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As the uncertainties of the fiscal cliff increase, I think raising some cash makes growing sense

posted on December 26, 2012 at 5:26 pm
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The topic of this post is simple: The value of cash in uncertainty.

You can guess what prompts it: the looming U.S. fiscal cliff.

And the uncertainties that accompany it.

Let’s count up those uncertainties and then take them apart a bit.

First uncertainty: Will Congress and the President strike a deal before the December 31 expiration of the Bush tax cuts, the lower Social Security withholding rate, and extended unemployment benefits and the beginning of automatic budget cuts?

Second uncertainty: How will the financial markets react if the U.S. does indeed go over the cliff?

Third uncertainty: If the U.S. does indeed go over the cliff, how quickly will Congress and the President move on a solution in January?

Fourth uncertainty: Will the financial markets be placated if it looks like a January solution is likely?

Fifth uncertainty: Is the dysfunction in Washington as great as we fear in our nightmares and could the fiscal cliff crisis morph into a debt ceiling debacle with no solution to the cliff in January?

I could go on imagining better and worse for quite a while, but let’s stop there.

Here’s how I see the odds on these five uncertainties.

First, I think there’s just about no chance of a deal before December 31. The strategy of the Republican majority in the House and House Speaker John Boehner seems to be to try to force the Democrats in the Senate to put a proposal on the table with the hope—and it’s a reasonable one—that enough conservative Democrats will compromise so that the Republicans in the House get a better deal than the one they’ve turned down from President Barack Obama plus political cover by forcing the Democrats to provide the votes to pass the compromise. I think that’s one reason why the House is, as I write this on Wednesday afternoon, not scheduled to go back into session until Friday, December 28, at the earliest. I think Democratic leadership in the Senate and the House sees this one coming and they’re unlikely to bite. So no deal by the 31st by my math. (Senate Minority Leader Mitch McConnell, who could help broker a Senate deal, is up for re-election in 2014 and is likely to keep a lower profile rather than risk a conservative challenge in a Republican primary.)

Second, the financial markets have held up surprisingly well—the S&P 500 closed down just 0.45% today, for example–under the uncertainty of the fiscal cliff. I think there’s a likelihood that markets will continue to fret but not panic if Congress and the President miss the December 31 deadline—as long as investors believe in a January bungee cord. If, however, that belief starts to fray, then the market will quickly get more worried. Do note, however, that while this is in my opinion the likely market attitude, it is by no means certain. There is a sizeable, in my estimation less than 50%, chance of a sell-off if the U.S. misses the December 31 deadline. How bad could any sell off be? Well, the 2011 drop associated with the debt-ceiling crisis amounted to 18.2% from July 21 to October 3. (And, yes, I agree that not all of that was connected to the debt-ceiling crisis.) I’d guess-timate a maximum damage of less than half that—say 7%. But that’s only my guess, I freely admit.

Third, optimists are assuming that Congress and the President will reach a quick January solution if the U.S. does indeed go over the cliff. The optimists could be right—and I think their optimism is largely responsible for stocks holding up so well in this uncertainty. That also means, however, that the pessimistic possibility—that this crisis will get rolled into a debt-ceiling crisis in January—isn’t priced in. The likely shock here is to the downside if it looks like there won’t be a relatively quick January deal.

What does all this add up to in my opinion?

It suggests raising some cash right now. That move has the advantage of giving you some downside protection to any of the uncertainties I’ve outlined above. Moving to raise cash could cost you potential gains if we do get the traditional Santa Claus rally in the sessions between Christmas and the first couple of days of the New Year but the gains in such a rally, if it occurs this year, are likely to be muted from even the 1.5% gain that the Standard & Poor’s 500 has averaged since 1950. Raising some cash also gives you the chance of being in a position to bargain hunt if we do get a market drop in January or February because of this crisis. I’d expect the financial markets to bounce back relatively quickly if the delay in negotiating an end to this crisis is limited to just a few weeks. And if that’s the extent of the delay, I think the damage to the U.S. economy will be minor and 2013 could still turn out to be a good year for U.S. stocks. If that were the case I certainly wouldn’t mind being in a position to put some money to work at lower prices.

