The Great Rotation – What Happens When the Fiscal Cliff is Resolved

The Fiscal Cliff Approaches
With the US election now over, the Tea Party smacked down, and the Republicans licking their wounds, attention has shifted to the Fiscal Cliff. Should the politicians not reach agreement, a prearranged penalty system kicks in with large income tax rate increases and large expenditure cuts. Sort of a massive bluff by the political parties in order to previously agree to raise the debt ceiling.

Should an agreement not be reached by the new year, the reduction in the deficit will be accomplished by dramatic and penalizing automatic measures. Everyone agrees, that this is not the way to handle the problem, yet it requires a new agreement to avoid this calamity. The media is fixated on this approaching deadline, and as usual, fear sells and publicity attracts attention. It is quite profitable to invoke fear and to have a big issue to discuss on the airwaves.

However the reality is that everyone realizes that a rational resolution is necessary for all involved. Without going into the detail of who said what, both parties are sending conciliatory indicators. To fail to agree, is to bring down the wrath of the voters. A politician’s job is get re-elected. Above all else, a politician wants to keep his/her job.

Creating a greater recession will not win votes. Politicians will agree and the fiscal cliff will be avoided. The question is, what happens then?

The Great Rotation
Bank of America Merrill Lynch has a name for what will happen when the Fiscal Cliff disappears. They call it the “Great Rotation” — a move out of bonds and into stocks triggered in part by a resolution of the crisis at some point in 2013.

Put another way, we have been hearing about the trillions of dollars sitting on the sidelines, and invested in very low yielding bonds and money markets. The returns being achieved on this money are negligible and in order to satisfy investors’ needs, this money has to make a Return on Investment (ROI). Pension funds, mutual funds, money managers and everyone else who has been sitting on the sidelines are anxious to start showing their investors that they are making money.

What is holding them back, is fear of losing money and being criticized.

So what we have is a delicate balancing act. Tremendous sums of money are waiting to be invested, and the managers of these funds are balancing their fear of losing money as the Fiscal Cliff approaches, with the pressure on them to start doing what they are supposed to do , which is making money.

BofA Merrill Lynch thinks the resolution of the Fiscal Cliff problem will tip the scales towards confidence, and as this confidence grows, fear diminishes. The result is a movement of funds back into the stock market.

The Cycles of the Stock Market
Would that our economy becomes stable and the cost of an apple remains constant year after year. Would that the value of a stock be traded solely on the merits of that stock. However, this has never been, and will likely never be, Alan Greenspan, former Fed Chairman, thought he could get rid of economic cycles by printing money when the economy slowed. We are all still paying the heavy price of that foolishness.

While research analysts value a stock on tried and true models, a far greater judge of value of a stock, is at what point in the economic cycle are we. Stocks are weaker and are at lower prices at the bottom of an economic cycle. That is where we are now. Stocks are at historic lows, given inflation and their intrinsic value.

In a few years, madness will have overtaken the stock market as the economic cycle reaches its zenith, and stocks will be widely overvalued. When would you rather buy the stock?

What to Expect
The Fiscal Cliff will be resolved. Employment numbers will continue to improve, but as in every cycle, employment will lag recovery and many workers will remain permanently underemployed or under employed. Every year, the large debts accumulated will seem just a bit more manageable. Confidence will slowly return to business and to the stock market.

As this cycle was particularly painful, and as this cycle was made by Mr Greenspan to last longer than it should have lasted, the recovery will be equally slow and painful. No great rush of confidence will instantly appear until all of the excesses of the current cycle are wrung out of the system. But confidence will gradually recover as will the stock market.

The retirement of the Baby Boomer generation depends on it.

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