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This relief rally could punish latecomers Add to ...

The resolution to the so-called “fiscal cliff” has sent stocks surging on Wednesday, but now investors are left with a thorny issue of their own: Do you buy into the rally or sell into it?

The agreement in Washington on New Year’s Day is a big source of relief: In agreeing to a budget, the U.S. Congress has averted punishing automatic tax increases and spending cuts that would have pushed the economy back into recession, extended a period of uncertainty for companies and walloped investor confidence.

That uncertainty had been weighing on stocks toward the end of 2012, when the S&P 500 slid more than 7 per cent between mid-October and mid-November in one of the most severe selloffs of the year. If one of the biggest obstacles to a renewed bull market has now been removed, the hope is that major indexes can make some impressive gains in 2013.

However, the sober reality is that markets could continue to grind along.

For one thing, averting the “fiscal cliff” is more of a short-term victory over uncertainty than a long-term triumph over gridlock. The agreement has dealt with expiring tax cuts, but has merely delayed any solution to spending cuts and extending the debt ceiling for a few months, meaning that more political battles are coming.

Indeed, reports suggest that the Republican capitulation on tax increases for the wealthy has merely made them more determined than ever to demand deep spending cuts in exchange for an increase in the debt ceiling. President Barack Obama has said that he won’t negotiate over the debt ceiling, but some observers aren’t so sure about that commitment, given his flexibility on other issues.

“Maybe this time will be different. Maybe the Treasury is secretly preparing to invoke the 14th amendment, or issue a trillion-dollar platinum coin, or direct that the whole budget gap be taken out of spending dear to Republicans,” said Paul Krugman , in his New York Times blog. “But I have to say that I now expect Obama to cave on the ceiling; and so, of course, do the Republicans, which means that the crisis is going to happen.”

That could be a recipe for declining investor confidence and could even bring the debt rating agencies back into action, as they issue concerns about U.S. credit worthiness.

Meanwhile, cliff or no cliff, observers are still worried about the potential drag on the U.S. economy. According to Brad DeLong, an economics professor at the University of California at Berkeley, the deal struck on New Year’s Day will avert a 3.5 per cent fiscal contraction on the U.S. economy in 2013, but will still present a 1.75 per cent drag on the economy.

“That is only 40 per cent of the way back from the ‘austerity bomb’ to where we want to be,” Mr. DeLong said.

On Wednesday, the stock market rally reflected all-out euphoria, lifting 92 per cent of the stocks within the S&P 500 and all 30 Dow Jones industrial average components. It also drove most European indexes up by 2 per cent or more.

However, the underlying economic and stock market fundamentals don’t look much different today than they were in the dying days of 2012. Relief rallies are great, but they can be painful if you jump in too late.


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