The Dow's "Deal Rally" Is Suspect


The stock market's strong performance on Dec. 31 signaled some sort of agreement on the fiscal cliff -- which we got. But if a deal was factored into Friday's closing prices, far from selling on the news, investors are showing yet more enthusiasm to start the year: The Dow Jones Industrial Average and the broader S&P 500 have gained 2% and 2.1%, respectively, as of 10 a.m. EST. However, the specifics of the deal mean there is cause to be skeptical of the market optimism.

What's the deal for investors?
The deal, which was hammered out by the Senate, will prevent income tax rate increases on all but those earning more than $400,000 (or $450,000 per married couple) annually -- and does absolutely nothing to address government spending. While it offsets the near-term drag on the economy of higher tax rates, lawmakers have once more delayed taking any difficult decisions to address the spending component.

Investors should keep a couple of points in mind.

First, don't be mistaken: The U.S. economy has begun to head down the fiscal slope. Economist and blogger Brad deLong estimates that the current deal still leaves a fiscal drag on the economy equivalent to 1.75 percentage points of GDP growth in 2013 -- a harsh toll on an economy experiencing a slow-growth recovery.

Second, if you were tiring of the market's focus on the fiscal cliff during the last couple of months, prepare yourself for more of the same over the next couple of months. Essentially, all of the hard work remains to be done as the U.S. runs up against its borrowing ceiling. (Technically, the debt ceiling has already been met, but the Treasury has a few tricks up its sleeve to keep things running until February or so.) Many were hoping the markets' risk-on/risk-off dynamic would disappear along with 2012 and allow investors to focus on fundamentals. But they will surely be disappointed; today's rally is prime evidence of that.

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Originally published