How to Read a 'Cliff'-Induced Sell-Off

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. The uncertainty quotient is high as we approach the end of 2012, with a lot of headlines focusing on the fiscal cliff and other issues, so what should you do if we do see a big selloff in the market in these last few days of the year? Here to offer his insights is Sanibel Captiva Investment Advisers President Pat Dorsey.

Thanks for joining me, Pat.

Pat Dorsey: Go eat more of your Christmas Turkey; that’s my answer.

Stipp: That's number one. The number one thing investors should do.

Dorsey: Exactly.

Stipp: There are concerns that we could see some volatility here at the end of the year. Up until mid-December, we've had a good year in the stock market. If people start to get worried, maybe they take some of those profits. If I see a bad day in the market here in these last few days, what should I be thinking about fundamentals, sentiment--how should I calibrate?

Dorsey: I think it's probably going to be caused by Boehner and Obama not being able to play nice with each other, and that's probably what will cause a big sell-off like that. And so, I think what you need to do is look at it on a company-by-company basis.

Let's say that, for example, defense sequestration is going to be worse than anticipated, or there is a big defense program that's now on the chopping block that wasn't before. That might actually affect a specific company, like a Lockheed Martin or General Dynamics. And so that might be a reason to reassess what you think the company is worth.

But do fiscal regulations affect Apple, in any way shape or form? Probably not. So, if that's been a company that's been on your radar screen, you get a big drop in the market because people are worried about the fiscal cliff. Well, how many iPhones they sell really isn't terribly well-connected to what our budget does.

Stipp: We know that tax changes are also on the table. What if we get some more information about tax hikes on capital gains, for example. What if it's higher than expected or what if the deal that they're trying to craft would make the tax burden higher on investors in different ways or at different income levels? Does that change the fundamentals of your stocks?

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Dorsey: Not really--the best tax you can pay the government is none. So, I mean this whole idea all year of "sell it now, pay your 15% and then buy it back later"--why even pay the government 15% if you don't have to pay them anything. The only thing we've been doing at Sanibel Captiva on the tax front is, we’ve been telling investors, if you have a concentrated, low-basis position, it's big part of your portfolio, and you've been selling it down, accelerating those sales makes sense.

So, let's say in the next couple of weeks, we hear that the long-term capital gains might got to 30%--not probably going to happen--but let's say it did. Well, maybe then you've got that big, low-basis position, you may say let me just get rid of most of it now. But if you weren't thinking about selling it already, there is no reason to do so, because the tax you defer is the best tax of all.

Stipp: So far, we've been talking about potential for specifics that we could get in the framework of a deal, but you also mentioned early on if the two parties don't play well together, we might not get any specifics and we might not get any kind of framework for a deal.

The market is likely to also be upset about that, so if that happens and you can't go back to your companies and look at specifics against their prospects, how then should you think about what the sell-off means?

Dorsey: Well, then I think really it's time to go shopping. Because at the end of the day, a deal that puts our country on a more sustainable fiscal path--because our current path is not sustainable; I think both sides agree or not that fact, they just disagree on how to fix it. And this has been problem that, frankly, our political masters have been kicking down the road for several years now. If we actually see some progress on that front, a good deal that puts our country on a sustainable fiscal path that is struck in February, [that] is far better than some band-aid over this gaping fiscal wound that is just crammed in through the end of the year, but that doesn’t actually solve anything. It causes more short-term pain, but it puts our economy on a sounder long-term footing, and that's better for every business.

Stipp: So, let's talk about that short-term pain a little bit, because we are going to see some headwinds on the economy deal or no deal; the magnitude we don't know yet. If we get close to a recession or if we see much slower growth because of some of these changes, how does that change your thinking as a fundamental stock investor? If we see recession sooner than we might otherwise have, would you make any changes to your portfolio?

Dorsey: First let me just say I think that's a highly improbable scenario. Remember, the fiscal cliff is not a cliff; it’s a steep hill. It's not like tons of federal workers will all go home with no paycheck on Jan. 2. Spending authorizations get reduced; the actual spending doesn’t stop dead on that day. Payroll checks--if taxes go up a little bit, that probably might affect people to some extent.

In the super-unlikely scenario that we actually see some kind of recession coming, you lighten up on cyclicals like a Parker Hannifin, for example. Probably companies like Philip Morris International will hold up still fairly well. But I just think that's a pretty out-there scenario at this moment. We just heard recently that the U.S. economy grew 3.1% in the third quarter. Was anybody expecting that one? I think they were probably shooting a lot lower. So, 2% growth next year wouldn't be great, but 2% growth is not a recession.

Stipp: All right Pat, always levelheaded advice for us in these turbulent times. Thanks for joining me and for your insights.

Dorsey: Thanks for having me Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.