The Fiscal Cliff & Market Uncertainty….

For weeks now the market has been hung up on two big events.  The election and the fiscal cliff.  Those who were buying stock yesterday vastly miscalculated the importance of the election relative to the fiscal cliff.  Yes, the election results reduced some uncertainty, but the fiscal cliff is a far more important issue.  President Obama’s re-election is essentially a status quo result.  Ie, there are no big changes coming in terms of Fed policy or the President’s stance on fiscal policy.  Romney obviously would have been dramatically different given his negative rhetoric around the Fed and balanced budget approach.

If you follow our macro work you understand the importance of the large budget deficit in this environment.  Not only has it steered GDP growth, but its steered corporate profits as private investment has remained weak as a result of the credit bubble bursting and the lack of aggregate demand.  So a $600B cut to the budget is enormously important for 2013.  In a research note last night I summarized the keys here:

“The primary market takeaway is that considerable uncertainty is likely to develop in the coming weeks as
this result will increase the odds of gridlock in Washington and the fiscal cliff is unlikely to be resolved until December at the earliest….We remain strategic cyclical (longer-term) equity bulls, and short-term tactical cautious.”

The market hates uncertainty.  And that’s what the fiscal cliff creates.  A resolution on this is increasingly important for understanding market directionality and economic directionality.  Unfortunately, we won’t know the answer for several weeks and maybe even months…..

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. With the passage of Prop 30 in Cali, multi Millionaires like Cullen :)
    will be paying a lot more dough to back stop teachers pensions. looks to remove 6 Billion a year from Cali tax payer poxkets.
    Less money to spend now.
    Not Good.

    • As a (barely) middle age, middle class Californian, I would say longer-term it is very good.

      • Good Afternoon-
        Well I figured it was time to come back after a couple of calls I made several months ago.
        A. to buy china vis a vi two options….FXI and BTU.
        B. the SPX would be between 1470-1485 on Nov. 6th.

        Well…we are up 15% on FXI as of that date and BTU was up 25% on Nov. 6th. We closed out BTU this morning up 13%.(this could be a mistake but…we do what we do knowing the facts today and estimating some things in the future) Either way we made money
        The SPY as of that call on Nov. 6th was down 1% but clearly did not hit the target. More it came NO where near the doomer scenerio Bond Vigalante was calling for. But…I did not get this call right.
        Now…for you Mateo…Longer Term..the idea that we raise taxes on the wealthy so the elected can give the money out to get re-elected is not a long term strategy for growth. If the Dems in California cared so much about education then why is the Blue state of california in such a postiont that it must raise taxes again? Why if they care about education does education suffer under them? What is the line in the sand for Californians? The children where the bait to catch the vote. Smartly played. The Voters shoudl have called his bluff and forced a rewriting of contracts. NOW that would have forced the Fire fighters form taking money from the kids to pay there retirement and overtime benefits. Anyone who’s had access to a Fire Fighters retirment knows the PV the private sector would need to retire with in a 401k would be around 1.5 million today to provide the 65k-70k a year income at 4.5%. What is the yield on the 10yr again? Must be nice.

        RE: understanding the macro to get this move right.
        Since 1936 election the avg return on election day has been up.
        2 days before election on avg. 1.62%. The day of up .73%. Nothing new..it had nothing to do with those buying stocks miscalculating anything. It has done this 18 times up and 3 times down. All you needed to know is it does this. If you did not know this you’d attach a phrase like someone miscaculated something that you in fact were.
        Post election here are the numbers.
        Since 1928
        1 day after the SPX is on avg. down -1.47% 3 up 8 down.
        1 week -1.58% 5 up 6 down
        1 month -2.74% 4 up 7 down
        When the Democrats win from now until year end the numbers are poor.
        When the incumbent wins the numbers go down but typically finish the year positive form election date.
        Attach the fiscal cliff or what ever…but this is not about investors needing to understand the macro to know the pattern here.
        It is the macro needing to understand the pattern so as not to attach something incorrect. Intermediate..term..yes the Macro matters. But it all matters. T/A, FA, Cycles, Analogs, Fractals, Seasonals, etc. It all matters.

        • You’re back! I was afraid your bets had gone so sour, you’d entered a ’12 step’ program for recovering investors.

          However, I do have to point out rhat ‘Proposition 8′ might have had something to do with the state of education in CA.

          • Haaa..No, I like many here are involved in a lot of things and I made some calls and there was no point in having the same argument over again with the same guys.

            I went back and looked at my call. It was this…short version made on 9/10/2012.

