Fail

Ryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Would you take investment advice from a bipolar teenager?

Believe it or not, that’s a serious question. When I first became interested in the markets, my father imparted his best insight to me – and it’s something I’ve remembered ever since.

“Son,” he said, or something less printable, “Son, always remember the markets are – over the short term – an emotional beast. And not just an emotional beast, but a manic-depressive beast that would most likely be locked up in the looney bin if they actually lived life like that.”

He’s right, of course. The markets undergo crazy swings in the matter of days, hours – sometimes, now, in the matter of seconds. The markets are a knee-jerk, sky-is-falling chicken little one moment, and an optimistic pollyanna the next.

Back in 2000, the market fell 5% just because we didn’t know who was going to be president for 36 days. To be clear – there was no doubt that there would be a president, or that the government and economy would continue to function as normal. We just didn’t know who would fill the role – and that uncertainty was enough to fill the markets with irrational dread.

Of course, as soon as Gore conceded, the markets bounced right back. There was nothing fundamental driving them lower – just emotion. Sure sounds like a bipolar reaction to me.

The Flash Crash of 2010 was even stranger – with the markets all reacting, it appears, to a single mutual fund selling S&P stakes as a hedge against a down day.

The Dow had already dropped 300 points worrying about Greek debt, but when this mutual fund trade went through, it triggered a number of high-frequency trading programs. Suddenly, like teenagers trampling each other getting away from yesterday’s fad, everyone was selling – and the Dow was down 1,000 points in the blink of an eye.

Amazingly, almost the entire loss was reversed in a matter of minutes once cooler heads prevailed and the panic was over. Like teenage boys suddenly aware everyone was seeing them cry at The Little Mermaid, everyone returned to their previous state.

Remember in the summer of 2011 when the original debt ceiling debate and a downgrade of US debt drove the S&P from 1347 to 1101 in a little over a week? Why? Politicians were making the bipolar system nervous, and disapproval from the S&P downgrade made the markets downright glum… even though the debt ceiling debate was always destined to come to some solution, and the downgrade was long expected and didn’t actually change anything fundamental.

Once the ‘crisis’ was averted, and the world realized that the US government was going to keep on paying its debts, the markets bounced right back.

This isn’t to say that, sometimes, market reactions to news aren’t justified. Sometimes they are – sometimes the fundamental ground has shifted and smart investors need to reassess given the new conditions.

Usually not, though. Usually, markets are overreacting to a piece of news that hasn’t changed a thing – like a jobs report that is barely above or below expectations, and will be drastically revised next month anyway.

The perfect current example for overreacting markets? The fiscal cliff.

Tempest in a Teapot

There are four basic outcomes to the fiscal cliff dilemma, and three of them are positive.

1. The President and Congress come to a happy solution before January 1, and the markets rejoice, having their best days in months, if not all year.

This, to me, would be a pity. Of course I want to see the fiscal cliff problem resolved, and investors will benefit – but if it happens before January 1, the markets will lose their best chance in a while to absolutely lose their heads. And when markets lose their heads and emotionally sell, profits abound for calmer, cooler investors.

2. A half-measure gets passed before January 1, kicking the can down the road a bit longer. The most likely solution here is the House GOP agrees to extend the current tax rates for middle and lower class citizens, while everything else will be decided later – most likely when, come April, the GOP can use the debt ceiling extension at the bargaining table.

This is less exciting, at least for the immediate future. The half-measure will goose markets a little, but not nearly so much as a full solution. However, the markets will get another chance to manically sell when the debt ceiling debate and the fiscal cliff collide later in 2013.

3. The brinksmanship on both sides of the aisle goes far enough, the new year comes and goes without a fiscal cliff deal. Nothing really changes – the ‘immediate’ return to old tax rates won’t really matter until tax time in April, and spending cuts won’t go into effect for a while as well. In truth, nothing will have changed – but the markets will go bonkers anyway.

Every day will be a bad day, until the deal eventually gets done. At that point, the markets will shoot upwards with tremendous velocity, as recession and catastrophe have been averted.

This is the best scenario for an investor – because all sorts of quality stocks will be sold at a steep discount, even though fundamental conditions haven’t changed at all. Only emotional conditions are at risk here.

4. Same as above, except neither side can come to an agreement. Grover Norquist calls President Obama dirty names, Senate Majority Leader Harry Reid spits in the eye of a Tea Party Congressman, and the country goes into a mild recession while we deal with tax rates and austerity measures that more closely resemble Europe.

This is the worst-case scenario – and you know what? It’s not even that bad. There will be some short-term pain – and the markets will be panicked and/or jittery for months on end – but, in the end, we would have exchanged some points off near-term GDP for the end of deficits.

Not ideal, certainly – but, in the long run, not the disaster everyone currently envisions.

How To Play The Fiscal Cliff

What do these four scenarios mean for the smart investor? Today, you should take small positions in various American blue-chip companies – outfits like GE (NYSE: GE), Caterpillar (NYSE: CAT), and Verizon (NYSE: VZ). All of these companies have been sandpapered down by the looming fiscal cliff - GE is down almost 7% in the last two months. Caterpillar is down almost 8% since the middle of September. And Verizon is down 6% since we hit October. If the fiscal cliff is resolved quickly, they’ll recover all those losses in a matter of days - maybe hours.

However, if we make it to 2013 without a deal, add to these positions heavily. They’ll be falling – which means you’ll be able to get them at tremendous valuations (and greater profits once a deal gets done). In fact, valuations on Wall Street are already quite attractive – Caterpillar, for instance, has a P/E under 9. During a true fiscal cliff panic, valuations may well be historic. Grab as many shares as you can afford, and when a deal is reached and the markets turn, you’ll make a fortune.

What if no deal is reached? First off, I consider that a remote possibility. Disasters do strike – but usually not disasters we see coming from a mile away. Neither Obama nor the GOP want to be blamed for plunging America back into recession, and I’m confident neither side will let that happen, no matter what bluster precedes a deal.

However, even if we fall off the fiscal cliff and no one does a thing to stop the fall, the market reaction will be overdone. It may take a while longer to see your profits, but in three or five years, you’ll be happy you got your blue chips at the price you did.

After all, in the end, the fiscal cliff is really just an austerity package – and not even a particularly harsh one, compared to what’s happening in Europe. And mild austerity packages don’t destroy economies – they just slow them down. If we get a balanced budget out of the deal, it may well be worth it – and your blue chips could look even better in the long run.

In short – don’t lose your head just because the market does. Invest with an eye towards something other than today’s news, and you’ll be amply rewarded. Just ask anyone who bought blue chips in early 2009.

letsryan has positions in General Electric and Verizon. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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