Cliff Delayed

Last week we argued:

As a result of this {market sell-off] and public pressure in the first few weeks of January, it is very likely that some sort of compromise can-kicking deal will be reached reversing some, but most likely not all, of the revenue increases and expense reductions.

As it turned out, a mini “compromise can-kicking deal” was reached on December 31, not mid January.    And the deal was not even a true deal, in the sense that it addressed most of the outstanding issues that made up the fiscal cliff. The deal primarily addressed income taxes. While raising income taxes on top earners, it also raised the payroll tax on 77% of all wage earners. The net result is a REDUCTION in fiscal stimulus, which economists estimate will hit GDP by 1.0-1.5% in 2013. What was not addressed, but merely kicked down the road by only 60 days: spending cuts and the debt limit. And these two remaining “issues” will now create a larger “cliff” that will once again hit the markets and the economy in a few short weeks.

In the meantime, risk markets rallied—not so much due to enthusiastic buying, but mainly due to short covering and other hedge removals. In other words, by not going over the fiscal cliff (fully, but only partly due to the smaller tax increases) on January, traders and investors removed a lot of the insurance protection they had taken out in December to protect against losses if the fiscal cliff was not partly averted and delayed.

So the S&P500 jumped a whopping 4.57% and in an instant has become very overbought. Volume was not strong, supporting the argument that enthusiastic buyers were not rushing in to buy shares. Volatility slumped, or rather was crushed, in no small part due to the actions of the Fed which knows that by selling volatility (to drive its price down), traders and computers will then drive share prices higher.

The real economy however continues to struggle. ISM manufacturing just beat expectations but registered at barely over the 50.0 level dividing growth from contraction. Consumer sentiment badly disappointed. Jobless claims also missed estimates, by coming in higher than expected. The payrolls report was a dud, just meeting modest expectations, expectations that are typically associated with an economy that’s stalling, not growing robustly. One of the most disturbing, yet under reported, parts of the payrolls report was the employment-to-population ratio which FELL from last month. This is one of the few hard to manipulate BLS figures and the fact that this number fell again—almost four years after the supposed economic recovery began—suggests that the economy is struggling to create decent full-time jobs for the nation. Instead, prospective workers are continuing to drop out of the work force in droves. Not good.

So now let’s brace ourselves for another ‘fiscal’ showdown in six weeks or so. Meanwhile, fourth quarter 2012 earnings will begin to be announced this week; this should help to answer the question about how well corporations are doing, and to the extent that fundamentals still matter (not much lately since the Fed has taken temporary control of the stock market), the earnings reports could drive stock markets somewhat higher….or lower.

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