NEW YORK - Investors curious as to how the stock market might react if the "fiscal cliff" is avoided should consider Monday's bullish action on Wall Street as a likely blueprint of what to expect, investment strategists say.
Stocks soared 2% on Monday, with the Dow Jones industrial average up 208 points to 12,796. But the big rally, on top of an up day Friday, wasn't driven by a signed-sealed-and-delivered deal between Democrats and Republicans.
The gains were fueled by mere hope and encouraging signs that President Obama and divided lawmakers -- who have been pledging more cooperation in recent days -- will compromise in time to avoid the economic fallout that's expected if automatic tax increases and spending cuts kick in on Jan. 1.
Until the fiscal cliff uncertainty is resolved, the main driver of stocks will be headlines offering insight on whether the negotiations are heading in a market-friendly direction or not.
"Every step we take toward getting an agreement, you will see a positive market reaction," says Andrew Busch, global public policy strategist at BMO Capital Markets. "But on the flip side, I think every time the negotiations stumble leading up to the year-end cliff deadline, investors will get nervous, and stocks will take a hit."
The market's ups and downs in the face of the fiscal cliff are likely to be similar to the way financial markets have reacted in recent years to the on-again, off-again talks related to solving Europe's debt crisis, says Bill Stone, chief investment strategist at PNC. What investors want to avoid, he says, is a worst-case outcome.
"Europe is a real good analogy," Stone says. "When the European Central Bank did the work necessary to avoid a Lehman-like moment, the market melted up." The ECB came up with a bond-buying plan that removed the threat of sovereign defaults, which staved off the type of financial panic that occurred after the Wall Street titan Lehman Bros. declared bankruptcy in fall 2008.
What Wall Street "wants to avoid now is what appears to be avoidable": a recession caused by lawmakers letting the economy fall off the fiscal cliff, Stone adds.
Following the Nov. 6 election, the stock market dropped more than 5% amid fears that more divided government and partisan politics would reduce the odds of a deal.
"The direction of the market is hinging very much on the fiscal cliff issue," says Randy Frederick, managing director of active trading and derivatives at Charles Schwab. He says investors want to see signs of compromise and strong hints that the tax rates on dividends and capital gains, which are under negotiation, don't end up at the proposed high points.
Hope is not a great reason to buy, as the fiscal cliff negotiations are just beginning, he adds. There's nothing to say lawmakers won't hit an impasse. "The problem is lawmakers could dig their heels in again, and the market could give back all of its gains," says Frederick.