Markets calm amid cliff talks

Expectations of an imminent deal reflected in stocks

Dec 31, 2012 @ 11:54 am

By Jeff Benjamin

As the clock ticks down on the final day of 2012, the financial markets show a glimmer of hope that Washington will get its act together and reach some kind of agreement ahead of the year-end fiscal cliff.

The thinly-traded New Year's Eve market remained relatively calm, which was in line with the mixed pre-market futures trading activity.

The 10-year Treasury bond was up slightly, which is another indicator that the markets are expecting Congress and President Barack Obama to strike some kind of last-minute deal to head off or at least delay the sweeping tax hikes and spending cuts scheduled to kick in tomorrow.

“Traders seem to be betting on some sort of announcement,” said Quincy Krosby, a market strategist at Prudential Financial Inc.

The S&P 500 Index, at 11:30 a.m. ET was up about three points to 1405, for a 2012 gain of 11.8%. The Dow Jones Industrial Average at the same time was essentially flat, for a 2012 gain of 5.9%

“I think the market is still holding out hope that some kind of deal will be struck,” Ms. Krosby said. “It is a very thin market today, so you don't want to make too much of it, but over the past few days we still saw cyclical names leading, which is indicative of a market that believes in the growth story and wants to move higher.”

If the markets are any indication, there is some confidence that Washington will reach an agreement today, according to Joseph Witthohn, vice president of product development and ETF strategies at Emerald Asset Management.

“Right now the markets could fly in either direction, depending on what happens, but it seems like the markets would be a lot worse today if this thing was going to fall apart,” he said. “I'm trusting that the politicians are getting their act together and realizing the seriousness of this, and also realizing the frustration of the American people.”

Mr. Witthohn is not expecting a full-blown fix or sweeping agreement to deal with all the tax and spending issues involved in the fiscal cliff debate, but he does expect that at least a temporary fix will be installed.

“I'm optimistic that they won't just walk away from it,” he said. “And I would think they would handle the tax issues first with some kind of extension, and then I think they will promise to work on the entitlement issues later.”

Jim Russell, chief equity strategist, U.S. Bank Wealth Management Group, agreed.

A last-minute deal would help save the momentum in the economy and the financial markets, even though there is still much work to be done on spending, he added.

“Spending cuts, entitlement reform, possible tax reform, and lifting the debt ceiling are all substantial elements of things that will need to be dealt with,” he said. “Right now we're in the second inning, but the economic fundamentals in the U.S. are headed in the right direction and it would have been a tragedy to derail that momentum.”

Tim Clift, chief investment strategist at Envestnet Inc., also believes Washington is poised to kick the spending and entitlement issues down the road, but address some of the tax-related issues right away.

“It looks like they're dealing with a number of different tax compromises right now, and I think the likelihood of a deal today is a little better than 50/50,” he said.

As Mr. Clift sees it, both sides are likely to settle on tax hikes for households with incomes greater than $500,000.

The alternative minimum tax is also expected to get its annual fix, because there is support from both political parties to not let the AMT hit the middle class.

The debate over tax rates for dividends and capital gains will probably result in a compromise that has rates climbing to 20% from 15%, Mr. Clift said.

If no action is taken on dividends and capital gains taxes, the rates will automatically shift to ordinary income tax levels.

“One of the things that won't happen is an extension of the payroll tax cut, because that is money that funds social security, so everyone should expect to pay more taxes in January,” he said. “And I don't think today any of the spending issues get dealt with.”

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