The Fiscal Cliff Rally. It’s been a favorite expression among traders for the past few weeks. It implies that the politicians will eventually come to some sort of compromise, triggering a rally as the worst-case scenario does not come to pass.
Who is really expecting the worst-case scenario at this point? I imagine very few traders (and none who I interact with) expect no compromise and an immediate fiscal contraction. The large majority expect a kick-the-can compromise that puts off the large decisions for a later date. If that’s true, then how much of the Fiscal Cliff Rally is priced in?
We can look to market history to better illustrate my point. Over the last 3 years, we’ve had several long-anticipated policy events that eventually came to pass. The most notable in my mind were the initiation of QE2 (telegraphed months in advance), the resolution of last year’s debt ceiling talks in a kick-the-can compromise that has brought us to the current impasse, the announcement of Operation Twist (which had much less lead time, but one situation I want to discuss anyways), and the announcement of QE3.
Here is the 3 year chart of the SPX illustrating those events with their respective circles:
In chronological order:
- QE2 was finally announced after a multi-month basing process in the SPX index, and then a subsequent rally on QE2 expectations that took the index to the highs of the year. After a brief sell-the-news pullback, the SPX took off to new highs over the next 6 months.
- The debt ceiling talks that captured the headlines for most of July 2011 were finally resolved with a compromise at the end of the month, and technical default was averted. The market promptly crashed AFTER the compromise was reached, on a combination of European crisis fears and the nature of the compromise (the oft-cited S&P downgrade of the U.S. credit rating only occurred after most of the selloff had already taken place)
- The announcement of Operation Twist by the Fed was not as well telegraphed as the other events on the list, but I included it on the chart to point out that the Fed’s actions are sometimes attributed for price action that has much more to do with depressed or elevated market sentiment. Did Operation Twist cause the rally, or was the rally simply a result of depressed sentiment, aided by the Fed’s catalyst?
- Similarly, was the failure of QE3 to generate a rally due to the fact that QE is less effective now, or simply due to the fact that QE3 was initiated when market sentiment was euphoric? Not so simple to answer. In my view, the sell-the-news reaction to QE3 was a result of elevated expectations into the event more than anything fundamental related to QE3.
As we approach the resolution of the Fiscal Cliff, be aware that the market’s expectations heading into the event are probably more important than the event itself. The market’s gradual rally into the event might portend a much weaker reaction than most traders are expecting.