By Michael Santoli
The current welling up of nostalgia for Alfred Hitchcock evidenced by a cable movie and theatrical release makes it only natural to label the "fiscal cliff" the stock market's MacGuffin — Hitchcock's name for a plot device that animates a story but in the end doesn't really matter for how it turns out.
On the surface, the cliff drama seems all that matters in the short term, stock indexes hinging tick by tick on every grunt and chirp out of Washington relating to negotiations over a budget deal that might head off automatic tax hikes and spending cuts Jan. 1. The past two days the S&P 500 index (^GSPC) yo-yo'd the equivalent of hundreds of billions of dollars in market value over minutes with every inference from every phrase in midday politicians news briefings. It's been enough to give anyone vertigo.
Traumatic Episodes: Then and Now
The market is acting as if most active traders are operating by the muscle memory developed during a couple of prior traumatic episodes when stocks were held hostage by maddening Washington standoffs, the initial failure in Congress of the TARP bank bailout bill in 2008, and last year's prolonged impasse over raising the nation's borrowing limit.
Then, as now, the majority of financial players saw the obvious and proper outcome being a compromise that would let Wall Street breathe easier and move forward, only to be driven to disgust by the typical partisan intransigence. The markets reacted with tantrums and eventually the "obvious" outcome emerged, but not before a major (2008) or mini (2011) market meltdown.
Familiar as it all must seem, though, the immediate stakes in the cliff episode aren't as high, and because the prospect of a nasty fight has been out there as the biggest economic story of the season its impact wouldn't come as a surprise. The clock was ticking fast on the survival of huge swaths of the banking system in '08, and last year the government's ability to finance itself went down to the wire.
Here we're faced with a potential damaging anti-stimulus, but one whose cost would unfold in smallish daily increments and could be reversed quickly with a Rose Garden handshake.
Closer analogies to what we're seeing might be the market's nervous, suggestible saw-tooth action in the fall of 2000, during the contested presidential election in the five weeks following election day, and in early 2003 when stocks flinched and exhaled with every headline about the prospective U.S. invasion of Iraq. Investors were captivated in both periods, believing the political verdict to come would decisively drive stock values for months to come. Yet in retrospect, neither ultimate result is viewed as the prime mover, whether in the unfolding bear market of 2000-2002 or the blast-off to a multi-year bull run in '03.
Jeff Saut, the veteran investment strategist at Raymond James & Associates, wrote in his market commentary this week that on a recent run of client meetings in Europe, nearly everyone protested his generally upbeat outlook by asking about the risks of the fiscal cliff. "Over my 42 years in this business," Saut said, "when e-v-e-r-y-o-n-e was asking the same question, it has typically not been the right question."
A close look at the market action, too, reveals that it's really only been stocks, not all capital-market indicators, that have been fickle in their response to the vapors of fiscal negotiations coming from D.C. The ten-year Treasury yield since the day after election day has stayed in a narrow range within 0.06 percentage points of its current 1.62% level. Charts of high-yield debt funds such as SPDR Barlays Capital High Yield (JNK) show no quicksilver swoons based on press-conference phrasing the way the S&P 500 does. Gold has stayed rangebound. These are the smart-money asset classes that would presumably respond more dramatically to the cliff noise if it were significantly altering economic prospects into next year.
So, what then is the right question -- the one that might lead to an answer about which way the market "intends" to go regardless of the cliff denouement? There's no way to say for sure. One decent guess would be, is China truly executing the soft economic landing and reacceleration that the consensus seems to be taking for granted, despite the reluctance of the Shanghai stock market to sound the all-clear?
Another is whether the domestic economy and stock market have developed thick enough calluses to withstand a likely drag from higher tax revenue and at least prospectively tighter government budgets.
On the economic front, the consumer-related data have remained solid enough, gasoline prices are down 20% from a few months ago as the longest-possible Thanksgiving-to-Christmas shopping season unfolds, credit conditions remain quite firm and overall growth has stayed above stall speed even with state and local governments detracting from economic activity for three years running. MKM Partners' Michael Darda points out that just-released third-quarter GDP figures showed nominal growth (including modest inflation) at a 5.5% annual rate, indicating a better growth cushion than is generally acknowledged.
As for stocks, they are in a mature but battle-tested bull market. The fourth anniversary of the March 2009 bear-market low is four months away, and the corporate-profit cycle is up against a slower-growth phase at best. This bull market, which has seen the S&P 50 more than double, is unusually in that it has experienced a 10% to 20% gut check in each of the past three years. That has reflected the extraordinary macro risks on everyone's worry list, but the setbacks also have kept investor expectations and valuations in check, forestalling the buildup of broad-scale excess.
Big players appear to have operated in a hedged, defensive way most of the past six months, and in recent weeks bearishness reached the kind of extreme that tends to be worked off through crowd-spurning rebounds. Rallies in recent years have tended to top out when the S&P 500 reaches a forward price-to-earnings multiple around 14. Right now it's just below 13-times expected profits over the next four quarters.
And while analysts' earnings forecasts for 2013 are widely viewed as being vulnerable to downward revisions, the market seems already to have gone some distance toward accounting for this. All but two industry sectors (telecom and utilities) trade at a discount to their 10-year average forward P/E, with the most cyclically geared groups shouldering the largest discounts.
The bright side of there being plenty to worry about is that right now so many are already plenty worried.