I have recently returned from post-election meetings in Washington, D.C. where universal attention is now focused on the “fiscal cliff”, the automatic tax increases expected to kick in at the beginning of the year due to the expiration of Bush tax cuts and other provisions.  Lawmakers are once again preoccupied with breaking the impasse that has hamstrung policy advancement since the days of the debt ceiling crisis (May through August 2011), rejection of Obama’s bipartisan deficit committee proposal (also know as Simpson Bowles) and subsequent alternative proposals.   Time to resolve a large hit to the economy is of the essence, with less than fifty days until the deadline, and the consequences are sobering.

Last week, The Congressional Budget Office published a report that reiterates the difficult scenarios of either maintaining scheduled tax raises or extending Bush tax cuts:

1)                   If all provisions are allowed to expire, the debt to gdp ratio will come down over ten years but the economy will face a probable recession in 2013 or,

2)                   Extending tax cuts would maintain positive economic growth but increase long-term debt to unsustainable levels.

While it is debatable how much can be achieved by a “lame duck” Congress in 21 days of sessions until the end of the year, here are some of the things that lawmakers and pundits are saying inside the beltway:

• Both parties are claiming a “mandate.”  The Republicans base their assertion on the very close popular tally for the Presidential race.  The Democrats, of course, point to Obama’s electoral victory (and 49.4% of the popular vote versus Romney’s 49.1%.)  It looks to me as though Americans hedged their bets:  voting  progressively on social policies for Obama, but conservatively on spending policies since the Republican Congress controls spending.  The American electorate wants many things – universal healthcare, maintenance of Social Security and Medicare, and does not want to pay for it!

• Some lawmakers claim that going over the fiscal cliff could easily be reversed and that while uncertainty would prevail in the meantime, policy and tax reform cannot be hurried.  This argument could also be used to support a temporary solution and would be analogous to the last three years of continuing resolutions to enact annual budgets.  And while both sides may be using rhetoric, this writer asks, have any of these folks seen the stock market reaction to status quo politics when the stock market sold off almost 3% after the election?  Could lawmakers really be so deaf to financial markets, corporate CEOs, foreign leaders, credit agencies and the IMF?  

• Present lawmakers are likely to take an approach that buys time (until the more cantankerous newly elected Congress arrives in Washington) and avoids the automatic cuts in defense and discretionary spending.  The prevailing assumption is that the real deal will take some time. 

• Some numbers:  The US Treasury collects almost $1.3 trillion in revenues from individuals, while $1.1 trillion is lost to loopholes and deductions.  “Lowering rates and broadening the base” is probably intuitively attractive to any taxpayer because the verbiage seems to promise that those who are already paying will pay less at lower rates.  I expect, however, that all of us will be paying more in the long run despite any attempt by either party to protect a particular constituency.  Potential targets include homebuilders (save the mortgage interest deduction) or charitable organizations (save the deduction for charitable donations).  On the spending side,  entitlements could be tweaked with Social Security cost of living increases adoption of “chained CPI”.[1]

It remains to be seen if things are going to get better, or get worse before they get better, or just get worse.  As of Friday, both Boehner (who does not want to go down in history as a political hack) and Obama (also considering his legacy) have made conciliatory remarks, a dim positive if not yet substantiated by any agreement.  In any event, the Huffman Broadsheet promises to keep you up-to-date on how policy impacts financial markets and the economy and who blinks first.

While the S&P 500, Nasdaq (CCMP or orange line), and Dow Jones (INDU or yellow line) are up nicely for the year, the market accelerated its retreat last week after peaking in September.  Source: 

Last week I highlighted the positive implications of a stronger real estate market.  Confirming this view are reports this week showing that residential construction rose smartly in September, by 2.8% and average home prices by 2% compared to last year[1].  Residential real estate improvement implies the positive spillover effects of increased durable consumption (think washing machines, refrigerators etc.,).  It is time for a positive feedback loop – that is consumers spend more, demand increases , businesses hire and the economy grows!  Consumers are feeling better off and more confident now that their net worth has increased.  Could this positive sentiment translate to a stronger economy and stock market?

Here are the economic positives:

• Today the Labor department reported that payrolls increased better than forecast with 171,000 jobs added in October.
• On Nov. 1,  ADP reported that 150,000 jobs, also better than expected, were created in the private sector.[2]
• Also on Nov. 1, unemployment claims were lower than predicted at 363,000
• Consumer sentiment is the highest since September 2007 when the recession started. (See chart below)
• Oil prices are receding putting more discretionary spending in consumers’ pockets.
• Consumer debt has decreased after several years of paying down debt.[3]  So consumers are starting to spend and as a consequence, retail sales are up more than 5% versus a year ago.[4]
• Household net worth is up more than 17% compared to a low in 2008.
• Economy is growing at a moderate 2% pace.

Could these positives affect future stock market performance?

Assuming a snap back to historical averages, the market is poised to go higher once investors return to owning stock ownership at their usual 60% allocation (instead of the current 50% levels).  Currently both individual and institutional investors shun stocks and prefer bonds.  According to ICI, the Investment Company Institute, investors have withdrawn money out of equity funds four years in a row with $100 billion pulled out in 2011, for example.  This year through September, investors have sold $83 billion of equity funds and channeled roughly 3x that amount into bond funds over the same period.[5]  It appears that investors are preparing for the last Global Financial Crisis instead of a future bull equity market!

Additional supportive factors for stock ownership are low inflation (with the Federal Reserve promising to keep interest rates low for the foreseeable future), decent profits reported this earnings season (despite some challenged revenues for multinational companies), and increased productivity at American companies.  All of these factors argue for a higher stock market once some of the uncertainties are cleared away such as the election and fiscal cliff.

Caveat:  Hurricane Sandy’s destruction is a big negative whose effects and costs are still being measured.  In fact, your author is writing these words at her New York gym due to Sandy’s effects!  Long term, nevertheless, it looks like consumers are getting ready to spend, demonstrating their dominant portion (about 70%) of the gross domestic product.

Chart Source: St. Louis Federal Reserve