Fiscal Cliff Update
 
So, here it is, December 28, 2012, and the outcome of the fiscal cliff remains uncertain.  And, one thing we know for sure about investing is that financial markets hate uncertainty. The greater the perception of uncertainty, the greater the premium investors demand as compensation for taking risk. Rising risk premiums cause bear markets. And, if the problems created by the fiscal crisis in the Eurozone weren't enough to cause investors concerns, the potential for falling off our own fiscal cliff surely is. 
 
Investors seem to be hanging on every word from the leading players in the drama, including Rep. John Boehner, Sen. Harry Reid and President Barack Obama. And, investors are right to be concerned. Failure to resolve the problem would likely send the markets lower, as the combination of sharp tax increases and severe spending cuts would damage the economy, at least in the short term. That said, there are some important points for you to consider.
 
Economic Dip Forecast
 

According to the Congressional Budget Office's projections, if all of that fiscal tightening occurs, then GDP will drop 0.5 percent in 2013 (measured by the change from the fourth quarter of 2012 to the fourth quarter of 2013). Growth would likely decline in the first half of the year and rebound at a modest pace in the second half, according to the nonpartisan research arm. So, even without a deal by year-end, the economy isn't expected to crater.

Of course, any projections and forecasts should be taken with a grain of salt. Such forecasts are often off the mark. That's partly due to the inability to fully forecast the responses that governments and markets make to such looming or occurring crises. In other words, if we do go over the cliff, that might be the catalyst that makes Congress act and turns the markets around quickly.

Finally, while no one wants to go over the cliff, doing so might, at least, be a step toward solving our country's fundamental long-term problems -- the U.S. isn't generating enough tax revenue and we're spending far too much. Unless Congress dramatically changes its political and economic priorities, the current situation with unfunded entitlement programs is simply unsustainable. Obviously, if something can't continue, it'll end.  The only question is whether it will well or badly (as the Greeks found out).

All that said, the current question remains:  What, if anything, you should you do with this information?

Here's how you might think about the problem.  First, making changes to your long-term plan because of current economic conditions doesn't make sense. If you react to, say, Boehner's comments, you're reacting to something that everyone else knows as well. If everyone else knows it, then that information has already been incorporated into prices. The only thing that truly matters is the overall outcome of the fiscal cliff issue and whether the outcome is better or worse than the market is expecting. The market response will be according to the "odds" that it placed on the specific outcome actually occurring.

For our purposes, let's assume the market thinks the odds are 60 percent in favor of a good outcome. If Congress is able to do a deal, the 60 percent becomes 100 percent, and, all else equal, investors will reduce the risk premium they demand and the market will likely rise - quickly and sharply. On the other hand, if they fail to come to terms, the 40 percent becomes a certainty and the market will likely fall - quickly and sharply. 

The Bottom Line

The losing strategy is to focus on trying to manage returns by forecasting what is unforecastable -- the future.  Instead, smart investors know that the winning strategy is to have a well-designed plan that has already incorporated the virtual certainty that there will be bear markets, which can't be accurately forecast. Thus, instead of focusing on what they can't control, smart investors focus on the things they actually can control:
  

  The amount of risk they take

  Their diversification 

  Their costs

  Their tax efficiency  

Assuming your investment strategy balanced your ability, willingness and need to take risk before the fiscal cliff issue, then it should see you through this temporary period of uncertainty. Remember, investing is a long-term proposition -- much longer than one event or even one or two presidential terms.

 

As always, we are here to help.  We welcome any comments or questions you may have.  We are watching the situation very carefully and we are (or already have) taken the actions we deem most prudent under the circumstances.

 

Sincerely,

 

Signatures with CFP 

  
Align Wealth Management
  
Credits:  The contents of this email were adapted from comments of author Larry Swedroe and from DFA.
  
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