We used to think the "January effect" played a key role in how investors figured out investment tactics for picking up good stock-market bargains. Theoretically, at the end of the year you could buy stocks knocked down by tax-loss selling, then take benefit as the selling abated in January.Judging by the newfound negative turn of the averages, I am wondering if we won't see a "February effect" this time around. That is, perhaps accelerated selling will knock down stocks in December as investors endeavor to unload before any raise in capital-gains or dividend taxes -- and then again in January as we now acknowledge the unlikely nature of a deal by year-end. Yes, business leaders are in Washington to talk about a deal. But they don't get a vote on this issue. Yes, President Obama is taking it to the people, but they don't vote on this, either. Yes he's going on Twitter to talk about the consequences, but the Twitter followers also won't vote on this. The voters are in Congress, and we are seeing that something that was supposed to be totally draconian -- unpalatable increases in tax rates and cuts in spending -- may not be that unpalatable at all. That's because the politicians believe their careers will be more negatively impacted by compromising than by standing steadfast and allowing the U.S. to go over the cliff on principle. I get this. If you believe entitlements should never be cut, then you are going to send us over the cliff. If you believe taxes should never be raised, you are going to send us over the cliff. If you believe your House or Senate seat is going to be jeopardized by cutting entitlements or boosting taxes, what incentive do you have for compromise? It is both rational and opportunistic not to compromise? Are those who try to compromise, in this regard, sinking below principle, breaking their word or going back on why they were voted in? I will go one step further. The potential loss of jobs and higher mandated taxes may be a very small price to pay for standing fast on your principles -- and, for many, rising above the fray is simply a total betrayal to the electorate.
That is why it's time to prepare for the failure of talks and a potential December-to-January market decline, until the hardships become so clear that compromise on principles may become the only way to avoid a recession. That, after all, could mean new candidates rising up to try to take the jobs of the intransigents. To put it another way, let's call it the 10% solution. That is the approximate level of stock-market pain I think Congress can take before it will capitulate. Why 10%? It's about where the Congress agreed to pass Troubled Asset Relief Program (TARP), which is about has hated as the compromise needed to solve the cliff. But the U.S. must first go over the cliff to feel the pain, just like we had to see the market tumble to provoke the TARP passage. That can only happen when the paychecks shrink and the layoffs begin in earnest. OK, that's the bad news. The good news? Because I believe a December-to-January decline will breed a deal, in the words of Warren Buffett this morning, you should not make any long-term investment decisions based on the cliff. But trades and opportunistic tactics? I think you need enough cash to be able to buy a down-10% market if the cliff is breached. We are going to get plenty of "positive" deal talk, as we've got from House Speaker John Boehner (R-OH). We will also see negative deal talk, as we got this morning from Erskine Bowles, who champions a long-term solution to the U.S.'s budget issues. The important change, at least for me, is that a December resolution is now looking like a lost cause. This means that, instead of just a lack of hiring because of the uncertainty, we will see actual firings because the onerous provisions will come into play. You know what's truly ironic? When Congress agreed to create the cliff, it was meant to be so catastrophic that an agreement would have to be reached or else. It turns out that it wasn't nearly draconian enough to cause politicians to rise above politics. The outrageously bad tax increases and the spending cuts simply can't trump the belief that compromise represents the lowest form of life and a total betrayal of principles, even if it causes tremendous strife for the voters.
So prepare for the worst and then get ready to buy after the worst has happened. In the eyes of Washington, the worst isn't as bad as that hated, despised word, "compromise" -- the real enemy of the economy all along.