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Wall Street reacted enthusiastically this spring, despite budget cuts

If the federal budget sequester, which went into effect at the start of March, was expected to be the trigger for a sharp drop in stocks prices, investors failed to get the message.

Included in the Budget Control Act of 2011, sequester mandated $1.2 trillion in budgets cuts beginning this year and continuing through 2021. The cuts are to be divided equally between defense spending and discretionary domestic spending.

While legislators and the Obama administration were able to avoid the “fiscal cliff” at the start of the year and agree on increases for the debt ceiling, sequestration remains a reality.

So, how did Wall Street react to the beginning of mandatory cuts? To put it in a word, enthusiastically. The Dow Jones industrial average gained 524 points in March, taking the index to 14,578. During the period the Dow repeatedly set new all-time highs, breaking the old record set on October 9, 2007, at 14,165.

In fact, March proved to be the icing on the cake for a successful and profitable start to 2013. During the first three months of the year, the Dow industrials were up an impressive 11.3 percent. Yet, amidst the celebration, some are wondering if the stock market has gone too far, too fast.

“If history is any guide, a strong start to the year has actually added to the S&P 500's average return during the rest of the year, as well as during the remaining quarters of the year,” said Sam Stovall, chief equity strategists at S&P Capital IQ.

Stovall's research finds the frequency with which the S&P 500 stock index rose during the remainder of the year increased to 85 percent following a positive first quarter compared to 74 percent for all years.

Interestingly, the one sector potentially at risk as a result of the sequester -- defense -- actually performed very well on Wall Street in the first quarter of 2013 and many company stocks continue to trade at or near multi-year highs.

“While we still face the uncertainty of sequestration, we remain focused on delivering innovative solutions, meeting our commitment to customers and returning value to our shareholders,” said Lockheed Martin chief executive officer Marilyn Hewson, after releasing the earnings report in January.

Yet, despite the benefit of momentum in early April, there are still concerns by some investors the “buy in October, sell in May” strategy could kick in again, risking the loss of gains that were rung up in the first quarter.

“Previous years have been marked by ugly political battles that have unnerved investors. From debt ceiling debates to pending sequester and tax increase battles and a downgrading of the U.S. credit rating, there was plenty to send investors toward the exit. However, we have seen some progress in deficit reduction, with tax rates being solidified, spending growth being pared back, and an agreement on the budget for the rest of the fiscal year,” said Liz Ann Sonders, chief investment strategist at Charles Schwab.

But, one factor is different in 2013 that, while not linked directly to the stock market, could be evidence of a critical change in the economy. According to S&P Capital IQ, the strong rebound in the housing market is giving a big boost to consumer and investor confidence.

“The latest Fannie Mae survey shows 48 percent of respondents believe home prices will rise in the next twelve months, while only ten percent expect a decline. Buyers' expectations influence home-price growth rates, and price gains will likely help ease credit conditions, increasing mortgage availability,” said S&P's Stovall.

Yet, despite rising home prices, record levels for stocks, and household wealth nearing all-time record levels, the economy remains susceptible to events away from the economy. The recent terrorist attacks in Boston resulted in a two percent drop in the Dow industrials in the following week.

And, several economic reports have provided evidence of a possible slowdown in the economy. The index of leading economic indicators from the Conference Board – a guide for where the economy may be headed in the next six to nine months – decline in March for the first time in four months.

“In addition to headwinds from government spending cuts, the private sector economy may struggle to maintain its momentum. The biggest challenge remains weak demand, due to nervous consumer sentiment and slow income growth,” said economist Ken Goldstein.

Perhaps the stock market is the best possible leading economic indicator and, right now, it still seems to be pointing to better things ahead.

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