            “…the SPX would top in 2012 between 1465-1485.(check)…SSEC had bottomed and the best way to play this was VALE and BTU..(Vale up 15%..BTU up 25%) Check.
            I would close these postions out in January of 2013(I closed BTU out already and kept Vale long term. I also Bought FXI to play SSEC(closest I could get) and it is up 15% from where I bought it…..Lastly I said the SPX would hit 1500 by January/Feb before starting it’s decline.” This post was at the time a discussion between me and Bond Vigilante. And I can say that Like Oregons offense the game was over at half time.
            Now he can leave this board..as the bet goes.

            I won’t go into all the stuff but since March of 2012 we’ve had our best year.

            What are you referencing in prop 8? Candidly I’m confused.(true story)

            • As I understand it. Proposition 8, passed some time ago, severely limited any increases in property taxes (even as values increased dramatically), which greatly limited the funding available for public education (my sister has worked for a couple decades, as a special ed. teacher in the CA school system, including in some of the toughest inner city districts).

    • No it isn’t… They are more like transfer payments. All taxes taken by states and other currency users are spent. Not hoarded like corporate profits. :-)

  2. Cullen question, we continue to get downgraded by the ratings agencies due to keeping large and continuing large spending deficits in this country, when we get downgraded that historically shown to be very very bad for everyone.

    So why is all the macro data either stagnant and still bad, or getting worse, if this deficit spending we have been doing has been in effect?

    • The simplest analogy is to think of the economy like a human body. When the flow stops the body dies. Likewise, with an economy, when the flow of spending stops the system dies. When the credit bubble burst the credit flow (our primary source of flow since most money is bank deposits) turned off. The govt came in and turned on their flow by spending more. That turned a depression into a great recession. The alternative is what’s happened in Greece and Spain. They’re over there throwing molotov cocktails at eachother (literally) as we speak because the austerity has cut so deep. You can’t be austere during a credit collapse. Otherwise, there’s no flow. And no flow means molotov cocktails get thrown in your face.

    • I would add. The USA has zero solvency constraint since it can always procure funds by harnessing its banking system. So ignore the ratings agencies. They have no idea what they’re talking about. Rating the USA’s solvency is like rating the sun’s ability to rise. It’s pointless. We can print too much money. We have no problem printing enough though. That means our true constraint is inflation. Not solvency like Greece or businesses or households (who can’t print their own currency).

    • xD – if you ignore the role of private sector money creation AND private sector money destruction you come to the conclusions you are coming to… that Gov spending did nothing or next to nothing these past few years. Money is being destroyed (by private sector deleveraging) almost as fast as money is being created (gov borrowing and spending).

  3. Yes i understand all of that, but what im saying is you spend via gov then you tax, almost seems like all of the money is cycled back in, where as money created in the market is spent…in the free market….no tax, just an increase in Money Velocity and Aggregate Demand, where as downgrades for (it doesnt matter that we can never have solvency issues) create massive sentiment based sell off’s which is bad…

    My solution is to focus on increasing the velocity of money (reducing commodity prices would be nessecary) which in turn would rise Aggregate demand, and would in turn heal the economy. Would you not agree?

    • Deficit spending does two things in a credit collapse. 1) Adds net financial assets. 2) Increases incomes via the flow of spending.

      So the question is, how do you achieve these things if the private sector is not borrowing? Balance sheets can’t expand, investment won’t expand and spending will remain stagnant. That’s the problem with a balance sheet recession. Only the govt can turn on the flow. How would your approach turn on the flow?

  4. Deficit spending can have quick real effects, but if that was the case (considering we have spent much via deficit spending) and GDP is getting worse after all of this. So evidently gov spending is not increasing growth, the opposite of what your advocating is happening (i guess you could argue it could be “worse” then it is, but that’s hard to really measure and still doesnt fix the situation)

    Private sector is not borrowing, because the private sector is pessimistic towards the future of their bottom lines due to rising AVC and higher possible tax’s, and healthcare “tax” in the works as well.

    To turn on the “flow” reduce tax’s but cutting gov spending, and the capital that isnt taxed will be spent in the economy or saved (which would more than likely be invested, hence increase investment) if the cash is spent, Aggregate Demand rises.

