Stock Market Achieves Historical Gains Upon Fiscal Cliff Resolution

The market made historic gains last week as economic calamity was averted on January 1 when lawmakers approved a deal to prevent huge tax hikes and spending cuts that would have pushed the U.S. economy off the fiscal cliff and into a recession. The agreement was a clear victory for the president as his Republican antagonists were forced to vote against a core belief of their anti-tax conservative beliefs, as the crisis ended when dozens of House Republicans gave in and supported the tax hikes that were already approved by the Democratic-controlled Senate.

The vote avoided immediate pain like tax hikes for almost all U.S. households but did nothing to resolve other political showdowns on the horizon such as spending cuts of $109 billion in military and domestic programs and the $16.4 trillion dollar debt ceiling that must be raised in the next two months as well.

On January 1, House Republicans were forced to decide whether to accept a $620 billion tax hike on the wealthiest or take the blame for letting the country slip into budget chaos, as they mounted an effort to add hundreds of billions of dollars in spending cuts to the package and initiate a showdown with the Senate. But cooler heads eventually prevailed and with the specter of the country going over the fiscal cliff, they decided that they did not have the votes in favor of those spending cuts. As a result, they reluctantly approved the Senate bill with a bi-partisan vote of 257 to 167.

Even though this bill eliminated the possibility of a recession, a series of tax hikes will nonetheless be a drag on economic growth this year as it will raise taxes on most Americans through an increase in the payroll tax from 4.2 percent to 6.2 percent on the first $113,700 of income; this will be used to fund Social Security pensions. The payroll tax hike alone could push the average household tax bill up by around $700 this year. This could likely reduce consumer spending and subtract around three-quarters of a percentage point from economic growth, according to the estimates of some analysts.

The bill will also raise income tax rates for individuals making over $400,000 a year or households over $450,000, although rates will remain at 2012 levels for everyone else. In addition, rates on dividends and capital gains will increase from 15 percent to 20 percent for those in the brackets just mentioned.

Ongoing talks in Congress will eventually lead to spending cuts put off until next year presumably once lawmakers reach a deal to reduce spending over the longer term while at the same time granting the government the authority to increase the debt ceiling. On the other hand, a deal might not be reached, which could then cut deeply into economic growth in the second half of the year.

The minutes of last month’s F.O.M.C. meeting were released last week and they showed that Fed officials are increasingly concerned about the potential risks of the central bank’s asset purchase program on financial markets while at the same time they look set to continue their open-ended stimulus program for now. The minutes showed a growing reluctance to increase their now $2.9 trillion balance sheet, which expanded sharply in response to the financial crisis and recession of 2007–2009. They said that “Several officials thought that it would probably be appropriate to slow or stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.” This statement revealed a somewhat surprising level of concern regarding the long-term impact of the bank’s asset purchase program, known as quantitative easing.

Fed officials generally agreed that the labor market outlook was not likely to improve without further stimulus from the monetary authorities as even though the U.S. economy expanded at a respectable 3.1 percent in the third quarter, growth is thought to have slowed sharply to just about 1 percent in the last three months of the year. The markets calmed down after officials said that they would keep interest rates near zero until the unemployment rate falls to 6.5 percent from its current 7.8 percent level and as long as estimates for inflation do not exceed 2.5 percent.

Now that the fiscal cliff worries have been put aside, investors will have to deal with fourth-quarter earnings reports that start this week, and these are expected to be only slightly better than the third quarter’s lackluster results. As an example of these concerns, the negative to positive guidance by S&P companies for the fourth quarter has been 3.6 to 1, which is the second-worst such reading since the third quarter of 2001.

S&P revenue fell by 0.8 percent in the third quarter for the first decline since the third quarter of 2009 and earnings growth was a paltry 0.1 percent. Only 42 percent of S&P companies beat revenue expectations while 64.2 percent beat on the bottom line. For the fourth quarter, estimates are slightly better but are well off what they were in October, when earnings growth for the fourth-quarter was forecast to be up 10 percent. Now they are expected to have risen by 2.8 percent while revenue is projected to have increased by 1.9 percent.

Despite these earnings anxieties, the resolution of the fiscal cliff issues allowed the stock market to put in a historic performance last week with the following accomplishments: the S&P reached its highest level since December 2007, it was the best weekly market advance since December 2011, the market put in its best last day of the year performance since 1974, the Dow achieved its best first day of the year performance ever, all of the small and mid-cap indexes reached all-time highs, the Dow Jones Transport Average came very close to its all-time high, and 2012 was the first year since 1979 that the market always remained above its closing level of the prior year, which means that the major averages were never negative at any point during the year.

The VIX, which measures short-term volatility expectations and is therefore an indicator of investor anxieties, made its largest weekly decline ever, an astounding drop of 40 percent. Finally, 2012 was the first year that the VIX remained below 30 for the entire year since 2006, and this is the level that marks the dividing line between investor calm and nervousness. These accomplishments in light of the many potential market headwinds both here and abroad were quite significant.


 

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.
If you have any questions, contact dselkin@nationalsecurities.com .