Its All Good

As the year wraps up for 2012, markets continue to benefit from the Fed's ever corralling of investors to seek returns exceeding treasuries. Wall Street claims the US is only in need of a resolution to the fiscal cliff problem to resume an even greater growth trajectory.   Proof they say comes primarily from the recovering housing sector and in the never ending story of cash on the sidelines and strong corporate balance sheets. 

Regardless of the fiscal cliff, although certainly made more troubling if no agreement is ever reached, is an economy weighted by dismal job growth prospects as a result of demographic and structural productivity changes effecting future income potential for its citizens.  The US economy may be at the end of a powerful economic run starting after WWII which had tremendous spill over in job opportunities engined from investments in infrastructural, housing, and technology.  And while modest economic growth will continue, job and income upside may be capped for generations.

Equities are currently pre-priced for the next leg up and commodities correspondingly are  priced to accommodate growing demand.  The Fed has helped a recovering economy by keeping rates extraordinarily low.  But like all actions, there are multiple potential outcomes and not all of them are positive.  The Fed believes if they accommodate long enough the same economic mechanics which worked in the past will catch on again.   But the reality is equity and commodity markets sit atop a massive rally supported by pathetic annual growth rates and future expectations.  Playing the odds on that continuing is risky. 

Odds Increase of an Over the Cliff Event

In this game of Over the Cliff, the odds of going over the fiscal cliff now are 50/50, up from about a 33% chance earlier.  As a player, assume there are three potential choices; 

(1) Over the Cliff           (2) Good Compromise          (3) Bad Compromise (Boehner Plan B)

Given these three choices, in a game of chance you would have a 33% of picking the right one.  But now with the White House rejection of the Boehner Plan B proposal being representative of the Bad Compromise choice, it it would seem there are only two outcomes left;  Over the Cliff  or Good Compromise.  In this particular game you would then have a 50% change of choosing the right one.

Inside the game you have two choices while outside of this game, given these two choices, the path of least resistance for all parties is to do nothing or Over the Cliff. 

Bears may feel an Over the Cliff event is a win for them, but the event itself would lead to another set of possible outcomes.

Over the Cliff Rally                  Over the Cliff Break             Over the Cliff Nothing

Even knowing the outcome of the first set, you can be sure market players are positive they know the market direction given the particular outcome, but they really only have a 33% chance of being right here.

Political Tradeoff Matrix

The political deal tradeoff matrix gives you two most likely scenarios of action by the Washington participants.  Choices (in red) on any two leaves the probable required tradeoff (in black) for the particular strategy.   There seems to be no real difference between choosing to do the top matrix action and doing nothing in the bottom set.  So the political choices probably leave the same economic results; a declining economy. You can play the game by picking any two.  No winners here.

Market Participants Begin Move to Sidelines

Next week, with the fiscal cliff approaching, many market players will  begin to reduce daily exposure to trading in futures and equities leaving  the bulk of price action to professional traders to play thinning volume and the resulting increased volatility.  Decision strategies for Democrats and Republicans have begun to emerge with  both sides claiming they are restricted to an all or nothing outcome and unable to compromise.  Of course, the rule here is to never press the other side with what you think is a dominant strategy unless you absolutely know your own worse case outcome.   Many fools over the years have increased their own exposure by pressing a strategy they believe will absolutely motivate the other side.   More to come.....

Preparing For Cliff

Fed shifted the qualitative and quantitative asset rules a bit today when they decided to use an economic outcome as a benchmark for continued accommodation; 6.5% unemployment rate.   In a news conference later, Bernanke seem to be preparing for what the Fed sees as a long drawn out battle for economic recovery, one that is threatened by a likely over the fiscal cliff event.  Equities seem to be convinced of a just in time end of year positive outcome to negotiations which may confirm the contrary. 

The Bad News If There Is Good News

Regardless of the outcome of the fiscal cliff, lets look at where the equity markets are in terms of value.

Conventional wisdom apparently reasons any decent resolution to the fiscal cliff problem will send equity markets higher and interest rate markets lower (higher rates).  Various reasons are applied most notably is the uncertainty element shall be removed and thus release the upside horde in large part because of the forever anecdotal "cash on the sidelines".  

However, many are looking at the equity markets only in terms of its current price being as high as it can get  without more good news.  So it has a set point bias. The fiscal cliff has set up this line in the sand reference point where resolution is good and non resolution is bad.  But since the market sits at a price location much higher than its 2008 lows, it needs to rationalize the best possible outcome to maintain value.  Thus, to slightly modify the disposition effect, the market is less willing to recognize potentially downside market moves and more willing to accept positive upside moves. 

To understand the bulls; real estate, technology growth, and greater economic expansion will be positively influence by fiscal cliff resolution.  But the market may want to concern itself more with some of the least positive potential outcomes.  One of these is that large advances in equity prices over the last several years and certainly advances this year have led to a potential over subscribed market.  That does not mean there are not reasonable explanations to explain valuations, but there are simply fewer participants to take the markets higher.  And if the cash on the sidelines is the only hope, be aware most of investor reserves represent a generational cash stockpile reflecting loss aversion;  people would prefer avoiding losses than acquiring gains.   Thus the greatest potential outcome for the market may be down whether the fiscal cliff crisis is resolved or not.

QRiskValue Over/Under

Monthly QRiskValue Over/Under

AAPL   Over
BAC     Over
GOOG  Over
GS        Under
IBM     Under
MSFT  Over
F           Over
PFE      Over

Cliff or Not to Cliff

It is much easier to win an election than it is to redistribute wealth.   Since any deal before the Fiscal Cliff deadline is unlikely to be truly effective over much more than short term period, it is clear there is limited leverage in the deadline.  Though we are dealing with economic issues facing the country, the real story is about political gains and losses.  Thus there are two different dimensions here.  One economic; jobs and growth.  The other is political; using the Fiscal Cliff to get party control in Washington.

The Democrats have just emerged from a general election with a limited momentum they believe has some sort of mandate to drive a deal favorable to their agenda.  The Republicans, having been humbled by a changing political demographic, are trying to walk a fine line between looking reasonable without alienating their only real constituency, a sort of Ayn Rand meritocracy which blends fundamentalism with general accounting.

Now the Democrats may believe the last election gives them the upper hand but that trade is over.   And since Obama  had a  sort of non confrontational bargaining approach in his first administration, they are hard pressed to deliver before the deadline.

So the choice for both parties is clear.  Go over the cliff.  And indeed it may be the right decision for both.   But since this battle is a political one and not economic, the winner will ultimately be the party with the greatest ability to play the outcome and not have the outcome play them.  Going into that event the Democrats have Obama and the Republicans have nobody.