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  • kentagum on 26 December 2012

    The problem in all this political mess is the very strange American political system. The President is Democrat which leads people to believe that they have a Democrat government, but in fact they have a Republican government because Republicans have the majority in the congress, where the proposals are made and voted for. The president can come up with as many proposals as he like, but if they do not fit the Republicans they are worthless. It is as simple as that. People should stop voting for a Democrat president and then for safety they vote for a Republican in congress. Peoples way of voting have brought on this mess.

  • wwlettsome on 26 December 2012

    We vote this way because every time we give the keys to the government to one party we get a massive entitlement expansion that we can’t afford and/or wars we don’t need to have. See Obamacare and before that see Senior Prescription Drug and Iraq War 2 for examples within the last 10 years or so.

  • bsorge on 26 December 2012

    I think the time to raise cash was a long time ago – maybe even late summer. That’s what I did, but I have a relatively large portfolio so it is hard to make quick moves. I think the writing has been on the wall for some time now that any quick agreement is not in the cards. It has been very tough sitting on the sidelines with little trading waiting to see the final,result.

  • eremmell on 26 December 2012

    I agree the market has held up reasonably well, and missing the 12/31 deadline (and a brief fall off the cliff) appears to be priced in. I have had cash on the side waiting for a fiscal cliff sell-off, but due to the overall market strength, have decided we won’t see it. Today I started buying back in (SBR, NUS), but still have a bit of cash out … hoping to see AAPL and ORCL go even lower. Whether or not there is a Santa Claus rally will be another data point to pay attention to. Certainly I don’t want to miss any rally … and right now it seems the market will be strong in 2013.

  • Yclept on 27 December 2012

    I picked up some SDOW today, adding to short positions I already had. My opinion is that we are past the point of simply shedding long positions (though I still have a few of them — mostly dividend plays).

  • pat255 on 27 December 2012

    It is impossible to deal with the House…Gop congressmen dont care about the country ..they are driven by the Tea party zealots who dont understand the economics and feed off lies & propaganda. Cheney said famously debt dont matter but now the Gop sings a different tune. Gop is all about lies, bs and propaganda, it is better to ignore them and do what is best for the country.
    Let it go over the cliff and then see what happens. may be some common sense will prevail and they will compromise.

  • wdonley on 27 December 2012

    Lots of comments about what will happen to stocks over the cliff. What will happen to bonds? Will we get the flight to safety effect?
    Bill Donley

  • greedibanks on 27 December 2012

    Agree with bsorge — the time raise cash was long ago unless you had a Pollyanna view of our government.

  • dermp1 on 27 December 2012

    pat255- I think there is enough blame to go around for both political parties. If revenues are your only concern, the IRS will be glad to cash any check you want to send beyond your required taxes. The problem is not a revenue only- expenditures are greater than 1 trillion dollars per annum greater than 2008. That is additional borrowed money from the government that has to be paid back- alot to China.

  • dxia on 27 December 2012

    Come on. Let’s face the reality. Can someone tell me who understand the economy? Greenspan? Bernanke? Jim? You and me? No one understand the economy because it’s not understandable. There’s only one thing everyone understand — keep piling up debt is not sustainable!

  • dxia on 27 December 2012

    The biggest risk is that people always try to help because they think they understand what is going on. That’s why we have these “boom, bust” cycles. Just make sure your portfolio can stand these cycles and don’t let the wild swings knock you out of the game.

  • Jim Jubak on 27 December 2012

    wdonley, the key for bonds probably isn’t the fiscal cliff but the debt ceiling. If that goes relatively smoothly, then I think the bond market will continue in its current mode with the U.S. Treasury seen as a safe haven. If Congress reminds the world that the U.S. could default, like it reminded the markets the last time the debt ceiling came up, then I think you’ll see some rethinking. But the saving grace is the relative weakness of other currencies. What you going to pick–in the short run–over the dollar? Yen. Euro. (Don’t tell me yuan–I said short run.)

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