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Four Ways the Fiscal Cliff Could Play Out

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Your investor guide to the financial opportunity presented.

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The constant news coverage of the fiscal cliff is becoming nauseating. So I thought I'd pile on, but cover it from a slightly different angle.

The media is focused on the impending recession from the budget cuts and tax increases. That is the main story. But what should an investor do about it? What should an investor expect to happen in the markets? That's the more important question. Let's see if we can rappel this cliff from that perspective.

First, if you need a primer on what cuts are coming and what tax changes are imminent with the cliff, check out this story at CNN Money. It's an excellent summary of the impending changes.

If we reach January 1 without a compromise, then the spending cuts and tax changes outlined in that story will go into effect. Even if they do take effect, more than likely a compromise will follow within one to two months, give or take a month.

So, with a compromise almost a certainty, you need to have a view on what will be included in it. I believe the compromise will include the following:

No. 1: Capital gains tax rates are going up, but dividend rates are not.

The fiscal cliff includes higher tax rates for everyone including the highest earners. Plus, long-term capital gains rates will go up 5%. Lastly, the qualified dividend tax rates are going to go up from the 15% rate today to whatever your regular income tax bracket is.

To me, the question is, what changes are implemented that causes the taxes to go up for the highest earners?

In the end, I think the dividend tax rate goes back to the lower levels. But the capital gains rate is likely to go to the 20% level from 15%.

The high-end tax rates is where the debate rages. The pundits think the Republicans have to give in here because the Democrats can bring the vote after January 1 to lower tax rates for the middle class alone – and would they dare not vote for it? Not voting for it is their only hammer in the debate on tax rates for the wealthiest earners.

I have more confidence that the dividend changes will be reversed and the capital gains rate will go up.

The Market Impact: There will be some selling pressure at the end of the year from people that have long-term capital gains and want to take those gains now at the lower rates. But that pressure will be short-lived. It will be more like a ripple than a wave. Why? Because those investors need to re-deploy those funds back into the market so they need to be buyers again – more than likely of another stock.

The likely losers: stocks with large gains over the last 12+ months. The entire market has had a nice run the last year so many companies fit this description. The Apples (NASDAQ:AAPL) of the world probably have the most to lose (and are already seeing some of that pressure).

But these investors will need to come back in to the market – and after 30 days could even come right back in to the stock they sold.

Don't believe the hype that a large sell-off will have legs because of the capital gains changes.

No. 2: Tax reform in 2013 of some sort is likely.

The Republicans are willing to see taxes for the highest earners go up. At this point, that change is inevitable. However, they would like to trade that issue for a change to bad policy in the tax code – namely, misguided exemptions. The GOP would rather see the increase in taxes to the wealthy come through elimination of exemptions instead of an increase to the tax rate.

The GOP does not like the fact that the Congress has 'picked' certain industries to be winners by delivering them favorable tax incentives. They believe it has artificially propped up certain industries and is bad policy. A lower tax rate for everyone (even lower than the Bush levels in place now) but a reduction in exemptions would be better policy.

The GOP in particular thinks this would be good for small businesses. If a person grows his small business, he would get to keep more of profit because he would have a lower tax rate. It creates incentive for small businesses to invest in their businesses because of the predictable and lower taxes paid on the increased growth.

The Market Impact:
If this reform comes along, it should be good for small businesses and the public companies that service small businesses. Think about companies like VistaPrint (NASDAQ:VPRT), which is an online supplier of printed and promotional material as well as marketing services to micro businesses and consumers.

If reform occurs, I think it will be tempting for the Congress to address the mortgage interest deduction. I know this has been a 'holy' deduction that can't be touched. But I would not rule it out. As a consequence, avoid homebuilders for now. Home prices will be negatively affected by such a change in policy – if they have the guts to go after it.

No. 3: Defense cuts and entitlement spending cuts will occur, but on smaller scale.

The cuts that take effect in the fiscal cliff scenario are significant. In fact, Congress made them intentionally significant so that they would be forced to deal with them. They are split evenly between defense and non-defense cuts to the tune of $110 billion overall in 2013.

These cuts would significantly hurt a handful of industries based on the targets for these cuts. Some cuts are definitely going to occur, but probably something in the neighborhood of half of this total.

Also, Medicare payments to doctors are set to drop by 27%. This will likely be addressed by Congress. Expect the payments to doctors to decrease, but not by 27%. Overall, expect the negotiations to include some creative changes to Medicare in other areas as well.

Market Impact: So, these changes will affect some industries. The problem is the market has already reflected a decrease in the stocks that it expects to be affected. And the drops in the stocks are based on the magnitude of the cuts that are expected by the market. The cuts in the end will probably be something less than the $110 billion total, but still something in the neighborhood of half.

For now, I would avoid defense contractors and health-care companies. You don't want to be picking the winners and losers there while the negotiations are still ongoing. Just avoid them as they will likely trade in a more volatile nature than usual.

No. 4: Financials may be a buying opportunity.

Financial reform is not part of the fiscal cliff. But the day after Obama won, financials took the hardest hits. The expectation is that taxing the wealthy will hurt the sector and that reform is coming.

I think this is a buying opportunity. The sector is already showing healthier balance sheets and improved earnings. I think that trend continues. However, I think the negotiation in Washington on bigger issues will distract Washington from financial industry reform.

In addition, I think a lot of the financial industry attacks on the campaign trail were meant to get Obama elected because they are consistent with the populist outrage. But in reality, it was mostly talk and there won't be much follow-up.

Market Impact: I think financials look good here on the 'misplaced' dip.

(See also: Fun With the Fiscal Cliff.)
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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