Who is Afraid of the Fiscal Cliff? We Are!

Who is Afraid of the Fiscal Cliff? We Are!

Posted on November 09, 2012

The election is over, so now the news had been dominated by the upcoming “fiscal cliff.” I have found that most people don’t understand exactly what the “fiscal cliff” is or why we should be afraid. The word “cliff” can definitely produce fear and emotion, especially if there is the potential of falling off one. Should we fear a substantial market decline as a result of the “fiscal cliff?”

The fiscal cliff refers to several laws due to expire on December 31, 2012. The expiring laws that could cause a “fiscal cliff” are as follows:

  • The end of the temporary payroll tax cuts.
  • An end in various tax breaks for businesses.
  • Changes in the alternative minimum tax which would mean a tax increase for many investors.
  • End of the Bush tax cuts.
  • New taxes to be used to fund Obama care.
  • Spending cuts connected to the debt ceiling agreement in 2011. Over 1,000 government programs will be subject to substantial cuts.
  • Etc.

Lawmakers can either let the current policy go into effect, which would probably slow down the already weak economy. On their other hand, they could agree on an almost infinite number of compromises.

The markets are not driven by events. Markets are driven by the irrefutable law of supply and demand. Supply and demand, in turn, is driven by the collective knowledge, beliefs (right or wrong) and actions of market participants.

Investors, and therefore, the markets are well aware of the fiscal cliff and its potential ramifications. All known information is already reflected in the current market pricing. As events unfold, good or bad, they will be interpreted by the market participants. Their actions will result in the future increase or decrease in volatility and the accumulation or distribution of individual securities. Regardless of the outcome, some markets and securities will benefit and others will lose value.

Most economists agree that the stock market can be a leading indicator of the future direction of the economy. Our studies show that an increase or decrease in the market’s volatility can be used as an indication of future market direction. High and increasing volatility is typically associated with an emotional and Bearish market environment.

Should we be overly concerned about the looming fiscal cliff’s impact in our Portfolio Thermostat investment management model? The answer is: No, not really.

Our Portfolio Thermostat model is a dynamic rules based process designed to respond to the changing nature of the markets. The model was created to manage asset allocation and security selection to match the unique characteristics of the existing market environment. The Portfolio Thermostat process helps maintain “acceptable portfolio fluctuations” and attempts to avoid “substantial declines.” Substantial declines destroy the likelihood of generating compounded returns, which is the primary objective of all rational investors.

What is the Portfolio Thermostat model and indicators telling us now? Current Market State 2 = Long term Bullish; Current volatility equals rational; Short term negative but nearing oversold (oversold means rebounds are likely) Buy the dip. Canterbury Volatility Index (CVI) = 68 (CVI below 75 is considered to be rational)

Our Canterbury Volatility Index (CVI) acts similar to a thermometer and measures the current volatility of any market traded security. Contrary to popular belief, the current stock market volatility is in the normal and rational range. Computer driven/high frequency trading programs can easily cause an isolated 2% fluctuation. The typical market correction, when the CVI is lower than 75, is in the -4% to -8% range. The current decline from the market peak through yesterday (Thursday) was -6%. We performed a study using data from 1970 through the present. During that 40 plus year period, the S&P 500 never had a decline greater than -9% when the CVI was below 75.

As long as our CVI remains below 75, the risk in the market should be limited.

The Canterbury Portfolio Thermostat Matrix identifies 12 different Market States (environments). Of the 12 Market States, 6 are Bullish Market States, 4 Market States are Bearish, and 2 States tend to precede a transition to a Bearish Market State, meaning caution.

Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom Hardin, Chartered Market Technician (CMT), makes all the final decisions on all investment and portfolio management decisions for Canterbury Investment Management. Tom has more than 30 years experience in the investment management industry and has broad breadth of knowledge. He is known as an innovator, educator and been revolutionary in the advancements in portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.