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Forget Earnings. Washington Dysfunction May Be Behind Dow's Rise

Danielle Kurtzleben

Gridlock has ruled in Washington for much of the past few years, and stock markets have posted big gains. Coincidence? Neither the threat of a fiscal cliff nor sequestration cuts has halted the seemingly inexorable rise of the Dow Jones Industrial Average, the S&P 500, and the Nasdaq.

The Dow Jones has climbed over 2,800 points over the last year alone, breaking its previous record high, set pre-recession. And while a strengthening economy and a money-printing Fed have indubitably boosted stocks, it may be that Washington's inability to ever reach consensus on virtually any topic could be as much a tonic as favorable price/earnings ratios.

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The situation can perhaps best be phrased with a bit of Rumsfeldian lingo: while markets might prefer certain certainty, what they're getting right now is certain uncertainty. And for the short-to-medium term, that status quo -- slow economic improvements with no policy shifts on the horizon -- is perfectly comfortable for investors.

"From the market's perspective always, uncertainty is the enemy. So once you can get rid of uncertainty markets tend to at least then know what they're dealing with," says Michael McKiven, managing director and portfolio manager at Cumberland Advisors. "A cynical view of government says if they're gridlocked and not doing anything, maybe that's what they do best, which is nothing."

Scandals aside, long-term deficit- and debt-reduction is now arguably the key focus in Washington. Both parties agree that the nation's current debt trajectory is unsustainable, but that's about as far as the agreement goes. And even that Sword of Damocles has lost some of its edge of late, as higher tax revenues and a strengthening housing market have boosted government coffers. The CBO recently estimated 2013's deficit to be the smallest since 2008 (though future deficits and debt will continue to rise as entitlement and interest costs stack up).

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"Congressional Democrats are unlikely to agree to entitlement reforms and Republicans are unlikely to agree to revenue increases, especially after taxes rose as part of the fiscal cliff deal," wrote analysts from Keefe, Bruyette, and Woods in an investor memo this week, explaining why a so-called "grand bargain" on budget issues is not likely.

Like politicians, investors agree that fixing the nation's long-term fiscal situation should be a top priority: "We would be the first to say we want constructive dialogue from our politicians," says McKiven. Still, the thing about long-term problems is that their consequences also exist in the future. If lawmakers continue to dawdle on reducing entitlement spending, the key driver of future debt growth, it likely won't directly affect stocks in the short term. Meanwhile, housing and a steady (albeit slow) job recovery continue to buoy the economy, regardless of Washington's legislative impotence.

One coming speed bump that could rattle markets is the fight over the debt ceiling. When it last was an issue, in summer 2011, the stock market plunged over 1,800 points in less than a month as it watched lawmakers inch toward default, prompting S&P to strip the nation of its triple-A credit rating (and even after that, the stock market soon bounced back). The nation is now due to hit the debt ceiling again in September, meaning the potential for yet more market turmoil.

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Then again, there's also the real potential for minimal market impact. The economy is much stronger than it was during the 2011 debt ceiling fiasco. And it's possible that this will be an opportunity for a whole lot more of nothing from Congress -- most lawmakers likely want to avoid the catastrophe that could come with default. That fear, combined with an inability to reach consensus, may mean that the fight over the debt ceiling could be little more than sound and fury. And markets, having faced this fight once before, may be less flappable this time around, continuing their climbing as lawmakers continue to clash.

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