Even after the automatic budget cuts known as "sequestration" went into effect last Friday, while Congress stood impotently on the sidelines as another deadline came and went, Tuesday's trading session saw the Dow Jones Industrial Average (^DJI 1.05%) surge to a new all-time high. If you're scratching your head in disbelief, you should be -- and you should also be wondering why more people aren't joining you. Unlike the fiscal cliff that passed before the turn of the calendar, the sequester seems to have been easily dismissed by both Main Street and Wall Street.
Stephen King, who serves as the chief global economist at HSBC, commented that the growth projections being used by the U.S. when considering the economic future of the country land us in a "fantasy world." If his projections are accurate, within an alarmingly short period we will all witness horrors on the level of those depicted by the novelist of the same name. At some level, it's easy to dismiss the current goings-on in Washington as the cheap dinner theater it is -- until you remember that politicians are playing with live ammunition (literally, in the case of the $500 billion set to be cut from the Department of Defense budget over the next decade).
Congressional Budget Office projections
The data coming out of the CBO seems to paint conflicting pictures depending on who you ask. King told CNBC: "If you look at the projections from the Congressional Budget Office (CBO) they assume that growth goes back to between 4 to 5 percent in real terms between 2014 and 2018. Their numbers suggest that the U.S. will post the fastest rate of productivity growth of any decade in the last 50 or 60 years." This comment suggests that the future predicted by the CBO is not only rosy, but inaccurate.
According to another CBO statistic, if the sequestration cuts are allowed to stand, it will likely cost 1.4 million Americans their jobs. That's far less rosy. If you take these two pieces of information in concert, it suggests that the number of jobs that could be lost is much higher. Even at the more conservative estimate, this is not a promising view of the future, particularly when you add in the fact that the Federal Reserve continues to reiterate its intention of keeping rates artificially low so long as unemployment remains above 6.5% and inflation stays in check. At the rate the Fed is pumping money into the economy, by the time inflation shows up in its statistics, it will be very difficult to stop, particularly if unemployment is spiking, rather than subsiding.
Charging bulls
Tuesday's session not only saw the Dow hit a new all-time high, but saw several Dow components touch 52-week highs. The day after Apple (AAPL 3.40%) hit a new 52-week low, Johnson & Johnson (JNJ +2.22%) and Disney (DIS +0.52%) touched new highs. I mention each of these names as evidence of both the widespread strength of the market and the unlikely nature of the rally. Apple has faced significant concerns over its lack of a new blockbuster product in the last few years. Rumors of the iWatch continue to circulate, but no release date has been given to the public. Meanwhile, Disney hit this new peak even as it prepares to face a serious challenge to ESPN from Fox. The strength of the stock speaks to the company's diversification.
Stocks in the health care sector, which was the strongest sector in 2012, are staying strong in 2013. As Fool Brian Orelli explained, J&J has faced negative news from the FDA recently, but the stock has remained strong all the same. While Xarelto, the subject of the letter, is but one of many drugs in the company's product line, negative FDA news is usually very bad for a stock. The strength shown by J&J despite this setback is a testament to the market's momentum.
What happens next?
With these two seemingly divergent pieces of news coming in such close proximity, you must wonder what happens now. Are stocks poised to run even further, or will the sequestration cuts put an end to the market's exuberance? And how could these two events happen at the same time?
As to the timing, the ability of traders and investors to overlook Friday's deadline owes partly to the fact that the cuts do not all take immediate effect; Congress still has a little time to work it out. King points out that it may take a few years to see that the realized growth rates fall absurdly below the projected ones. Additionally, early indications suggest that despite the missed deadline, the U.S. will not receive a credit downgrade, but rather will stay on the negative-outlook list.
At the extreme, some commentators suggest that the cuts will actually be good for the economy, as they will force reduced government spending. Returning to the CBO, this year's $85 billion in cuts equates to a reduction of only $44 billion in real spending. The remainder is a reduction in spending authority; basically, Congress' credit card now has a lower limit. When these reduced figures are used, things look a little less bleak.
The sequester will not immediately stop the Dow, primarily because it's not the force the market is focused on as a catalyst. The more time that passes, however, the more impact those cuts begin to have, and the more likely it is that the market will react. The Fed cannot prop up stocks forever. Running to the sidelines as others pour into equities in hopes of not being left behind may be premature, but caution is warranted. When the so-called "dumb" money is joining the party late, it is often a sign the music is about to stop.
