The turbulent fiscal cliff negotiations may have shaken the stock market last week, but they haven’t really unnerved investors – at least not yet. Analysts say that could still change, though, and stocks may take a tumble if negotiations break down and the nation is subjected to an extended economic hit from the tax hikes and spending cuts scheduled to take effect in 2013.
“The market is still being supported by the fact that we haven’t yet crossed over to January 1st,” says Mark Luschini, chief investment strategist at Janney Montgomery Scott. “But if this bickering and acrimony continues without resolution to the fiscal cliff into January then I think that becomes a more prominent concern.”
Investors, who for weeks remained hopeful that a deal would be reached, have lately showed signs of increasing jitters about the cliff, with stocks seeing some sharp swings in recent days as the result of rumors and news about the troubled negotiations. Luschini notes that the stock market also slumped in the days after President Obama’s re-election last month as investors began to price in the probability of going over the fiscal cliff. But the S&P went on to gain nearly 7 percent from November 15 to December 18. “Equity investors were basically trading the market up on hope,” he says, “as opposed to any evidence and any track record by our elected officials that gives one reason to think they will work together without market pressure being applied.”
More recently, as the last days of the year dwindled away without real signs of progress from Washington, stocks fell for five straight trading sessions through Friday. The Standard & Poor’s 500-stock index and the Dow Jones industrial average both lost more than 2.8 percent over that period. The losing streak – the worst such stretch in months – has dragged both indexes into negative territory for December, traditionally among the strongest months for stocks.
Market volatility has also increased in recent days. The Chicago Board Options Exchange’s Volatility Index, or VIX, spiked nearly 17 percent on Friday, it’s biggest one-day move since November 2011. Over the last two weeks the VIX, often called the fear index, has risen 46 percent, though it remains far below the levels reached after Washington’s contentious debt ceiling debate in the summer of 2011.
“The last couple of days of volatility are more indicative of what we should expect to see,” Luschini says. “And that [the stock market] hasn’t sold off more, in my opinion, is only due to the fact that there is still a day left in the calendar until we roll over to 2013.”
Despite the heightened volatility and sustained selling, stocks have not taken the type of panicked tumble they suffered during other recent displays of Washington dysfunction. In September 2008, during the depths of the financial crisis, the Dow lost more than 777 points – and stocks overall shed more than $1 trillion in value – after the House of Representatives voted down a bank bailout package. In August 2011, the S&P 500 lost 8.5 percent in three days as President Obama and lawmakers took negotiations on raising the debt ceiling down to the wire, prompting a downgrading of the country’s sterling AAA credit rating by Standard & Poor’s. From July 22 to August 19, the S&P 500 sank 16.5 percent.
“For now, as long as the two sides are talking and some sort of deal (any deal) is on the table, markets will keep their cool,” wrote IHS economists Nigel Gault and Paul Edelstein on Friday. “The bad scenario is when there is no perceived progress and no communication between lawmakers.” The markets likely view January 1 as a “soft deadline,” they noted. While the more than $500 billion in tax increases and spending cuts go into effect with the new year, the economy wouldn’t be plunged into recession overnight, as businesses and consumers would only feel the full brunt of the imposed austerity measures over time. That leaves time for politicians in Washington to undo at least some of the damage, but the IHS economists say that, “the two sides would have to be locked in negotiations for markets to remain patient.”
But if the market has been patient thus far and the drops tame compared to those past plunges, analysts and investment strategists expect that anxieties will only grow the deeper we go into January without a deal. Compounding those cliff fears, the U.S. government is also poised to hit the legal limit on its debt Monday, and while the Treasury Department will begin taking “extraordinary measures” to postpone default, that financial engineering will only buy about two months’ time. President Obama has said he will not negotiate to secure an increase in the debt ceiling, but Republicans insist that any move to raise the borrowing limit must be accompanied by an equal amount in spending cuts. Those positions set up the possibility of another battle that could shake investor confidence.
“In the most extreme case, where we went deeper into 2013 – not by a day, not by a week, but going into the first couple of months of 2013 without resolution” – and with the debt ceiling also unresolved, says Luschini – “then I think that would lead to a pretty severe market riot.” He suggests that the S&P 500 could drop to around 1,250 – about 11 percent below where it closed on Friday and some 15 percent off where it had been mid-month. If, on the other hand, lawmakers can pull out a deal, Luschini and other analysts say the prospects for continued market gains in 2013 look strong.
One other market measure may be worth keeping in mind: An old Wall Street adage holds that, “As January goes, so goes the year.” Investors heed such sayings over more rational analyses at their own peril, but this one has held true in 61 of the past 84 years. In this case, if the nation goes over the fiscal cliff for an extended period of time – and the economy hits the rocks as a result – there may be good reason to heed that January barometer.