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The global markets wait in breathless anticipation for a solution to the fiscal cliff and a failure to resolve the issue is expected to push the U.S. economy into a recession. But will a solution clear the way for a multi-year bull run?

For those who don't know, the fiscal cliff is the confluence of the expiration of the Bush Era tax cuts and sequestration. The tax cut expiration increases income taxes for everyone, but also pushes up the dividend and capital gains taxes substantially. Sequestration will result in massive federal spending cuts. All these factors are expected to push the economy into a recession as they go into effect next year.

From the talk coming out of Washington it does not seem that a solution to the fiscal cliff will solve the long-term issues. Look at what is being offered by both sides.

The White House wants a tax rate increase on the upper middle class and the rich ($250,000 per annum and above) to raise $1.6 trillion, increase infrastructure spending and gives only a promise to cut spending.

The Republicans on the other hand too want to raise taxes by $800 billion even though they call it tax reform by reducing deductions and plugging tax loopholes. There is also some entitlement reform in their proposals.

If you clear away all the partisan posturing it is evident that both sides want to raise taxes. So taxes are going up no matter what. For some it may not go up if the White House plan passes.

A little digging shows that both sides also want to increase spending. The White House is very clear on increasing spending and asks for more money from the tax payer. The Republicans are more devious. While talking about cutting spending they stay mum about increases the size of the budget each year.

While talking about cutting spending both sides stay mum about baseline budgeting, which automatically increases the size of each new budget. Baseline budgeting uses current spending levels as the "baseline" for establishing future funding requirements and assumes future budgets will equal the current budget times the inflation rate times the population growth rate. This ensures automatic increase in the size of the budget. Put in a different way, if private sector employees got the benefit of baseline budgeting, they would get a pay raise every time they had a baby.

On average baselining results in an increase of 6% in the size of the budget each year. So if in any year the politicians are able to reduce the increase to 5%, they call it a cut. The size of the budget and the deficit continues to increase in absolute terms, but for politicians it is still a cut.

Hence it's very clear that taxes are going to go up and especially negative for the market is the huge increase in taxes on capital gains and dividends. One may say that if the fiscal cliff is averted and taxes go up as planned by the White House only people making over $250,000 will be affected and they are just about 2% of the population. But remember that they constitute a large part of the investing community and once they begin selling the markets will crash. Since the rest of the 98% is not getting a tax break or any extra cash from any deal, they will not be stepping in as buyers to stop a bleeding market.

The plan of Republicans does not increase taxes on dividend and capital gains, so that's not a negative for the market. But as there is no cut in taxes, the markets are not expected to get a long-term boost. Sure if the Republicans' plan passes the market would get a temporary boost just because the fiscal cliff is averted. The same could be true if the White House plan passes. But as sigh of relief subsides reality will kick in.

They reality includes the following:

  • Continued increase in spending
  • Trillion dollar deficits for years to come
  • New healthcare law taxes
  • Eventual increase in taxes on everyone to pay for it all

These are tremendous long-term headwinds for the stock market that keep equities bearish. They spring from the core problem that the government is spending too much and eventually will find a way to raise taxes. Unless the spending problem is solved, the long-term economic decay will continue.

However, if we see a double down on the deficit spending of the past few years and a larger monetary expansion by the Federal Reserve, the markets can catch a bounce. But remember it will not be a sustained bounce. Look at what happened to Japan over the past 20 years. The Nikkei is around 9500 now, down from 40,000.

So as you look at the sometimes comic and sometimes tragic drama of the fiscal cliff and hope that the ending is happy, remember that the scenario outside the theatre is still gloomy.

Source: A Fiscal Cliff Solution Is No Real Solution; Bearish Headwinds Will Continue

Additional disclosure: I am long and short several stocks, but this article does not include any particular stock.