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How the "fiscal cliff" is affecting the markets

(MoneyWatch) As we've discussed here many times, markets hate uncertainty. And with Congress going to the last minute (and potentially longer if they don't reach an agreement today), uncertainty abounds. Inaction would mean major tax increases, and ratings agency Fitch has warned that the U.S.'s AAA rating is in jeopardy without a deal. And it's also possible that if a deal isn't reached in time that the Treasury won't be able to fund the government because it will have reached the debt ceiling. (The estimate is some time in March.)

One of the biggest questions is what would happen to the markets if a deal isn't reached. If you're a regular reader of my blog, you know it's impossible to know for certain what the markets will do. The best we can do is use history as our guide. Recently, we've seen the stock market trade down since President Barack Obama and House Speaker John Boehner broke off talks, and consumer confidence fell 6 percent in December.

We also know what happened back in 2008, when Congress initially rejected the $700 billion TARP bailout. The Dow Jones Industrial Average dropped 777.68 points the next day, the largest point drop in the index's history. The silver lining is that Congress got the message and passed the bailout a few days later.

Longer term, we have to rely on history and forecasts, though taken with more than a grain of salt, as we've seen that there are no good forecasters. First, the Congressional Budget Office is projecting that not reaching a deal would cause real (inflation-adjusted) gross domestic product to drop by 0.5 percent in 2013 (as measured by the change from the fourth quarter of 2012 to the fourth quarter of 2013) -- reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year. However, such a relatively modest drop shouldn't provide much comfort, given that there's some historical evidence to suggest that the CBO is wrong.

Perhaps the biggest reason involves how many people will be affected by tax changes. In addition to the tax increases that would take effect, millions of taxpayers will be caught in the snares of the alternative minimum tax (AMT) if there's no deal. The reason is that the AMT wasn't designed to be adjusted for inflation. Congress has passed a patch every year, but there won't be any time to pass a patch this year. It's estimated that about eight times more Americans than usual, about 32 million people, will get dinged with a higher tax bill because of the alternative minimum tax.

Making matters even worse is that while the other tax increases at stake in the fiscal cliff would apply to tax year 2013, the one involving the alternative minimum tax applies to this year's return. Many people will be shocked to find that their taxes due April 15 could be several thousands of dollars higher than they were expecting. And that certainly could impact future spending.

Another problem is that a recent research paper by the National Bureau of Economic Research showed that spending cuts have been far better received by world economies than raising taxes. The research found that when fiscal deficits are addressed mostly through tax increases recessions tend to be more severe and last longer than they are when the actions are more on the spending side. Given that going over the fiscal cliff involves about five times the tax increases ($500 billion) relative to spending cuts ($110 billion), the research calls into question the CBO's forecast of only a mild and short-lived recession.

Facing the uncertainty and the potential for a severe bear market, what should investors be doing? Nothing. The bottom line is that reacting to each bit of news on whether or not a deal will get done, or even reacting to the failure to get a deal done by the end of the year, is the losing strategy. As Napoleon said: "Most battles are won or lost [in the preparation stage] long before the first shot is fired."

What holds in warfare holds true in investing. Thus, if your investment plan doesn't already incorporate the virtual certainty that you will face many of these crises over your investment lifetime, it's time to fix your plan, perhaps lowering your stock allocation and your exposure to these type of risks. And if you don't have a plan, it's time to write one. Otherwise, the only way you're likely to achieve your financial goals is by luck. And relying on luck isn't a good strategy.

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