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Investors should prepare for market correction

In the months leading up to the re-election of U.S. President Barack Obama and the return of the usual partisan culprits to Congress, the markets were remarkably sanguine about the looming crisis known far and wide as the fiscal cliff.

Market players seemed much more focused on the spate of better-than-expected corporate earnings, the halting comeback of U.S. housing and whatever China was up to than on the very real risk that continuing gridlock in Washington could slam consumer, business and investor confidence and pull the crutches out from under the still-recuperating economy.

It is not only the gloom-and-doom crowd that has been warning of the coming black cloud of recession. The Congressional Budget Office, hardly a hotbed of radical thinking or sensation-seeking prognostications on fiscal matters, has been saying since last May that the enforced austerity would trigger a made-in-Washington recession in the first half of 2013, with the economy shrinking 1.3 per cent and unemployment climbing back above 9 per cent. Its latest update, released Thursday, projects contraction of 0.5 per cent for the full year, down from its earlier guesstimate of slim growth of 0.5 per cent.

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Yet until Wednesday, the day after the election, when U.S. stocks went into a two-day tailspin, volatility remained remarkably tame and investors unusually complacent about the ability of warring Democrats and Republicans to reach a compromise to delay or eliminate a series of automatic deep spending cuts and tax increases that come into effect starting Jan. 1.

"It was a very strange thing," says veteran U.S. market strategist Russ Koesterich, who has seen more than a few strange things in his more than 20 years in the business. He estimates an economic contraction of 1 per cent or so in the first half would shrink equity multiples by about 10 per cent. It would also mean that analysts' earnings estimates would be worth less than usual, because they have been based largely on the economy growing at a 2.5 per cent clip.

"There was a very widely held belief that the fiscal cliff would be avoided, that there would be a last-minute compromise," says Mr. Koesterich, chief investment strategist with BlackRock's iShares unit in San Francisco. "While that's still a reasonable outcome, people are aware that there are some risks. I don't think prior to Wednesday that those risks were really discounted into stocks."

And even now, he adds, "the risks of going over the fiscal cliff are probably greater than the market is still discounting."

Maybe that explains why a gaggle of investors bailed after they heard Republican House leader John Boehner declare that his members are well aware of the need to reach a deal to avoid the dreaded cliff edge, as long as no tax hikes are involved. President Obama then weighed in with his own "compromise," which includes extending middle class tax breaks, one of his campaign promises, but boosting taxes on the wealthy, another of his promises.

Surely, neither party wants to carry the blame as the author of an unnecessary recession that would spill over into Canada and quite likely trigger a global slump. But the experts have been wrong repeatedly when they assumed that Democrats and Republicans would opt for pragmatic solutions to solve budget impasses. One intriguing theory is that the two sides will let the fiscal nightmare play out temporarily and use the immediate negative fallout as cover to reach a deal over the objections of hard-line ideologues like Paul Ryan, who was part of the losing presidential ticket but managed to hold on to his seat in Congress and likely his key role on the House budget committee.

But investors need to be prepared in any case for a coming market correction, Mr. Koesterich advises. That means putting more money into non-U.S. assets – he likes Chinese and Brazilian equities, which have fallen out of favour, and even Russian stocks for the truly adventurous, along with some exposure to commodities, including gold. In the U.S. market, mega-cap stocks and such sectors as health-care and consumer staples tend to be better insulated in a falling economy.

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Most investors – and not just in the United States – "simply own too much of their home country," he notes. This is a particular problem for Canadian investors, faced with "a relatively concentrated market that's very geared towards commodity plays and financials. Owning a more diversified basket of international stocks helps to mitigate that sector concentration that people are often taking on unintentionally."

With only seven weeks to the fiscal cliff deadline, "no one expects a grand bargain," Mr. Koesterich says. "It's very unlikely that you're going to get a real long-term solution in a lame-duck session. All people want to see is that this problem is put off for six to 12 months and that there's some reasonable path toward a long-term compromise in the next Congress. They don't have to solve all the world's problems; they just have to avoid an unforced error."

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