I would hold off buying stocks here. Earnings momentum is poor, much of the world is in or near recession, stocks are not particularly cheap at 13.4x 2013E EPS of $106, and the probability we go over the fiscal cliff on January 2 is high—over 75%, in my opinion. Why am I bearish on the Fiscal Cliff? Right after the election, John Boehner offered a significant concession – raising taxes on the rich by cutting loopholes. The White House came back with a complex proposal, really a Democratic wish list, that Republicans considered “unserious” if not insulting. When he heard it, Mitch McConnell burst out laughing. Meanwhile, just three weeks after the election, Obama is back on the campaign trail, agitating for higher tax rates on the rich. Not an auspicious way to start productive negotiations.
An optimist would say Obama’s opening bid is just posturing aimed at impressing his base, prior to concessions he will have to make later. If so, he was successful. NPR reporters were positively giddy when describing his derisive offer; CNBC likened it to the Godfather scene where Michael Corleone offers “nothing” to a corrupt Nevada Senator who demands a bribe to grant a gaming license. But this opening gambit, the optimistic scenario goes, will soon be followed by serious negotiation to avoid the cliff. Larry Kudlow reasons it would be terrible for Obama’s legacy if, following a pathetically weak economic recovery in his first term, his second term starts with a recession. He’d make Herbert Hoover look good. Some pundits say “the blame” would be heaped on the Republicans, not Obama. To which Kudlow correctly counters, “No one knows who was the Speaker of the House when Herbert Hoover was in the White House. The President gets the blame.”
While it is impossible to disprove this optimistic scenario, there are good reasons to be skeptical. Following the bitter 2011 negotiation—when Obama became enraged when Boehner broke off talks—there is already plenty of “bad blood” between the two, and now Round II has started off on the wrong foot. Obama has always wanted to be a “transformational” President willing to take chances with the economy; in 2009 he focused on healthcare reform rather economic recovery. Income redistribution is his top priority, and in his mind that means higher tax rates; liberal Democrats blame the infamous “Bush tax cuts for the rich” for all that has gone wrong with the economy over the past decade. (Weird but true.) And Obama considers himself to be in a very strong position, because if we do go over the cliff taxes rise on everyone; he can blame Congressional Republicans for that and then negotiate a tax reduction for the “middle class” while leaving most of the defense cuts in place.
Another reason for caution is that the issues in play are numerous and complex—tax rates on ordinary income, potential cuts in tax deductions, tax treatment of dividends and capital gains, whether to extend the payroll tax cut, cuts in discretionary spending, the Alternative Minimum Tax, and reforms of Medicare and Social Security. And don’t forget the need to raise the debt ceiling. Republicans sound serious that they refuse to yet again “kick the can down the road” on entitlement reform, but liberal Democrats oppose changes to Medicare and Social Security (apparently even changes that mainly hit “the rich”).
Furthermore, we are hearing that the “cliff” is actually more of a “staircase.” Unlike 1995 there will be no dramatic government shutdown, just a supposedly temporary rise in tax rates and a slow-walk by bureaucrats in Washington DC to reduce spending. (The Pentagon has yet to make contingency plans for going over the cliff.) So the sense of urgency is greater on Wall Street than in Washington which, after all, never saw a tax increase it did not like. But the Alternative Minimum Tax raises the stakes. Mellon Bank’s Dick Hoey reckons that if the AMT is not fixed 28 million middle-class taxpayers will be hit with the AMT and, in many cases, not receive the tax refund they were counting on.
Which takes us back to the stock market. If I am wrong and we do get a deal before year-end, one inducements is likely to be a stock market plunge in the U.S. and perhaps overseas. So, whether we do or don’t get a deal by year-end, the upcoming fiscal cliff fisticuffs are likely to create a buying opportunity over the next couple of months.
