The Fiscal Cliff

What is the Fiscal Cliff anyway? I like the Washington Post’s definition best, “Much too much austerity, much too quickly.” The fiscal cliff is nothing more than a large set of tax increases and spending cuts set to kick in at the beginning of the year. And most experts agree these tax increases and spending cuts are large enough to cause a recession if not modified.

The Fiscal Cliff Crisis should actually be called an Austerity Crisis because we have no choice but to cut back and begin borrowing less as a percentage of GDP. This can only be accomplished by either raising more revenue or cutting expenses or a combination of both. Experts agree that it’s highly unlikely enough revenue can be raised through future economic growth so increased taxes and reduced spending are inevitable.

Essentially we are now debating how fast we want to go through the pain of having lived beyond our means for decades. Do we want severe pain over a short period or do we want less pain over a much longer period? One option we no longer have is remaining in denial with our heads in the sand doing nothing. This is almost always the preferred choice of our spineless politicians on both sides of the isle.

The proper incentives simply do not exist for politicians to make the tough choices and compromises to put our nation back on a path to fiscal sanity. If the proper incentives did exist, we would never have found ourselves in this position in the first place. Warren Buffet said it best when he said, “I could end the deficit in 5 minutes. You just pass a law that says that anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.”

Should this fiscal cliff drama cause us to change our investment strategy? In our opinion the answer is no for the following reasons: 1. we already have our clients’ portfolios conservatively positioned, 2. although a poor resolution to the fiscal cliff crisis could cause the market to drop, a positive resolution might cause the market to rise and 3. market sentiment is currently on the bearish side as indicated by the chart below.

This chart shows the Merrill Lynch “sell-side indicator,” which asks institutional sell-side representatives (analysts employed by brokerage firms) if they are bullish or bearish about the market outlook. You can see that the bearish sentiment is extreme.

Experienced investors understand that investor sentiment is a contrarian indicator. When investors are overly bullish it’s often not a good time to add to equities and when investors are overly bearish it is often a good time to invest or at least hold onto your current equity positions which is what we recommend.