Going Over the Fiscal Cliff Won't Tank the Markets

Stocks are poised to rally, if only Congress would do its job.

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Investors are going a bit wobbly as Washington politicians careen ever closer to the edge of the fiscal cliff.

If there was ever any doubt, it's now clear that negotiations over the big set of tax hikes and spending cuts due to go into effect on January 1 will go right up until the last minute. Republican House Speaker John Boehner has now sent his members home for the Christmas holiday, after failing to muster enough votes to pass his "Plan B" alternative to President Barack Obama's plan to raise taxes on the wealthy and cut about $900 billion in federal spending. It's now up to Obama and his fellow Democrats to propose a plan that might be able to pass in the House—if legislators even bother to come back to Washington after Christmas.

[ENJOY: Political Cartoons on the Fiscal Cliff]

The whole drama is lurching toward a worst-case scenario, which would be no deal at all by the end of the year. Congress could start over in 2013, and make any measures it passes retroactive, but as more time passes, more economic activity is lost as business and consumers pass up opportunities to spend. The stock market fell by roughly one percentage point the morning after Boehner's Plan B failed, signaling growing worry that intransigence in Washington will cause a new recession.

But the markets may hold up better than expected if Washington does go over the cliff, and there may be no "TARP moment"— a market plunge that gets Washington's attention and finally triggers action. Here are seven reasons why:

President Barack Obama gestures as he talks about the fiscal cliff negotiations during a news conference in the briefing room of the White House on Wednesday, Dec. 19, 2012, in Washington.
President Barack Obama gestures as he talks about the fiscal cliff negotiations at the White House in December.

Nobody trusts Congress anyway. Since the summer of 2011, when Congressional Republicans nearly torpedoed a deal to extend the nation's borrowing limit, Congress's approval ratings have sunk to record lows. That fiasco demonstrated a significant chunk in Congress is willing to block budget deals and threaten the whole economy for political ends. So if the same thing happens with the fiscal cliff, at least it won't be a surprise.

[NEWMAN: The Economy Is Already Going Over the Cliff]

Wall Street has been warning this might happen. Many consumers are just starting to pay attention to the cliff, but Wall Street analysts have been warning about it for a long time—and telling their clients to prepare for the worst. Bank of America Merrill Lynch, for example, has long been predicting that negotiations would go down to the wire, and perhaps past the deadline. Even then, they predict about half of the fiscal cliff provisions will go into effect, cutting GDP growth by about 2 percent in 2013. Not all investors have been paying attention to such warnings, but many have.

Companies are ready for the cliff, too. CEOs have hunkered down, one reason business spending has been so weak recently—they're waiting to see if Washington causes another recession before investing more in future operations. That's bad for the economy today, but it does mean most businesses can ride out whatever is coming.

Another U.S. credit downgrade might not harm anything. The Moody's and Fitch rating agencies have both warned if Congress can't make progress on fixing the national debt by early 2013, they will downgrade the U.S. credit rating, just as Standard & Poor's did in 2011. But it may not have the same shock value the second time around.

"Credit rating adjustments, in and of themselves, I don't think are important," says Nigel Gault, chief U.S. economist at forecasting firm IHS Global Insight. "To a large extent, downgrades simply confirm what financial markets have already seen." After the first downgrade in 2011, the stock market plunged, but nothing really changed, so stocks eventually drifted back up.

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Many investors are on the sidelines already. Financial advisers complain that too many of their clients are keeping their money in supersafe investments like Treasury bonds, to reduce their exposure to anomalies such as the fiscal cliff. So there shouldn't be a mass sell-off in the event of a cliff dive, because many nervous investors have already sold.

A stock market drop would be a buying opportunity. The now-famous "TARP moment" occurred in the fall of 2008 when Congress initially voted down the bank-bailout legislation. Stocks fell by nearly 9 percent, then rallied after Congress finally passed the bill a few days later. But the markets back then were already in a free fall, as a vicious recession intensified. Today, most economists think the recovery is poised to pick up steam, if only Congress will do its job--so a drop in the markets might be short-lived.

"Think of volatility as an entry point," advises Russ Koesterich, chief investment strategist for money management firm BlackRock. "If Washington does disappoint with a deal that doesn't satisfy the markets, that might present a buying opportunity."

Beyond the cliff, the road flattens out. Many forecasters believe a modest compromise deal to avert the cliff would unleash a stronger recovery and push stocks higher. Merrill Lynch, for instance, says there could be a 10 percent stock-market correction in 2013, but it still expects stocks to end the year about 8 percent higher than they are now. Others are far more bullish. Investing firm Piper Jaffray, for one, expects stocks to appreciate by nearly 19 percent over the next year, and by nearly 40 percent over two years. If members of Congress would simply consider their own investment portfolios, that might be enough incentive to strike a deal.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.