Investors, Beware Fiscal Cliff Ahead

Fasten your seat belts. We're rolling full speed ahead toward the fiscal cliff. If you expect investment markets to be calm until the January 1 deadline, please remove your rose-colored glasses. It's going to be a roller coaster -- with the ride mostly down -- until a deal is cut. The last couple of days make it plain that the stock market will not tolerate a mindless ad nauseam repeat of congressional talking points and dogmatic posturing without a solution.

The market is already partying like it's the summer of 2011. In case you've forgotten that little shop of horrors, that was when President Obama and House Republicans deadlocked over raising the debt ceiling and cutting spending. They finally reached agreement, but they got so close to breaching the debt ceiling that Standard & Poor's downgraded the credit rating of U.S. government bonds, the first time any ratings agency ever did such a thing. (Many people didn't know the U.S. government even had a rating.) From July 22 through October 3 last year, Standard & Poor's 500-stock index plunged 17.8% (including reinvested dividends). The losses could have been way worse.

Now comes the sequel, and, if anything, it's uglier. So what should you, the investor, do? Timing a short-term move out of stocks and back into stocks is market timing and simply too fraught with danger. If you're overweight in stocks, though, now might be just the time to lighten up, shifting some of your portfolio into cash and bonds.

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Failure to avert the fiscal cliff, the Congressional Budget Office warns, will drive the U.S. back into recession. The non-partisan CBO projects gross domestic product would fall by 0.5 percentage points and unemployment would rise to 9.1% by the end of 2013. That puts the pressure on although it's only been days since voters returned the stars of 2011's fright show, President Obama and House Speaker John Boehner, to office.

Obama and Boehner both genuinely want a "grand bargain" that would set the U.S. on a long-term path toward fiscal sanity. In 2011, they tentatively agreed on huge spending cuts and some tax increases. But Boehner couldn't sell the deal to the most fervent opponents of tax hikes in the House, so the agreement blew up. Boehner, Obama and the Senate contrived at the last second before the Treasury was going to default to essentially kick the can down the road to here and now.

Obama and Boehner need to either hatch a new and improved grand bargain, or, at the least, allow themselves time to prolong the negotiations and reassure the financial markets. You can read the details elsewhere (for great detail, look no further than the CBO's most recent report), but suffice it to say that the fiscal cliff would bring about $500 billion in tax increases in 2013 -- an average of almost $3,500 per household, the Tax Policy Center estimates. It would also prompt more than $100 billion in automatic cuts to military and domestic spending.

What's to keep us from falling off the cliff? The main reason for optimism is simply how awful it would be to fall. Remember, though, that's precisely what everyone said in July 2011.

The election has brought some changes -- some helpful, some not so much. Obama can't run again. That should make it easier for him to do what he thinks is right, rather than what's politically expedient. He knows that setting the country on a long-term course toward a much lower deficit is essential.

Boehner has read the election returns, too. He knows how many Tea Party candidates and incumbents just got the gate. He's sounding serious about reaching a grand bargain this time around. Another plus: Both sides saw how badly Wall Street reacted in 2011 and how angry the voters were as they watched their freshly-recovered IRAs and 401(k)s fall without really understanding why.

There are some negatives. Some surviving House Republicans resolve to oppose any tax increases, just as they did before. In the Senate, where Democrats picked up several seats, leading liberals such as Charles Schumer think it's folly to cut Medicare and Medicaid, although those gigantic programs would seem to be essential to any bargain that includes spending.

Some liberals have even said going over the cliff would be a good idea. How crazy is that? The bottom line: No one knows what will happen. The smart money in Washington is betting on a deal at the last minute. But until and unless a deal is cut, expect the financial markets to be messy. Christmas vacations could be anything other than merry.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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