    • Your math won’t work. Private investment is growing too slowly to be offset by a huge decline in govt spending. Ie, economic growth can’t yet be sustained by the private sector alone. So it needs govt help. The reason growth is slowing is primarily because the rate of private investment is slowing at the same time as the govt deficit is contracting. If we do what you want and essentially run a balanced budget that blue line in the following chart will crater which will mean the economy is in a guaranteed recession (and won’t come out of it until the deficit expands). There’s no avoiding that.

      http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=FPI,GGSAVE&scale=Left,Right&range=10yrs,10yrs&cosd=2002-07-01,2002-04-01&coed=2012-07-01,2012-04-01&line_color=%230000ff,%23ff0000&link_values=false,false&line_style=Solid,Solid&mark_type=NONE,NONE&mw=4,4&lw=1,1&ost=-99999,-99999&oet=99999,99999&mma=0,0&fml=a,a&fq=Quarterly,Quarterly&fam=avg,avg&fgst=lin,lin&transformation=pc1,lin&vintage_date=2012-11-07,2012-11-07&revision_date=2012-11-07,2012-11-07

      • Okay i will for the sake of argument say “very well” and say that my tactic would create a recession. So…

        1. What makes you think GDP will rise, clearly gov spending has done nothing, or caused it to fall since QE3 and all the fun gov spending in the last 2.5 years

        http://www.tradingeconomics.com/united-states/gdp-growth

        How do you explain that? I guess we need more right? So thats like saying, my trading algo lost money for the past two years…i havent changed the inputs of the algo at all, i just need to put more money into the account and it will stop loosing. Thats terrible logic, you dont average down on anything.

        2.Private investment would sky rocket with news of less spending and a serious reduction in taxation, dont believe that go ask any board of directors what they will do with more profits. You could even make the stipulation, that if you invest the money into new products growth of the company w.e etc you get the tax cut, if you just pay on your debt and dont spend it you dont.

        • Also with unemployment levels and shrinking GDP and horrible stats and the market setting up for another down-trend, nothing is going to change until your reduce commodity prices increase MVT then AD will increase,

          until that happens….more monetary policy, stimlus G-spending, raining gold, or unicorns will not fix this economic situation, you will just have more and more capital put into a massive gov spending taxation deficit cycle while growth continues to shrink, we are seeing it now, history has proven that gov spending isnt going to help us in this situation, we spent record amounts of money to get us back on track, and we couldnt even test the 1999 2007 market highs after all of that.

          “Equity markets cannot be a indication of economic healthiness” prob be your response, so how you fix it is the real question.

        • “thats like saying, my trading algo lost money for the past two years”

          Govt spending hasn’t resulted in contraction or “losses” in the last few years. In fact, it’s led to record corporate profits, record stock gains, huge increases in household net worth and continued economic growth. I know things aren’t great, but they’re not nearly as bad as you imply.

          I run a business. My customers don’t spend just because they are feeling more confident. They spend because they can afford to purchase the products and services I sell. Besides, confidence is largely a function of having the healthy balance sheet with which to spend. Spending is a function of saving relative to future expected income. That’s what creates confidence. Confidence comes as a result of the latter. It doesn’t drive the cart.

          • Cullen,

            by focuing on the circular flow of the economy, you risk forgettign that there is the quantitative effect (flow, growth) and qualitative aspect to GDP growth (value added). And the two are not synonimous.

            So by constantly increasing the share of government as a % of GDP, you are calling for a dilution of the quality of growth or a reduction in the potential growth rate. And I say increasing share, because avoiding structural change, which is called for by a recession, means that more and more government intervention will be required to ensure “smooth sailing” or as is the case with the weak economy now “any sailing at all”.

            • IX,

              I actually discuss that quite often. The flow is meaningless if it doesn’t provide the nutrients and growth to the system required for health and vibrancy….

              CR

            • This sounds like the “small govt is automatically better” argument to me, but what do you mean, really?

              Unless the govt is hogging manpower or natural resources that would be used elsewhere… where is the problem? Is there a problem with the current govt size? (Would there be a problem with a govt 10 times the current size? Yes! We are in full agreement! But that’s not the question.)

              If you are worried about govt taxation (which immediately get recirculated into the economy), then you should be a lot more worried about where profits are going. (Hint: NOT back into the economy!)

  5. Rising AVC (Food costs, Oil, all commodities) is due to the psychological mis-interpretation of QE2 & 3 ….the market is always right, so QE2 QE3 is an asset swap not inflationary, it does not matter, because speculators run commodities up and short the dollar, so the illusion becomes real anyway.

    You claim to be a behavioral based in thinking and understand the importance of market sentiment in asset pricing and economics as a whole, this inefficiency is there, and it obviously is not going to change, so its a failed tactic.

    • Yes, QE123 will act inflationary on assets that “investors” work with. It doesn’t do squat for the real economy which is the basis that lets the financial sector exist at all. Which sector are we talking about?

      • Banks do not need the real economy. They care only about nominal GDP growth. And the Fed / Treasury can still create nominal GDP growth.

        • Oh, you are, of course, absolutely right. I was more alluding to the fact that below a breaking point the financial geniuses no longer have food, transportation and offices. (I’m not suggesting it’s disappearing any time soon. Merely pointing out that reality is the underpinnings.)