"Men wish to be saved from the mischiefs of their vices, but not from their vices" - Ralph Waldo Emerson
The market has staged significant rallies on both Monday and Tuesday on hopes for a resolution to the fiscal cliff. It appears that we will get some sort of resolution to this issue by either the end of the year or soon thereafter. There is a high likelihood that the market will rally into the conclusion of these budget talks. However, investors should be cautious about how equities will perform after the "fiscal cliff" is no longer on the radar.
Given the rally, there is a good possibility the resolution of this issue will be a "buy the rumor, sell the news" event.
The deal being discussed is far from anything that will address deficit concerns over the medium or long term. Every credible deficit cutting plan including Bowles-Simpson had at least $400B annually in spending cuts and tax increases. The current plan being discussed looks like it will amount to $200B to $250B a year over the next decade. $100B to $125B in tax increases that take effect immediately and $100B to $120B in spending and entitlement cuts; most of which will take effect sometime in the "future". It is hard to see bond investors taking this effort seriously as we continue run up trillion dollar deficits. Being short Treasuries via an ETF like (TBT) has not been the right play over the last year or two, but given how low the yield is on 10 year treasuries ending 2012, they might be a stellar performer in 2013. They have had a nice run over the last week as this fiscal cliff plan gets hammered out, and the Federal Reserve can only continue to buy most of Treasury's new debt for so long.
Even if this deficit plan does little to address our long term deficit issues, the immediate tax increases should have some impact on economic activity and small business hiring. This will serve as a headwind to 2013 economic and market performance on the margin.
It doesn't appear that any new stimulus will be included in the "fiscal cliff" package. Although probably a good thing given the record on "stimulus" packages, the economy will get no short term jolt in new spending. In addition, the resolution of the fiscal cliff may not do anything about the debt ceiling. This will be another bruising fight that could rattle the market as it will be right around the corner.
Some of the damage of the fiscal cliff might have already occurred. Companies make plans for the next year in the last quarter of the current year. Given the uncertainty of the last few months, this likely delayed or cancelled a lot of plans to expand or hire. A lot of companies used their extra cash or even borrowed to pay "special dividends" to their shareholders so they could avoid the higher dividend taxes in 2013. Although this will provide a short term lift to personal income, it also moved forward income from 2013. In addition, that cash will not be going to increase companies' economic activity in 2013.
Bernanke's latest policy to tie Federal Reserve easing to the unemployment rate is going to have some unintended consequences. One of these that I can foresee is that the 6.5% unemployment target will be hit much sooner than the market anticipates. Most observers have the United States getting down to the 6.5% unemployment level sometime in 2015. However, if we continue to have 350,000 people drop out of the workforce per month as we did on the last monthly job report, we could hit that level much sooner than expected. This will put the Fed in a quandary and could rattle the market as well.
There is good reason to believe this has a high probability of occurring as a declining worker participation rate has been one of the consistent trends of the last few years. Some of it this is due to more people retiring as our population ages. However, a substantial portion of this declining participation rate is due to government policy. We have increased government subsidies substantially (Welfare, foodstamps, unemployment benefits, easier to get on disability … etc. ...) over the past few years while making it less advantageous to hire (more regulation, Obamacare, uncertainty, and now higher taxes). This has resulted in much higher structural unemployment. This is one of the key reasons a lot of industries (manufacturing, construction) are having a hard time filling entry level job openings right now. This will be a further drag on economic activity.
Finally, the costs of Obamacare will start to become apparent in 2013 and will erase a good portion of the measures of any fiscal cliff deal. Already even democratic senators are making noises about delaying or cancelling the medical device tax as they start to realize what a job killing measure this is. While this could be a major positive for medical device makers like Medtronic (MDT), it takes over $25B annually from addressing the additional costs of Obamacare and will worsen the deficit. For more likely and job killing consequences of this health care legislation, click here.
Bottom line: Enjoy and ride the rally while it lasts, but do not expect a smooth ride in early 2013. Prudent investors should take advantage of the low volatility of the market and buy some puts to protect their portfolios. For my longer term view of the market, click here.