Stocks brace for fiscal cliff reckoning

The deadline to avert a looming fiscal crisis is fast approaching. Investors are hoping for the best, but bracing for the worst.

NEW YORK (CNNMoney)

For weeks, many have worried that no resolution to the fiscal cliff would lead to the kind of brutal sell-off that followed the voting down of the TARP bailout and the downgrade of America's credit rating.

Now, with the deadline fast approaching and no clear resolution in sight, strategists aren't so sure.

"I don't know how the market is going to react," said Ben Schwartz, chief market strategist at Lightspeed Financial. "But I do know that people are upset with what's going on in Washington."

The dysfunction in Washington has cast a pall over Wall Street since Election Day. But despite all the hand-wringing, stocks are currently trading at levels seen just before President Obama won a second term.

So, where do stocks go from here? Good question.

Much depends on what House lawmakers do Sunday, when they meet for a last-ditch round of budget talks. The hope is that a stopgap measure is put in place to prevent some of the tax hikes and spending cuts set to take effect on Jan. 1.

Related: Going over the cliff: What changes, what doesn't

Here are two possible outcomes:

Partial deal, modest sell-off

Like most Americans, investors view the budget impasse as an epic failure of leadership in Washington. But they still expect a deal, because doing nothing would be "political suicide" for members of both parties.

"We think they will reach some kind of agreement before the end of the year, but not until the very last minute. And it won't be much," said Kate Warne, chief investment strategist at Edward Jones.

While the details remain sketchy, investors are expecting a short-term extension of Bush-era tax breaks and a suspension of defense spending cuts, among other things.

Despite its name, many strategists say the fiscal cliff will not hit the economy right away. That could give lawmakers some time to continue negotiating, but it's unclear how long the market will tolerate such uncertainty.

Related: Real fiscal cliff deadline is inauguration

"Unlike the debt ceiling and government shutdowns in the past, not all that much changes on January first," Warne said. "But the tone will get more and more negative as time goes on."

Even with a stopgap deal, stocks could sell off, according to Peter Tuz, a portfolio manager at Chase Investment Counsel.

"It doesn't have to be sharp," he said. "A 20% drop would be astounding, but a modest drop would not be surprising."

No deal, more volatility:

Investors could be in for a rude awakening on New Year's day. Despite the political and economic stakes, it's not a given that Congress will act.

"I don't think investors have taken into account that nothing gets done," Warne said.

Wall Street vigilantes believe a sell-off may be necessary to force America's elected officials into action. But there is no guarantee that a riot in the stock market will inspire sound policymaking.

For example, the sell-off that followed the S&P downgrade did not result in a long-term solution to the debt ceiling problem, said Lawrence Creatura, a portfolio manager with Federated Clover Investment Advisors.

"The market can act as a disciplinarian, but that doesn't ensure that we get a clean and lasting solution," Creatura said. "We didn't get that last time, and it's probably not realistic to expect it this time either."

The fiscal cliff was designed to force Washington to deal with the nation's long-term debt problems, but hopes for a grand bargain have diminished as talks devolved into stalemate.

The lack of progress on structural issues, such as entitlement spending, means investors will be dealing with a certain degree of political risk long after the fiscal cliff deadline has passed.

"They're not dealing with the big issues," Tuz said. "They'll come up with a band aid approach that just delays the inevitable."

In the meantime, trading in the stock market could be volatile as investors monitor the blow-by-blow in Washington.

The market's fear gauge, the VIX (VIX)has jumped 14% over the past five days -- a sure sign that volatility is indeed on the rise.

"We're floating around here and no one has any real idea where we're going to go," Schwartz said. "That's why volatility has popped up."

First Published: December 29, 2012: 9:03 AM ET

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