America is looking over the precipice of the fiscal cliff and it appears that a deal will not be reached before the New Year. About $600 billion in spending cuts and new taxes will begin to drag the economy lower, but despite what you might hear in the financial news, the fiscal cliff could be a golden opportunity.
The markets have sold off more than 4% since their September high and could give back another 10% if no deal is reached early in the New Year. While many anxiously await every headline from Washington and others have fled stocks all together, informed investors are crafting a plan to take advantage of market weakness.
A fiscal molehill
The media has dramatically over-hyped the so-called fiscal cliff. The majority of the drag will be from increased taxes which will take affect slowly through payroll and income taxes. This means the actual drag on the economy will be a gradual reduction rather than anything as dramatic as a cliff. In fact, the relative size of the fiscal drag has happened three other times in the last 60 years: 1951, 1960 and 1969. In all three years, the fiscal drag was accompanied by monetary restrictions by the Federal Reserve, and a recession only resulted in 1960 and 1969, with both being fairly short.
Ben Bernanke and the rest at the Fed are nowhere near the point where they will start pulling back on monetary stimulus. In fact, they have explicitly guaranteed that policy will stay accommodative until unemployment comes down to 6.5% or inflation increases above 2.5% a year. The real effect of the fiscal cliff is the negative sentiment it has caused rather than any economic certainties.
The stars align
After the fiscal cliff, the market is facing a surprisingly great environment in 2013. Europe has started to rebound, with its central bank ready to lend "as much as it takes" to debtor members. While we could see short periods of volatility in 2013, the commitment by the ECB and a softening to stimulus by Germany has taken a breakup off the table. Growth may not come roaring back next year, but a gradual workout will improve investor sentiment.
The Bank of Japan has already consented to implicit threats by its new Prime Minister and has doubled its inflation target in a sign that large-scale monetary stimulus is on the way. Manufacturing in China, meanwhile, grew at the fastest pace in 19 months in December. So the world's second largest economy appears ready for round two of its economic growth story. Together, the two Asian economies account for almost a fifth of global GDP and should support both growth and sentiment.
The United States is just coming into a secular rebirth of American energy and manufacturing growth that the markets have yet to fully appreciate. [Street Authority's Nathan Slaughter has touched on some of the biggest opportunities in this area here, here and here.]
Combine this renaissance in industrial growth with the fact that corporations are sitting on a historic $2 trillion in cash and you get the ingredients for significant growth down the line. In fact, global mergers & acquisitions surged in the fourth quarter to the highest level in four years -- a sign that companies are finding value and looking to the future.
A New Year's strategy
The S&P 500 is currently trading at 16 times trailing earnings, with next year's profits expected to increase by about 17% (for a P/E of 13.7). While factors point to strong growth in 2013, this price multiple is slightly above the long-term average P/E of about 15, and I don't know about you, but this value investor is not excited about jumping into new stock positions.
A fiscal cliff-induced 5-10% drop in the market, however, would bring valuations down significantly and set investors up for great returns next year. For example, if we assume a trailing price multiple of 15 at the end of next year, to the S&P would be at 1537, which is only 9.8% higher than current levels. But if we can buy into a position closer to 1300, then the rebound would produce a 17.9% return.
Why am I not worried that going off the cliff could result in losses beyond the first month of the New Year? Going over the cliff is going to incite so much vitriol for those in Washington that a deal will be reached by the end of January with largely retroactive stipulations. Basically, the government is giving savvy investors a chance to buy into next year's growth at discounted prices.
Risks to Consider: A fiscal cliff deal will eventually get passed, though it is less certain when Congress and the President will come to an agreement. I would recommend a laddered approach to getting back into the market rather than waiting for a singular low entry point that may never come.
Action to Take --> Investors should take advantage of a further selloff in the market to profit from some really promising growth next year. It is rare that the market offers a chance to get in at a lower price point ahead of strong tailwinds for growth, but the fear surrounding the fiscal cliff is offering a gift that many investors do not fully recognize.
I am positioning my own portfolio in bonds and defensive stocks like Philip Morris International (NYSE: PM), which pays a 4.1% dividend yield, and should be fairly insulated against a market selloff. [Phillip Morris is a great example of what we call a "Forever Stock," which is why it's a cornerstone in StreetAuthority Co-Founder Paul Tracy's Top-Ten Stocks portfolio as well.]