Market Rallies on Last Day of 2012 On Fiscal Cliff Hopes

After declining last week on every trading day for the first time since mid-May and ending lower for five straight days for the first time in three months, the stock market ended 2012 with a rousing rally on Monday with its best one-day gain since mid-November. And to no one’s surprise, trading on every day recently has been dictated by the perception of progress or lack of progress in resolving the issues surrounding the fiscal cliff.

To underscore the seriousness of the situation, last Wednesday the U.S. Treasury Department announced the first of a series of measures that should push back by around two months the day when the government will exceed its legal borrowing authority as imposed by Congress. This was crucial because without anything being done, the government was set to reach its $16.4 trillion debt ceiling on December 31. This crunch on the debt ceiling had become ensnarled in talks to avoid some $600 billion in tax hikes and spending cuts due to begin in January, the infamous so-called fiscal cliff. Failure to raise the debt ceiling could have caused the government to default on its debt.

For the remainder of the week, the political wrangling continued, resulting in a stock market selloff that had investors obsessed with the negative implications of a deal to avoid the fiscal cliff not getting done. Typical of this anxiety was a statement last Thursday from Senate Majority Leader Reid that “it looks like that is where we are headed,” namely, over the cliff, as he called on the Republicans who control the House of Representatives to get behind a Senate bill to extend existing tax cuts for all except those households earning more than $250,000 a year.

And to poison the atmosphere further, Reid added that “The House is being operated with a dictatorship by the Speaker, not allowing a vast majority of members to get what they want.” He also accused Speaker Boehner of delaying fiscal cliff action until after he seeks re-election to his current position on January 3 by adding that “John Boehner seems to care more about keeping his speakership than about keeping the nation on firm financial footing.”

This political dysfunction was primarily responsible for December Consumer Confidence declining to a four-month low as the budget crisis sapped what had been a growing sense of optimism about the economy evidenced in other reports released during this period. The October Case-Shiller Home Price Index rose to its highest level in more than two years; the four-week moving average of weekly jobless claims declined to its lowest level since March 2008; November new home sales rose by the most in more than two years and November pending home sales increased to their highest level in more than two years as well. These reports certainly showed that the housing market continues on the road to recovery, which was one of the reasons behind the stock market’s good performance in 2012.

The drama continued last Friday when both the president and vice president met with Congressional leaders to try to revive the negotiations as the odds of success were mixed, with suggestions that Congress might now try to stretch the deadline into the first two days of January and in order to try to get a deal done they convened a session for Sunday as well. The stakes were raised by a comment from a leading Republican senator that it “doesn’t feel like anything that’s very constructive is going to happen”as a result of the meeting because “it feels more like optics than anything that’s real,” according to him.

But Republicans in Congress also had to be wary about not wanting to compromise at all on taxes because polls showed that Americans blame them more than congressional Democrats for the fiscal crisis and coming on top of their setbacks in the recent elections, they do not want to further alienate themselves from voters. The polling showed that 27 percent blamed Republicans in Congress for the fiscal cliff, 16 percent blamed the president and six percent pointed to Democrats in Congress. The largest percentage, 31 percent, blamed “all of the above.”

As Sunday moved into Monday, it was reported that Senate Minority Leader McConnell and Vice President Biden carried on what were described as “good talks.” But Republicans in the House do not want to raise taxes without significant spending cuts and the Senate abandoned a proposal to trim cost-of-living adjustments to Social Security, which meant that there was no assurance that any deal could pass later this week in the House.

The recent negative stock market mood turned very positive on Monday, the last trading session of the year, as the potential for a resolution of the high-stakes game being played in Washington, D.C. allowed investors to finally breathe a sigh of relief that drove equities to their best one-day gain since mid-November. These gains were enough to push the major averages into positive territory for the month of December after two straight months of declines. The S&P ended 2012 with a 13 percent advance, which extended the bull market rally to 111 percent since the March 2009 bottom, as financial and consumer discretionary stocks lead the way with gains in excess of 20 percent.

The market assumed that some sort of deal was at hand after an early-afternoon statement from the president and a comment from Senator McConnell that an agreement was “very, very close.” The Senate did in fact approve the legislation on Tuesday morning with the House scheduled to vote later in the day on the agreement to raise taxes to 39.6 percent from 35 percent for individual incomes over $400,000 and couples over $450,000. There will also be a full year’s extension of unemployment insurance without strings attached and without offsetting spending cuts, an additional $30 billion. There will be a permanent tax rate increase to 20 percent from 15 percent on dividends and capital gains for people with the incomes just mentioned. Payroll taxes will rise starting this week to 6.2 percent from 4.2 percent on workers’ first $113,700 of income. Doctors were relieved as a 27 % reduction in payments to Medicare providers was cancelled.

Finally, the two sides worked out a deal for a two-month halt in $110 billion automatic spending cuts set to go into effect this year, and these will be paid for with unspecified spending cuts elsewhere. In a sense, what took place was that we went over the fiscal cliff with a parachute, so to speak.


Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.
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