What if the US avoids the Fiscal Cliff?

Lyle Stein - November 28, 2012

There is a lot of negativity surrounding capital markets, but with the right conditions stock markets could be flooded with money

Market pessimism abounds.

Whether it’s the fiscal cliff, the Euro collapse or the end of growth in China,  investors seeking negativity have plenty of excuses. Realizing the Canadian stock market is 20% lower today than it was in 2007 simply confirms the belief that market Armageddon is around the corner.

Thanks to a dividend-focused strategy, LFA portfolios have typically done substantially better than the stock markets in general. Yet it continues to be a very frustrating period for investors longing for the double-digit returns of the eighties and nineties.

As professional investors we continually ask ourselves where we could be wrong

As professional investors we continually ask ourselves where we could be wrong. In assessing economic outlooks, we are constantly asking where the consensus might be missing something. In looking at companies and their stocks, we focus as much on what could be as on what has actually happened.

Imagine the following scenarios:

  • In early 2013, the US Senate and the US House of Representatives come to a reckoning and pass a plan that raises taxes and cuts spending. A Value Added Tax, like our Canadian HST, is passed on consumption. The US deficit shrinks to $500 million, with a trajectory towards zero;
  • The recent actions taken by Mario Draghi and the European Central Bank actually stimulate demand in Europe. Spain and Italy do not default and interest rates in those countries continue the decline we have seen over the past few months; and
  • The new government in China stimulates domestic demand and China fulfills the next step in its economic evolution.

None of the above is out of the realm of common sense. Is it probable? Maybe not. But plausible? Absolutely.

The Canadian stock market has been a global laggard for the last two years, struggling to regain the level it began 2011. Why? Quite simply, we are a resource country and with all the fear of a global collapse, monies have avoided the Canadian marketplace in droves.

The chart  compares the S&P/TSX Composite with the Dow Jones Industrials and the German DAX Index. Since the beginning of 2011, the German DAX Index is close to its high, despite all that ails the Eurozone. Where is fear most reflected? Guess which market is the lowest?

One of the reasons the world should recover is simply the amount of money that has been poured into the global economy to create a positive result. Where has the money gone? Outside of real estate in Toronto and Vancouver, it has flooded the bond market, taking yields to levels that are, by historical standards, unimaginably low.

At the first hint of sustainable growth, the fiscal cliff could easily become the “bond market cliff.” When the prospects for
bonds – the most liquid asset class in the world – head south, look out. The money, which has to go somewhere, could easily flood equity markets, especially the markets for stocks with yields greater than those of bonds. We have seen it before; it could happen again.

We have seen market turbulence before; we know we will see it again. Amidst the volatility and uncertainty, we remain focused on the simple philosophy of never stopping to ask … What if?

THIS ARTICLE IS ADAPTED FROM THE LEON FRAZER MARKET PERSPECTIVES NOVEMBER 2012

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