For all the worry, the fiscal cliff was just a preview of the debt-ceiling ruckus ahead. Here's why that could be worse for investors-and how to get through it, counsels MoneyShow's Jim Jubak, also of Jubak's Picks.

You ain't seen nothin' yet.

Unfortunately.

The cliffhanger of a fiscal cliff deal was just a dress rehearsal for the late-January/early-February battle over raising the debt ceiling. This time it's worse-and more worrisome for investors. This one could really move global markets-and move them fast and hard, in the not-so-distant future.
Here are three reasons why, plus a strategy for getting past it.

The Crises Ahead
This time the damage from missing the deadline for a deal sets in on Day One. The negative effects of not reaching a fiscal cliff deal on taxes and spending on Jan. 1 or thereabouts was never going to be immediate. In the fiscal cliff crisis, tax rates indeed would have gone up immediately, but tax payments would have increased gradually and spending cuts would have been phased in over time. The damage to the US economy from a fiscal cliff failure would have been major-perhaps enough to send the economy back into recession-but it would have been felt only gradually. That's why economists, Wall Street pundits, and politicians kept saying that it was possible to go over the cliff and still fix the problem before the economy suffered major damage. (This was the so-called bungee-cord strategy.)

That's not true of the debt-ceiling crisis. This time, the damage is likely to be big and immediate, and some of it won't be easily reversed.

This crisis is really three crises in one:

  • Crisis No. 1 is the raising of the debt ceiling. If Congress doesn't raise the current $16.4 trillion debt ceiling, the Treasury can't increase net borrowing to pay the country's bills. In practice, the Treasury has ways to manage the country's debt levels so that it can pay US obligations until, according to estimates from the Congressional Budget Office, mid-February. After that, the Treasury would have to decide to pay some bills and not others. You can bet it would continue to pay the interest on US debt, even if it had to raid other budget lines to do so. Default on US debt obligations would throw the US and the rest of the world into financial market chaos.

  • Crisis No. 2 hits shortly after the Treasury runs out of room to finagle. The fiscal cliff deal put off $1.2 trillion in automatic spending cuts divided equally between defense spending and domestic discretionary spending-this is what's called the sequester-that were set to gradually take effect after Jan. 1, according to the terms of the Budget Control Act of 2011, which ended the most recent battle over the debt ceiling. (About $100 billion in automatic cuts would go into effect in the 2013 fiscal year that ends on Sept. 30.) The Jan. 1 fiscal cliff deal postponed the cuts until March 1. So, sometime in the next six to seven weeks, Congress will have to resolve the automatic budget cuts it has failed to address in a meaningful way in the past 18 months or so. Otherwise, federal spending gets whacked by $100 billion this year-with more cuts to come. That's certainly enough to take a bite out of first-quarter growth in gross domestic product that economists already fear could dip to a rate of just 1%.

  • Crisis No. 3 comes close on the heels of Crisis No. 2. The September 2012 continuing resolution that authorized spending by the federal government expires March 27. Unable to pass an actual budget or the appropriation and spending bills that go with it, our government in Washington has been operating under a continuing resolution that authorized spending for the first half of fiscal 2013. Unlike a failure to raise the debt ceiling-which would lead to the government paying some bills and not others-failure to extend the continuing resolution would mean that the federal government wouldn't have authority to spend any money. Here, we're looking at something that would actually shut down the federal government.

The two sides have already begun to double-down on their rhetoric. Congressional Democrats, afraid that President Barack Obama will negotiate spending cuts on entitlements including Social Security and Medicare, are urging the President to get tough. House Minority Leader Nancy Pelosi, D-Calif., has said the President should invoke the 14th Amendment to raise the debt ceiling by presidential order. Section 4 of that amendment says, "The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned." Some constitutional lawyers-along with some Congressional Democrats and some members of the Obama administration including Treasury Secretary Timothy Geithner-have argued that this language makes the debt ceiling itself unconstitutional and gives the President the power to simply raise or ignore the debt ceiling. (So far, the White House, aware that such an assertion of power would provoke a constitutional crisis, has said it does not intend to invoke the 14th Amendment.)

On the Republican side, Senate and House leaders facing a revolt by conservative Republicans have declared any further tax increases off the table. On Sunday, Republican Senate Minority Leader Mitch McConnell of Kentucky said, "The tax issue is finished, over, completed." That will come as a surprise to a White House that is holding to its position that any spending cuts must be balanced 1-to-1 by tax increases. Such extreme positions seem to mark the beginning of negotiations in Washington these days. And the distance between these positions, even if they are rhetorical posturing, is certainly enough to make reaching any agreement a long and drawn-out affair with big potential to worry the market.

|pagebreak|

What the Market Fears
That potential to worry the market is what interests investors most. Here's how I'd handicap that worry.

From the fiscal cliff deal, we know that investors are inclined to assume that, against all evidence, politicians will find a compromise rather than wreck the economy or destroy the US credit rating. I think in this case that means that the markets are likely to stay relatively optimistic until at least the fourth week in January.

How do I arrive at that? The next meeting of the Bank of Japan is set for Jan. 21 and 22, and the next meeting of the US Federal Reserve's Federal Open Market Committee is Jan. 29 and 30. The Bank of Japan is widely expected to cave in to pressure from the newly elected Liberal Democratic government and announce a big program of bond buying that would push inflation toward a goal of 2% and weaken the yen. Investors will be looking to the Fed meeting for signs that, after the fiscal cliff deal and with the looming uncertainty of the three February crises, the bank intends to keep its $85 billion-a-month program of economic stimulus (via quantitative easing) running at full throttle.

I think investors will be reluctant to do much selling of stocks and bonds before those dates, especially since Asian financial markets are likely to be strong over the next two weeks on hopes for Japanese stimulus and on evidence that China's economic growth is accelerating.

After that, though, global financial markets will be free to focus on the news out of Washington. I expect that news to be negative-I don't think we'll see a deal until the very last minute, again. And I expect that Wall Street gurus and the companies that rate government debt-Standard & Poor's, Moody's Investors Service, and Fitch Ratings-will keep reminding financial markets about the possibility of another downgrade to the current AA US credit rating. Granted, the last downgrade didn't produce any increase in US interest rates or a weaker dollar, but that was largely because the Eurozone debt crisis made the United States an attractive safe haven. The United States doesn't have that going for it this time, since the Eurozone has temporarily "solved" its crisis.

I don't know if this publicized uncertainty will be enough to end the recent rally and produce a significant sell-off in financial assets.

I do know that the next crisis will be enough to increase the odds of a sell-off, especially since stocks have rallied to five-year highs. As I've written recently, if you want to profit from the recent rally, you need to do it sooner rather than later. Before the end of the month, I think the odds will have shifted, reducing potential reward and increasing potential risk.

Raise Cash
Given the nature of the debt-ceiling crisis, in which fears of a credit downgrade for the United States would hit both US stocks and bonds (and, if it got scary enough, extend downward pressure to Asian and other emerging markets), cash strikes me as the best asset in the crisis. (Gold would normally be a safe haven, too, but gold has been in its own downtrend recently, and, for the moment, I prefer cash.)

How much do you want to move to cash? I'd use the rules I laid out in a recent post on Jubak Picks to increase cash holdings. As of this moment, I see any crisis-related downturn as a buying opportunity that I'd like to have enough cash-say 20%?-to exploit rather than as a reason to sell everything. Watch our politicians-and global market reaction to our politicians-to see if that changes.

You certainly can't say this is a dull market.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund owned shares of Johnson Controls as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund's portfolio here.