Goldman sees fear of 'cliff' hitting stocks next quarter

Goldman Sachs strategists expect the "fiscal cliff" to push the market lower in the fourth quarter, and they recommend investors sell the stocks that have lagged so far this year.

Goldman chief US equity strategist David Kostin writes that the SandP 500 should fall sharply after the election when investors finally realize that there is a possibility that the so-called "fiscal cliff" will not be resolved smoothly. He says the majority of investors expect to see the fiscal cliff avoided in the lame duck session of Congress, but Goldman sees a one-in-three chance that Congress will fail to address the issue. The so-called "cliff" is the slam the economy would take from the expiration of Bush-era tax cuts and the automatic spending cuts that will hit the budget Jan. 1 if Congress does not act. The USD 100 billion spending cuts were agreed to as part of the debt ceiling compromise and are onerous, with a disproportionate hit going to the defense budget. Kostin expects the SandP 500, starting this week at 1,460, to fall to 1,250 by year end and then rise back to be at 1,350 in 12 months. Meanwhile, many big investors lag the SandP`s 18 percent advance year-to-date, with the typical levered investor seeing a return of just about 6.7 percent. Only 8 percent of hedge funds are outperforming the SandP, he notes. Goldman says a catch-up strategy could be to sell stocks that have had the worst performance year-to-date, counter intuitive to the theory by many managers that they should buy the losers and sell winners. Kostin notes the strategy of selling losers has outperformed about 56 percent of the time since 1980, and it was particularly successful in years where the SandP was positive during the first nine months. In the 23 years that the SandP was positive in the first nine months, a sector-neutral basket of underperforming stocks continued underperforming by an average 291 basis points during the fourth quarter, giving the strategy a 65 percent outperformance rate. In most years, the SandP 500 rose in the fourth quarter, and the strategy returned 177 basis points versus the market. But in the six years that were negative in the fourth quarter, as Goldman suggests this year will be, the strategy worked four of six times, delivering an average of 270 basis points. Goldman says the five biggest laggards are Alpha Natural, Apollo Group, DeVry, Advanced Micro Devices, and Electronic Arts. Follow Patti Domm on Twitter: @pattidomm Questions? Comments? Email us at marketinsider@cnbc.com Copyright 2011 cnbc.com