As the uncertainties of the fiscal cliff increase, I think raising some cash makes growing sense

12/26/2012 5:26 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The topic of this post is simple: The value of cash in uncertainty.

You can guess what prompts it: the looming U.S. fiscal cliff.

And the uncertainties that accompany it.

Let’s count up those uncertainties and then take them apart a bit.

First uncertainty: Will Congress and the President strike a deal before the December 31 expiration of the Bush tax cuts, the lower Social Security withholding rate, and extended unemployment benefits and the beginning of automatic budget cuts?

Second uncertainty: How will the financial markets react if the U.S. does indeed go over the cliff?

Third uncertainty: If the U.S. does indeed go over the cliff, how quickly will Congress and the President move on a solution in January?

Fourth uncertainty: Will the financial markets be placated if it looks like a January solution is likely?

Fifth uncertainty: Is the dysfunction in Washington as great as we fear in our nightmares and could the fiscal cliff crisis morph into a debt ceiling debacle with no solution to the cliff in January?

I could go on imagining better and worse for quite a while, but let’s stop there.

Here’s how I see the odds on these five uncertainties.

First, I think there’s just about no chance of a deal before December 31. The strategy of the Republican majority in the House and House Speaker John Boehner seems to be to try to force the Democrats in the Senate to put a proposal on the table with the hope—and it’s a reasonable one—that enough conservative Democrats will compromise so that the Republicans in the House get a better deal than the one they’ve turned down from President Barack Obama plus political cover by forcing the Democrats to provide the votes to pass the compromise. I think that’s one reason why the House is, as I write this on Wednesday afternoon, not scheduled to go back into session until Friday, December 28, at the earliest. I think Democratic leadership in the Senate and the House sees this one coming and they’re unlikely to bite. So no deal by the 31st by my math. (Senate Minority Leader Mitch McConnell, who could help broker a Senate deal, is up for re-election in 2014 and is likely to keep a lower profile rather than risk a conservative challenge in a Republican primary.)

Second, the financial markets have held up surprisingly well—the S&P 500 closed down just 0.45% today, for example--under the uncertainty of the fiscal cliff. I think there’s a likelihood that markets will continue to fret but not panic if Congress and the President miss the December 31 deadline—as long as investors believe in a January bungee cord. If, however, that belief starts to fray, then the market will quickly get more worried. Do note, however, that while this is in my opinion the likely market attitude, it is by no means certain. There is a sizeable, in my estimation less than 50%, chance of a sell-off if the U.S. misses the December 31 deadline. How bad could any sell off be? Well, the 2011 drop associated with the debt-ceiling crisis amounted to 18.2% from July 21 to October 3. (And, yes, I agree that not all of that was connected to the debt-ceiling crisis.) I’d guess-timate a maximum damage of less than half that—say 7%. But that’s only my guess, I freely admit.

Third, optimists are assuming that Congress and the President will reach a quick January solution if the U.S. does indeed go over the cliff. The optimists could be right—and I think their optimism is largely responsible for stocks holding up so well in this uncertainty. That also means, however, that the pessimistic possibility—that this crisis will get rolled into a debt-ceiling crisis in January—isn’t priced in. The likely shock here is to the downside if it looks like there won’t be a relatively quick January deal.

What does all this add up to in my opinion?

It suggests raising some cash right now. That move has the advantage of giving you some downside protection to any of the uncertainties I’ve outlined above. Moving to raise cash could cost you potential gains if we do get the traditional Santa Claus rally in the sessions between Christmas and the first couple of days of the New Year but the gains in such a rally, if it occurs this year, are likely to be muted from even the 1.5% gain that the Standard & Poor’s 500 has averaged since 1950. Raising some cash also gives you the chance of being in a position to bargain hunt if we do get a market drop in January or February because of this crisis. I’d expect the financial markets to bounce back relatively quickly if the delay in negotiating an end to this crisis is limited to just a few weeks. And if that’s the extent of the delay, I think the damage to the U.S. economy will be minor and 2013 could still turn out to be a good year for U.S. stocks. If that were the case I certainly wouldn’t mind being in a position to put some money to work at lower prices.

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