S&P Reaches 5-Year High: Investors Ignore Potential Landmines

Whew! At least we do not have to hear the words “fiscal cliff” anymore in accounting for every twist and turn of the stock market going forward as President Obama and congressional Republicans face even bigger budget battles in the next two months after that hard-fought deal narrowly averted devastating tax hikes and spending cuts.

That agreement, reached late on January 1 with the Republican-led House of Representatives, was a victory for the president who had won re-election on the promise to deal with budget woes in part by raising taxes on the wealthiest Americans.

At the same time, it has set up the potential for bruising showdowns over the next two months over spending cuts and increases in the nation’s debt limit on borrowing. Republicans, angry that the fiscal cliff deal did little to bring down the federal deficit, have promised to use the debt-ceiling debate to win deep spending cuts this time, as they now believe that they will have greater leverage over the president when they must consider raising the borrowing limit, likely in February.

And the stakes could be even higher in this debt-issue debate than in the fiscal cliff because the failure to reach a deal could mean a default on U.S. debt or another downgrade to the U.S. credit rating such as what took place in August 2011, and which roiled the financial markets big-time. In fact, Moody’s Investors Service warned Washington earlier this month that it must do more to cut the deficit than it did in the fiscal cliff measure if the country is to turn around its negative sovereign debt rating.

The President urged that there be “a little less drama” when Congress and the White House next address budget issues like the government’s rapidly mounting $16 trillion debt load and vowed to avoid another divisive debt-ceiling fight ahead of the late-February deadline for raising the limit. He made his point clear when he said, “While I will negotiate over many things, I will not have another debate with this Congress about whether or not they should pay the bills they have already racked up.”

Republicans will be pushing for significant cuts in health-care programs like Medicare and Medicaid for retirees and the poor, which are the largest drivers of federal debt, while Democrats have opposed cuts to these popular programs, as spending cuts of $109 billion in military and domestic programs were delayed for only two months.

As the political drama in Washington, D.C., continues, the stock market has begun 2013 by continuing to move to the upside, as the S&P advanced by 3.2 percent during the first two weeks of the year. Investors in U.S.-based funds poured $7.53 billion into stock mutual funds, the most since 2001. When combined with money going into equity ETF’s, the amount was $18.32 billion, which, as one observer put it, meant that “stocks are finally expensive enough for retail investors to find them attractive!”

By this he meant that after withdrawing a net $380 billion as the market has rebounded more than 100 percent from its March 2009 lows while at the same time putting $1 trillion into low-yielding bond funds, individual investors now seem to have re-gained their appetite for equities. This is only the second time since the November 1973 to March 1975 recovery that investors sold stocks at the same time that the market was rising. And 2013’s inflows were the largest amount put into mutual funds since the third week of September 2007, about a month before the S&P made its all-time high. On the other hand, it was no surprise that money overall was pulled out of stock mutual funds as 65 percent of them have trailed their benchmark indexes.

The immediate concern facing investors is the start of the fourth-quarter earnings season, which gets underway in earnest this week with most of the large banks and other financial institutions reporting. As noted in last week’s column, expectations are currently for earnings growth of around two percent with revenues increasing by the same amount. And this is way down from as recently as last October, when fourth-quarter earnings were forecast to be higher by 10 percent, so perhaps the lowered expectations will be easier to surpass.

Unfortunately, the political intrigue is not going away, as the president on Monday rejected any negotiations with Republicans over the most pressing fiscal issue when he once again refused to exchange cuts in government spending for raising the debt ceiling by saying, “If the goal is to make sure that we are being responsible about our debt and our deficit, if that’s the conversation we’re having, I’m happy to have the conversation, but what I will not do is to have that negotiation with a gun at the head of the American people.” Republicans naturally responded with their demand that increasing the debt ceiling must be accompanied by spending cuts.

A trio of deadlines is approaching at the end of next month, and they are: the need to raise the debt ceiling, automatic deep spending cuts that were temporarily put off by the fiscal cliff deal, and the end of a temporary government funding measure.

A number of Republicans have said that they would be willing to allow a U.S. debt default or a government shutdown in order to force the president to accept deeper spending cuts than the White House would like, but the president has insisted that deficit reduction should include measures that would raise revenues and not come from spending cuts alone. Republicans have rejected that approach by claiming that the fiscal cliff deal should have put to rest any more tax increases.

The president countered these claims by raising the possibility of a severe setback to the U.S. economy if congressional Republicans continue with their threat of a debt default by saying. “It would be a self-inflicted wound on the economy.”

So far this year, investors are once again anticipating a satisfactory solution to these issues, similar to what took place with the fiscal cliff drama at the end of 2012, but with the low level of the VIX pointing to investor complacency as the S&P has reached a five-year high and with the potential for disappointments on the earnings front, investors should be prepared to take profits on any sort of potential setback to the optimistic view that market participants are currently exhibiting.