The Dow Jones fell by more than 300 points (approximately 2%) on Wednesday -- it's worst day for 2012 year-to-date. Was it Obama's re-election that scared investors? Not exactly; but that is part of the equation. Here's what happened and what to expect going forward.
Fiscal Cliff and Germany Combine for Big Negative
The prediction markets had expected Obama to win the US presidential election Tuesday but it had given odds of roughly 60%, with 40% odds going to Mitt Romney. With the "fiscal cliff" looming around the corner, investors were looking for some clue that gridlock in Washington could be unlocked, so to speak, and therefore the fiscal cliff could be averted.
Keep in mind here that the greatest damage done by the fiscal cliff would be uncertainty over its resolution. In other words, the fear of falling off the cliff may be just as damaging as the cliff itself because the stock market is a discounting mechanism, which means it makes educated guesses about the future and prices that expectation into stocks today. At the moment, investors have little confidence in Washington because, with Obama's re-election and the fundamental structure of Congress (Republican-controlled House, Democrat-controlled Senate), the nation faces a similar negative result as last year's "debt ceiling standoff."
Now back to prediction markets. Although the 60% prediction of Obama's victory seems high, there were still 40% that expected defeat (and thus greater odds of avoiding the fiscal cliff), which helps explain why stocks dropped even though Obama was seen as winning. If Romney had won, investors would have assumed that the fiscal cliff might be avoided and stock prices may have risen.
In summary, most investors were not surprised by the election, however the expectations of a large segment of investors (40%) now view the near-future in a different and negative light. Adding to the market's negative tone was news that Germany has begun to feel negative impact from Europe's debt crisis.
What Will Move Stocks Up or Down From Here
Logic is not always correct when analyzing what is often an emotion-driven machine. However, an investor can make a reasonable assumption that stocks will move higher if the fiscal cliff is avoided and if there is some kind of news that indicates Europe's debt crisis is only "as bad as we once thought but not worse." Therefore, expectations are everything, especially when uncertainty is at high levels. If gridlock in Washington drives the market closer to the cliff, and with no end in sight, market conditions might deteriorate.
I don't support absolute market timing strategies but there is no doubt that this bull market for stocks is getting old and expectations for (and perhaps exposure to) stocks should be gradually declining as the bull gets older. However, this does not mean a bear market has begun today.