The Cliff is dead; long live the Cliff. Yesterday’s impressive market rally was a great way to kick off the New Year, but (as ConvergEx's Nicholas Colas notes) we do have 251 trading days to go before we can lock in those gains and dance a celebratory jig. The market’s psychological pendulum swings between extremes of “Macro” and “micro” focus, and we shouldn’t take it for granted that the stock market’s positive take on the Fiscal Cliff negotiations portend a better economy, a stronger financial picture for the U.S., or any of the actual nuts-and-bolts which hold together the framework of corporate earnings and cash flows. Colas' prime concern is that the increase in Social Security tax withholding by 2 percentage points – back to its pre-2011 12.4% - will take a chunk out of the spending power for tens of millions of households. In the abstract, the amounts involved are not huge – perhaps 50 basis points of GDP. But everything counts when GDP growth remains stubbornly subpar.
And… Republican-leaning states have a disproportionate share of lower-income households that will feel the pinch especially keenly. Not good news for the next Cliff…
Yesterday’s rally in global equities – especially U.S. stocks – is difficult to explain, at least with conventional reasoning. The deal struck between Democrats and Republicans leaves a lot of unanswered questions, including a still-needed increase to the Federal Debt Limit, spending cuts to replace the 2011 sequestrations no one liked, and a reasonable approach to containing the long term growth of health care expenses in programs such as Medicare and Medicaid. The market’s positive response was a bit like giving a gold medal to the last man across the finish line, more in celebration of his effort than the result.
No – yesterday’s move seemed emotional rather than reasoned, and for that reason I would like to take a brief trip into the “Psychology of myth.” The foremost philosopher on the subject, a college professor named Joseph Campbell, essentially wrote the book on the topic in 1949. His work, The Hero with a Thousand Faces, outlines what Campbell calls a “Monomyth” – the most fundamental form that many cultures’ most important stories all share. Here is how he describes the essence of the form:
“A hero ventures forth from the world of the common day into a region of supernatural wonder; fabulous forces are there encountered and a decisive victory is won; the hero comes back from this mysterious adventure with the power to bestow boons on his fellow man.”
If you’ve seen the Star Wars movies, you’ve seen Campbell’s paradigm at work; George Lucas openly credited his work as central to the “Mythology” of the story. The Grateful Dead were also huge fans, as was Bob Dylan and Jim Morrison. Some critics suggest that the Harry Potter books are straight out of Campbell’s description, although JK Rowling is quiet on the comparison. In any case, whether you are talking about ancient myth, religious stories from Islam, Christianity, Judaism, or movie blockbusters, it is hard to argue that this storyline captures the human imagination in a very predictable and unusually compelling manner.
I know this is a stretch, so I will hasten to a conclusion. The bottom line is that investors went on a journey over the last few weeks. It is easy to be glib and say, “Oh, everyone knew it would work out all right in the end…” It would also be wrong. The U.S. political scene may not qualify as ‘Supernatural wonder,’ and we certainly haven’t had a “decisive victory.” But investors and market observers were certainly worried about the potential outcome of the debate – including the possibility of a “No decision.” So when we get a solution, even a half-baked one – the response is visceral. It fits the “Monomyth” narrative I quoted above, and now the market “Bestow(s) boons on his fellow man.”
If you don’t agree that impersonal financial marketplaces will succumb to cultural analysis, let me turn a hardened eye to the oddest bit about yesterday’s close-on-the-highs fireworks: most workers are seeing their taxes go up and their take-home pay go down in 2013 as compared to last year. Yes, in the midst of Democrats happy over higher tax rates for the “Rich” and Republican relief that defense cuts won’t kick in just yet, no seems to be too much worried that paychecks are getting smaller for just about anyone who works “On the books” in America. A few particulars:
- The employee portion of Social Security tax withholding goes up to 6.2% from 4.2% on January 1, 2013. Employers have until February 15th to make the change from the previous rate, but the IRS bulletin on the topic instructs employers to make up any difference due from late adoption by March 31, 2013. See here for complete details: http://www.irs.gov/pub/irs-pdf/n1036.pdf.
- Approximately 79.1% of all U.S. households make less than $100,000 and are therefore subject to the entire impact of the Social Security tax. The income cutoff is now $113,700, to be precise. It’s hard to know exactly how many of these households are retired or not in the workforce, but let’s say it is most of the households making less than $25,000 (25 percentage points of the 79.1% noted above). This still leaves just over 50% of all U.S. households, or +50 million families and other related groupings of people under one roof.
- How much less will these households be taking home? Assuming an average income of $50,000 – a decent approximation – that is $1,000/year. Yes, that is 3 iPad minis, or one MacBook Air, or two nice flat screen TVs (or one awesome one), or an unlocked iPhone 6, or a washer/dryer combo…. Or.. Or… Or… In reality, though, these households live largely paycheck to paycheck, so it pays to look at how much money they spend on a daily basis, out of pocket. The Gallup organization has that math (see here: http://www.gallup.com/poll/159128/consumer-spending-holds-steady-consistent-2011.aspx) and the number is currently $61/day for households which earn less that $90,000/year. Remove $1,000 (which works out to $2.74/day) and that is a 4.4% decline in spending power. We’re really not talking about iPads or smart phones. This feels more like eating out, family vacations, and extra school supplies or trips. Discretionary items that may well define subjective assessments such as consumer confidence, in short.
- Not to get overly political here, but it pays to remember that income levels by state skew quite strongly based on the “Red-Blue” divide. As we show in the accompanying table, the average household income for states which sided with President Obama is $55,558/year. The same math for the states which went for Governor Romney is $46,979/year, or 15% lower. The Social Security tax is regressive – losing $500/year for someone making $25,000 probably hurts their well-being more than the $1,800 in lost income for a household earning $90,000. Other credits may help the lower income household once they file their returns, but that doesn’t help much when the paycheck is smaller than you thought.
In summary, as much as the whole Joe Campbell “Myth” explanation may seem a bit squishy, I remained anchored to the thought that capital markets responded with emotion rather than logic in response to the “Cliff” debate. I know we aren’t talking about huge numbers with respect to the Social Security tax issue – maybe 50 basis points of GDP growth this year. So it isn’t like a huge swath of the S&P 500 is going to miss earnings because of this. But companies which rely on this middle class consumer clearly face an uphill struggle in 2013. And the same word – struggle – applies to the next battles in Washington: the Federal Debt Limit, spending cuts to replace the 2011 sequestration requirements, and the growth in medical expenses, just to name three.
If there is a bright side, it seems to be that capital markets think government is more “Zero” than “Hero,” and any resolution is greeted warmly, in the spirit of the Monomyth. So we may well be on track for more “Relief rallies” if Washington can remain focused on action. Now we just have to hope that there are enough boons to go around.