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What will happen to stocks if we go over the cliff

December 21, 2012: 1:58 PM ET

The market might have a good reason to be shrugging off the fiscal cliff.

obama-boehner

Obama and Boehner: Not market killers

FORTUNE -- For months the predictions for what would happen if we go over the fiscal cliff have been bordering on horrific. The Congressional Budget Office says the chance of recession is 100%. Moody's says it will be much harder for companies to issue debt. PIMCO's CEO Mohamed El-Erian says our children are all but guaranteed to be worse off than us.

Based on that, it seems like going over the fiscal cliff would be an absolute disaster for stocks. Yet the market reaction has been mostly a shrug. Even Friday, with the news that Boehner and Obama look farther than ever from a deal with just days to go before the end of the year, the Dow Jones industrial average was down less than 200 points. Not great. But not really the type of market move you expect if we are headed for a recession. Even after that drop the S&P 500 (SPX) is still up 13% this year.

One interpretation is that investors still don't think we will go over the cliff, or not completely. That's been the predominant line of market strategists for a while now. Markets aren't rational. We could still wake up one day, January 2 perhaps, and the market will be headed toward a 1,000 point fall. And I guess you can still believe that, but the number of days you can stick with that analysis are dwindling.

MORE: Fiscal cliff? What fiscal cliff? No evidence in jobs numbers

Here's another possible explanation: Not much will happen to the market if we go over the fiscal cliff.

In general, the market's direction is determined by two things -- earnings and the value that investors are willing to put on those earnings. Lots of things go into the valuation -- perception of risk, future earnings growth, interest rates, to name a few. But the biggest impact of the fiscal cliff will be on earnings. And it will be bad. But, surprisingly, this is not as bad news for stocks as you would think. That's the upside of a our slow growth economy. Earnings don't matter nearly as much as they used to.

Most market strategists expect about 2% growth from earnings, about 2% from inflation, 2% from dividends and 2% from a higher price-to-earnings multiple. Many of them expect the market to return around 6%-to-8% for 2013. Take away earnings, and the market could still be up around 6%. Expect earnings will go down 4%, and stocks are still likely to produce a 4% return. Compare that to bond yields. There's really nowhere for investors to run.

Here's the flip side of that: The idea that stocks will soar if we do end up getting a fiscal cliff deal is probably bogus as well.

MORE: Wall Street experts: What will do well in 2013?

Back to the second thing that pushes stock prices: valuation. One of the many things that factor into that is political risk. Stocks in emerging markets are able to go up a lot even with huge political risk, because of growth. Earnings matter more in those markets. Unfortunately, in the U.S. we have the opposite: a growing risk of political instability at a time when political risk, because of the slow growth, matters more.

Throughout the 2000s, even after the deflation of the dot-com bubble, the S&P 500 used to fetch a price-to-earnings ratio of around 20. Now 15 is the new normal. Amazingly, that change didn't happened during the financial crisis or right after. The real dip came in mid-2011, around the debt ceiling standoff, when the p/e ratio, for the first time in more than two decades, fell to as low as 13.50. It's rebounded, but stick to around 15 ever since. The good news is that stocks already took their lumps based on Washington's new normal two summers ago. The bad news is that the market is not going to be healed anytime soon.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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