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Plan B Fails; Obama Still Optimistic

Market Digest – Week Ending 12/21

Early optimism for a fiscal cliff solution faded when House Speaker Boehner’s “Plan B” failed to win support in his own party. Stocks dropped on the news but remained positive for the week. Boehner said he would continue to work with the President to avert the cliff before the January 1 deadline. Plan B would have maintained current income tax rates for individuals earning less than one million dollars. Somewhat lost in the noise, revised Q3 GDP was announced at 3.1%, ahead of most expectations. Treasuries and gold fell.

Weekly Returns:

S&P 500: 1,430 (+1.1%)

MSCI EAFE: (+0.8%)

US 10 Year Treasury Yield: 1.76% (+0.06%)

Gold: $1,656 (-2.3%)

USD/EUR: $1.318 (+0.2%)

Major Events:

  • Monday – Reports circulated that Obama was considering an adjustment to the Social Security cost of living adjustment formula as part of fiscal cliff negotiations.
  • Wednesday – The White House said it would likely veto the current “Plan B” which would extend tax cuts on income less than one million dollars.
  • Wednesday – US building permits for November rose to a four year high, suggesting the housing recovery will extend into 2013.
  • Wednesday – UBS admitted rigging LIBOR rates and agreed to a $1.5 billion settlement.
  • Wednesday – US Q3 GDP was revised up to 3.1%, ahead of most expectations.
  • Thursday – Sales of existing US homes in November rose to a three year high.
  • Friday – Speaker of the House Boehner said he was “prepared to come back if needed”, after he was rebuked by his own party on an alternative fiscal cliff solution.

Our Take:

Unfortunately, it appears our earlier prediction is coming true—a fiscal cliff compromise in 2012 looks increasingly unlikely. Boehner’s inability to get his party’s support to raise taxes only on income above a million dollars suggests compromise will be difficult. Still, we expect resolution in the early part of next year. Pressure continues to build as voters become increasingly upset. Once we enter 2013, any legislation will technically be a tax cut and will be easier to pass. Expect more political volatility in the coming weeks, but a solution should eventually be reached.

As the markets approach the 2012 finish line, it is worth noting that international stocks caught up to US stocks after lagging during the height of the European debt crisis. Both are up about 15% for the year. Within the US, small cap stocks are on pace to finish with a very similar gain. Foreign bonds did well, and foreign REITs were up more than 30%. 2012 was a year when almost every asset class provided satisfying absolute gains. But correlations between asset classes were high and diversification benefits were muted. Like markets, correlations rise and fall. After a year like this, it is important not to forget the incredible benefits proper diversification provides over full market cycles.

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