If August 2011 Is The "Fiscal Cliff Resolution" Template, Then Watch Out Below
Ever since late March, we have said that the only realistic resolution to the Fiscal Cliff standoff (and the just as relevant latest and greatest debt ceiling hike due weeks from today as well), driven by a congress that has hit peak party-line polarity and which the recent election loss only made even more acute, would be a market mandated "resolution" (read sell off) whose only purpose is to crack the gridlock as representatives are flooded with phonecalls from angry constituents who now, and always, will be far more concerned about the value of their 401(k) than any ideological split. By that we mean an identical replica of what happened in the summer of 2011 when the market had to tumble 17% before the debt ceiling "compromise" was finally reached. This also explains why with just 6 weeks of trading in 2012 left, Goldman still forecasts a slide to its 2012 year end target (which it has kept constant since late 2011) of 1250. So while a resolution will almost certainly come, it will not be until the very last moment. As GS summarizes, "Bush income tax cuts was not resolved until December 17th, 2010. Last year’s decision to extend payroll tax cuts was not finalized until December 23rd, 2011. The current challenge is significantly more complex. Divergent views on tax policy, defense spending, and entitlements need to be resolved in a short lame-duck session of Congress."
And while the market may or may not jump after there is an actual resolution, don't expect any real buying ahead of a compromise, as any uptick in the DJIA (the Beltway has still not heard of the S&P500 apparently) will immediately lessen the impetus for a deal. In fact, if the following chart from Goldman is correct, and if we are indeed to relive a replay of the summer of 2011, watch out below, especially since true wholesale liquidation across the hedge fund space has yet to occur.
Some other thoughts from Goldman's David Kostin, who most certainly realizes his dramatic breach with the prevalent Wall Street sell side consensus, which still expects a big push higher in the stock market in the last month and a half of trading:
S&P 500 has declined by 5% during the eight trading days since the election. Index appreciation YTD now equals 8%. We reiterate our 2012 year-end target of 1250 which reflects a potential decline of 8%. Our uncertainty-based fair value P/E model suggests a forward multiple of 11.2x bottom-up consensus estimates which translates into 1275.
Uncertainty swirling around the ‘fiscal cliff’ that must be resolved by year-end, the pending jump in capital gains taxes at the start of 2013, and the debt ceiling that will be reached in late February represent clear and present downside risks to the market in the near-term.
We believe the proverbial ‘fiscal cliff’ ultimately will be avoided, but precedent suggests any resolution will not happen until mid-to-late December. Debate regarding a two-year extension to the 2001/2003 Bush income tax cuts was not resolved until December 17th, 2010. Last year’s decision to extend payroll tax cuts was not finalized until December 23rd, 2011. The current challenge is significantly more complex. Divergent views on tax policy, defense spending, and entitlements need to be resolved in a short lame-duck session of Congress. Political platitudes about compromise will abound during the coming weeks but some disagreements will surely arise. We assign a 55% likelihood that an agreement is reached by year-end.
S&P 500 has near-term political risk but long-term policy support. Our year-end 2013 S&P 500 target of 1575 reflects nearly 16% potential upside from current levels. Although we believe investors will have an opportunity over the near-term to buy the S&P 500 at a level below today, portfolio managers with a longer-term horizon should consider increasing equity exposure.
Last year the S&P 500 fell by 17% between July 25th and August 8th as the US debt ceiling deadline approached. Uncertainty about sovereign
risk in Europe and mixed domestic economic data also occurred at the same time. In retrospect, the sell-off created an attractive investment opportunity given S&P 500 has since rallied by 21%.
History suggests the US stock market has downside risk in December as a result of the pending hike in capital gains taxes. Capital gains taxes are scheduled to rise at the start of 2013 from a 15% rate to 23.8% (20% plus a 3.8% tax associated with the Affordable Care Act). The nearly 9 pp hike in capital gains taxes is similar in magnitude to the 9 pp rise in 1970 and the 8 pp rise in 1987. In both prior cases S&P 500 posted negative returns in December as investors locked-in the lower tax rate. The S&P 500 fell by 1.9% in December 1969 and 2.8% in December 1986 running counter to trend given December has the second highest average monthly return (1.5%) and a 75% hit rate of positive return since 1928.
And so on.