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Is the Stock Market Priced for the Fiscal Cliff?

Scott Burns

Scott Burns: Is the stock market priced for the fiscal cliff?

Hi, there. I'm Scott Burns, Morningstar's director of fund research.

Joining me today is Russ Koesterich, who is the global investment strategist with iShares BlackRock.

Russ, today you spoke at the ETF Invest Conference, and we talked a lot about what's happening with politics and the economy. And I think the most timely, pressing thing is the fiscal cliff--it's ever there. You made the statement that, looking at the stock market today, the possibility of going off the cliff is not priced in.

Koesterich: Yes.

Burns: So, that begs two questions. What is the probability of going off the fiscal cliff, and if so, what is the impact?

Koesterich: I think the probability is, honestly, who knows?

It's going to depend very much on election, what is the outcome afterwards. It is very hard to understand or to know the minds of the politicians who ultimately are going to decide all of our fate. But I think what’s key is that, when you speak to people in Washington, the impression you're left with is that they are placing a much higher probability of at least temporarily going over the cliff than is appeared baked into stock prices. So, I think there is a disconnect.

Burns: I think a lot of people think that that's political brinksmanship, but you've been, and members of the BlackRock team, have been down to Washington, speaking with those folks. Is this political brinkmanship? The media kind of makes it out like there is this game of chicken, but is there some other game afoot?

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Koesterich: There certainly is going to be some brinkmanship, and how much and who is doing it is going to depend partly on the outcome, and who feels they've got the upper hand, but I don't think it’s just brinksmanship. I think there's another element here, too, which is that, in fairness to the politicians, there are some really different thoughts about how to tackle this. And this is coming out on the election, where there are some very distinct ideological differences between the Republican vision and the Democrat vision, and then the question becomes, can you bridge those differences in a scant seven weeks between the morning after the election on Nov. 7 and New Year's on Dec, 31.

Going back to the original point, the danger is the market seems to be saying, "we've seen this movie before, we saw it in 2010, we saw it last year with the debt ceiling, there is an 11th hour compromise, I am not going to worry about this"--which is one of the reasons-- maybe the main reason, I don't think it's reflecting the price.

The risk is, I do think that if it starts to look like this is more likely, you are going to see equities come under some pressure. The reason being that you've got a very fragile recovery, we are in a slow-growth mode, Q2 GDP was 1.3%, it may not be that much better in Q3. So, if you have an environment where growth is less than 2% and you have fiscal drag equal to 4% or 5%, that’s going to raise the probability of another recession. I think you are going to see a contraction of multiples, more volatility, and obviously earnings estimates would have to come down as well.

Burns: We've had some other folks come in and say, "Well, look the stock market always leads the recession"

Koesterich: Yes.

Burns: So, do you think that as we start to look at the market, factoring that in, that that will be a pretty good judge for us, or indicator of that recession likelihood?

Koesterich: I certainly think the market is going to react before you get there. So, if you do go over the fiscal cliff, and the odds go up in 2013, I do think we're going to see some pressure in the market in 2012.

This is an interesting case, because, again, if I look at the economic data, it suggests that the U.S. should be able to continue … in the slow growth mode into 2013. And really what you are betting on is not a garden-variety recession, but an exogenous shock. I think part of the challenge for investors is, this is tough to handicap. If I am an investor sitting here in Chicago, how do I handicap the extent to which the president and Congress are going to engage in this brinkmanship? That's not an easy thing to discount.

Burns: No, it's definitely not. And it kind of makes me think of what happened in the '70s a little bit, where you would get these oil shocks and things like that, people didn't expect it. But when you go back and think about the '70s, those shocks actually ended up having very prolonged effects.

Koesterich: They have an impact, and this would as well, I think.

Burns: So, we are looking at brinkmanship, we are looking at the outcome. You are also running portfolios for iShares BlackRock as the chief strategist. How are you positioning your portfolios now, given this handicapped, somewhat unknown outcome, [with a] fairly significant impact, but may be short term?

Koesterich: We are trying to get a bit more defensive, and there are several ways to do that--one of which is by thinking about what segments of the market tend to provide little bit more cushion in downturns. So, some examples of that would be mega-cap stocks, which I think look very cheap right now relative to the broader market.

Second thought would be high dividend payers, particularly outside of the United States, where they're cheaper.

And then finally, this is going to seem a little bit counterintuitive given the pattern of the last few years, this might be a good time for investors who are overweight the U.S. to take down that overweight. And that overweight has played out very well since 2010; the U.S. has dramatically outperformed. But now we are moving into an environment maybe for the first time in a couple of years where the big proximate risks to the market are not in Europe, they are not in the Middle East, they are here at home. And that suggests that given the fact that U.S. stocks are trading at a significant premium, maybe this is the right time to look to gain some exposure outside of the U.S., where some of the risks may be better reflected.

Burns: Well, as always in these uncertain times, the best way to deal with uncertainty is diversification.

Koesterich: Yes.

Burns: And a good asset allocation discipline.

So, Russ, thanks again for your insights, and thanks for being a part of the ETF Invest Conference.

Koesterich: Scott, thanks for having me.

Burns: I am Scott Burns with Morningstar. Thanks for watching.