Don't Believe the Hype

 | Nov 30, 2012 | 12:00 PM EST  | Comments
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This commentary originally appeared at 8:53 a.m. EST on Nov. 30 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

"Disaster has a way of not happening."

-- Byron Wien, Vice Chairman of Blackstone Advisory Partners

Recently, I opined that not only are the fiscal cliff fears overblown but so are the economic, political, geopolitical and tax fears overblown. Nevertheless, the earnings cliff fears (which will ultimately limit Mr. Market's upside) are not overblown.

In understanding why we will likely see a timely fiscal cliff compromise, it is essential to also go back to the November election, in which the message was one of moderation, and moderation equates to an ultimate compromise.

Some market participants (and certainly the media) seem to be now incorrectly playing the last war (which took place during the budget deliberations in August 2011). By contrast, I believe that fiscal cliff fears are likely misplaced, as we are at the point of necessity, and my view is that both parties get this. Sleeves will be rolled up in the next three to four weeks, and the outcome will likely be a relatively pro-economy/pro-business compromise with multiple concessions from both sides.

Compared to the budget deliberations of August 2011, this time around neither party can risk the perception of being obstructionists in the negotiations. Americans clearly have voted with their feet, and they want and prefer compromise over drama.

Once Bitten Twice Shy

My bet is that having been disappointed once and with the domestic economic recovery still subpar, we won't be disappointed twice. Fifteen months ago, neither the Democrats nor Republicans thought through the consequences of their partisanship. This time, they have clear knowledge of the potential adverse impact of stalled negotiations regarding the fiscal cliff -- both with regard to the economy and our stock market.

Arguably, both parties are now damaged goods (though for different reasons) and have to prove that they can legislate for the common good rather than on partisan terms. They cannot afford to do otherwise; they are not likely to make the same mistake twice.

Both parties find themselves in trouble, neither party is trusted (the overall voter turnout was weak), and it appears that Democrats and Republicans finally might/should recognize that the serious secular financial and economic problems should be addressed in a more bipartisan manner.

In the debt negotiations during the summer of 2011, the electorate was appalled by the partisanship and lost confidence in our leaders. They must earn that confidence back by resolving some of their differences. (They will have another two years before the 2014 elections to posture on a partisan basis.) It is my expectation that both parties will likely move toward the center in the fiscal cliff negotiations and will reject the more extreme members of their respective parties in making concessions to each other.

Again, the 2012 election was a win for the moderates. Compromise and agreement between the two parties remains my baseline expectation.

I expect the final fiscal compromise will produce only about a 1% fiscal drag in 2013, which will easily be overcome by a better-than-expected housing recovery and by improved business confidence, hirings and business fixed investment spending.

Geithner's Proposal Gets the Silent Treatment

The market's resilience in the face of early legislative posturing appears to be sending a strong message that the fiscal cliff will be resolved in a timely fashion by year-end.

Case in point: Yesterday Treasury Secretary Geithner (representing the Obama administration) delivered a one-sided proposal to the Republicans. His proposal offered $1.6 trillion in tax increases and only $400 billion of unspecified (and non-guaranteed) entitlement program cuts over the next 10 years. The 4:1 ratio of tax increases to spending cuts was a partisan and unbalanced proposal, far more lopsided than the tentative agreement made between the President and the Speaker of the House in 2011 and imbalanced relative to the Simpson-Bowles proposal (which had more in spending cuts relative to tax increases).

Upon release of this one-sided proposal, the market's reaction was muted, with S&P futures dropping by only 4 handles. (Since Thursday's 5:00 p.m. EST announcement, the modest falloff in futures has been reversed, and S&P futures are now up by three handles.)

Why didn't the market collapse upon receipt of the administration's proposal?

The answer is quite simple: The market recognizes that Tim Geithner delivered only the first proposal from the Democrats at the beginning of negotiations. The administration has absolutely no intention to stick to the proposal -- if it did, the House would soundly vote down the proposal and the full extent of the fiscal cliff's drag would be felt in the first half of 2013 (causing a recession and a sharp stock market fall).

The muted market reaction to the one-sided Geithner proposal makes sense to me.

Mind Your Investments, and Ignore the Media

There is little question that the schism between the parties is more venal than it was 20-25 years ago, which has led to the politics of division over the last decade.

Nevertheless, ignore the media's overhyped and extreme interpretations of both the Democratic and Republican Parties' gambits, especially in the early stages of negotiations (which is really more theatre and posturing than negotiations). And ignore items such as CNBC's promotional bug of the fiscal cliff countdown -- we have seen repeatedly, over time, other bugs that were killed off.

Being fearfully preoccupied with the first act of this fiscal cliff ballet could result in shedding investments that are attractive over the intermediate term. Instead of burying your head in the sensationalism of the media, try burying your head in balance sheets and income statements in order to find the next Ocwen Financial (OCN) or Altisource Portfolio Solutions (ASPS).

It will be a more productive endeavor.

In summary, be fearful of the earnings cliff not the fiscal cliff.

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