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Seeking a Beacon Through the Fog

By Roger Conrad on November 9, 2012

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The stock market’s dismal performance the past few days has been enough to drive even the most optimistic investors to despair. A growing number are wondering if there’s worse to come, as the US approaches the much-dreaded “fiscal cliff” in January 2013.

Washington lawmakers certainly didn’t give us much reason for confidence last year, squabbling until the last minute before they raised the US government’s debt ceiling and avoided default. The same voices today are still calling for confrontation rather than compromise, as the package of tax hikes and across-the-board spending cuts gets closer to taking effect.

Here are a few reasons to be positive. First, third-quarter earnings reported by Personal Finance Portfolio companies have once again supported strong balance sheets, growth plans and current dividends.

The numbers haven’t always matched such arcane benchmarks as Street estimates. But despite a generally challenging environment, these companies are still executing and laying the groundwork for building shareholder wealth. And that’s why we own them.

Second, there’s more than a little reason to believe that members of our national legislature will reach a deal and avoid an economic shock that could shave 4 percentage points off US gross domestic product (GDP) growth. The careers of the vast majority of those in Congress are at risk if they fail to act. And nothing concentrates the mind of a politican like the risk of political oblivion.

Political Kabuki Theater

If this little drama follows the formulaic script of summer 2011, we’ll see a lot of predictable public pronouncements supporting compromise as well as confrontation in the coming days. The former will cheer the market, particularly if they’re seen to emanate from intransigent negotiators. The latter will send a chill down investors’ spines and trigger selloffs that will be steeper and deeper as the deadline for action approaches.

Then just when hope seems to be lost, negotiators will discover some number they can live with and the action will turn to nervy votes in the House of Representatives and Senate. Assuming that’s successful, the two chambers will caucus, arrive at a deal again after much hair pulling and gnashing of teeth. The bill will be voted on in both chambers and finally will hit the president’s desk, averting the crisis.

The whole proceeding is likely to prove too much for credit raters to stomach and we could see yet another meaningless downgrade for US government debt. But with the cliff avoided, a massive cloud will lift off the economy and stock market. Stocks that were beaten down due to perceived risk of a fiscal cliff will recover.

Of course, when raw politics dictate economic policy, there’s no guarantee the outcome will be rational. And if our body politic collectively plunges off the fiscal cliff like mindless lemmings, not even a loose Federal Reserve policy would be able to fully offset the damage. But continuing to flood the system with money will keep interest rates low until economic growth really does ignite. As that keeps happening, recovery is inevitable.

One of the more benign comparisons for the current economy is 1992. Then, an American public impatient for recovery threw out a once-popular incumbent president. But the seeds for rapid 1990s growth had already been sown by a very loose Fed policy under Chairman Alan Greenspan.

Greenspan was combating deflation pressure from the 1987 stock market crash and total collapse of the nation’s savings and loan industry. His Fed of the early 1990s was frequently criticized for “pushing on a string” by flooding the money supply. The consensus was that low interest rates alone couldn’t bring a recovery.

By mid-1993, however, it was clear the critics were dead wrong. Despite a tax increase passed in 1993 to balance the budget (sound familiar?), the US economy came roaring back. In fact, the acceleration was so rapid and inflationary, the Fed was forced to ratchet up interest rates in 1994.

There are plenty of factors that could delay or derail a repeat of 1992. But if the worst is averted and growth does gain traction, holding onto your positions in good stocks is likely to prove the best decision you’ll ever make.

The real beauty is that after the market declines we’ve seen over the past week, you can bet on that probability, even as you prepare for the dreaded worst-case scenario of “sequestration.” That’s because companies with reliable revenue and low debt are a lot cheaper than they were just a few weeks ago. They’re in effect already pricing in a fiscal cliff even when one is still unlikely.

We may see further downside in the coming weeks with few if any stocks immune on the worst days. And the action could get particularly ugly if enough budget negotiators decide to play brinksmanship.

Even stocks backed by strong businesses lost ground during the 2008 debacle as panic spread. Nonetheless, they recovered their lost ground when the clouds lifted. As they stay strong as businesses, they’re a lock to recover from any damage from a selloff this year, whatever the reason for it.

Finally, the most important reason to stay just a little optimistic is simply the fact that the mood has grown so dark in global markets. Bear markets always begin with a whimper not a bang. That’s when most everyone is positive, and therefore leaning in the wrong direction when things start to turn negative. We’re about as far away from that as you can get following Tuesday’s election.

Remember, real market debacles can only occur when people don’t expect them and are leveraged the wrong way. They don’t happen when the consensus is doom and gloom, as appears the case now.


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