When lawmakers delivered a long-delayed, last-minute agreement on the budget, Wall Street celebrated. And it would be easy to think that the surge in the Dow the following day meant that investors had put their concerns about Washington's political gridlock behind them.
The Dow Jones industrial average surged on the news, but that doesn't mean the volatility is over. In fact, there could be more turmoil in the market soon because decisions on cutting the federal budget deficit have been put off until March, when the government will reach its borrowing limit. Republicans have already said they will demand cuts to spending as a condition for extending the limit.
"The uncertainty is still there, the key issues are spending cuts and entitlement reforms and, for the most part, those were not addressed," says Terry Sandven, chief equities strategist at U.S. Bank Wealth Management. "This sets the stage for sharper rhetoric and increased market volatility as these discussions evolve."
The last time lawmakers tussled over the debt limit, the stock market plunged and the U.S. government lost its AAA debt rating. The Dow fell almost 7 percent in the two weeks before an agreement was reached Aug. 3, 2011.
Many business leaders objected to the agreement lawmakers reached late Tuesday. The Business Roundtable, an association of chief executive officers of leading U.S. companies, said that although it addressed some of the immediate negative consequences that the economy would have faced going over the "fiscal cliff," it failed to address the "serious and fundamental" reforms the economy needs. The National Retail Federation said that the deal was welcome, though it was only the first step in necessary tax reform.
Companies are likely to remain wary of investing until they get more clarity from Washington, says Joe Heider, a principal at Rehmann Financial in Cleveland, Ohio. He likens the current U.S. business climate to a sporting event where the referees tell the players to take the field before telling them that the rules of the game will only be decided on once the final whistle has been blown.
"Washington needs to get out of the way of the financial markets and American business," said Heider. "They need to create some certainty over how businesses should best deploy all the cash that they're sitting on."
And corporations are sitting on a lot of cash. Companies have been steadily building up their reserves over the last five years and are now sitting on record cash piles. By the end of the third quarter of last year, S&P 500 companies had accumulated more than $1 trillion in cash, according to data from S&P Dow Jones Indices.
At least for now, companies are unlikely to invest much of that money back into their businesses simply because demand just isn't strong enough, says U.S. Bank's Sandven. Instead they will spend it on acquisitions, stock buy-backs and pay higher dividends. Those are all actions that should boost stock prices in the near term, despite the ongoing uncertainty and increased volatility that will be caused by political wrangling.
Investors should take advantage of any volatility in the market created by the political wrangling to seek out stocks that have a history of growing their dividends, says Sandven. He estimates that half of the stocks in the S&P 500 have a dividend yield that is higher than the current 10-year U.S. Treasury note. The 10-year Treasury note was at 1.90 percent Friday.
He also recommends that investors buy the stocks of companies that have exposure to emerging markets that have a growing middle class and don't have the same debt issues as the U.S.
Joseph Tanious, a global markets strategist at J.P. Morgan Funds, says investors would be wise to remain calm when the negotiations in Washington around the debt ceiling start to heat up this spring.
The stock market dropped sharply in the weeks after the election Nov. 6 as investors worried that a divided government wouldn't get a deal done in time to meet a budget deadline by the end of the year, but it has rebounded since then. The S&P 500 is now 2 percent higher than it was on election day, even after falling by as much as 5 percent in the two weeks following the vote. On Friday it closed at 1,466, the highest since December 2007.
"When push came to shove, Congress did come together to reach an agreement," says Tanious. "Many people were saying you should be out of the market ... (that) markets are going to capitulate, and that didn't happen."
Stocks have rallied over the last three years as investors remain optimistic that the economy will maintain a slow, but steady, recovery from recession, as the housing market improves and as the outlook for jobs gets better.
And while investors also see the wisdom in addressing the nation's long-term debt problems, they point out that businesses and consumers have been aggressively paying down their own debts in the aftermath of the 2008 financial crisis. That leaves more flexibility for people and companies to shop, invest, and spend money, helping to lift the economy — and the stock market — even if Washington's political dysfunction worsens.