US stock market rally deserves respect Everyone knows what will happen if the Democrats and the Republicans cannot cut a deal to avoid the fiscal cliff at the beginning of next year. The US economy is likely to fall into a short and shallow recession and the unemployment rate to head back up as tax rates rise across the board and spending cuts kick in. Going over the cliff would be the consequence of a bipartisan bargain worked out during the summer of 2011. While it may not be good for the economy, it would significantly cut the federal deficit. US stock prices would probably fall - although they have held up remarkably well, near the year's high, despite a lack of progress in Washington. Little has been said about the positive consequences if there is a deal to avoid going over the cliff, even if it leaves plenty of unresolved issues for serious negotiations some time next year. That is unfortunate, because if both sides were more aware of the upside, they might be less willing to countenance the downside. The fact is that the US economy is performing quite well despite the persistent uncertainty about fiscal policy. Granted, real gross domestic product has been growing at a subpar pace of about 2-2.5 per cent on an annual basis for the past three years. However, excluding government spending, it has actually been growing about 3-3.5 per cent. In other words, the non-farm business sector's performance does not jibe with the so-called "new normal" scenario of a structural decline in the economy's potential growth rate. That is quite impressive, given the failure of residential investment to recover along with the broad economy, until recently. If the cliff can be avoided, the housing industry may well contribute significantly to another year of solid growth in the private sector in 2013. The key variable is house prices, which have clearly started moving higher. The national median house price rose 11 per cent over the year to the end of October: that is after a peak-to-trough decline of 33 per cent from July 2006 through January 2012. If house prices continue to rise, so will consumer confidence and spending, especially for those homeowners with less negative equity, after having seen their property values drop up to a third. The S&P 500 could break through to a new record high early next year if the US avoids the fiscal cliff. The rally in stock prices since March 2009 has been the Rodney Dangerfield of bull markets. The late comedian regularly complained that he got "no respect." The bull market has been a series of powerful relief rallies following severe corrections triggered by "endgame" anxiety attacks. Despite the looming fiscal cliff in the US, the euro mess, turmoil in the Middle East and mounting tensions in the South China Sea, the S&P 500 is down only 3.3 per cent from its cyclical high of 1,466 on September 14. The naysayers say stocks are unlikely to continue climbing this wall of worry. There has been talk of the death of the "cult of equity." The retail investor has abandoned equities and fled to bonds. Trading volume is down on the New York Stock Exchange. The Federal Reserve's quantitative easing programmes, which aimed to lift stock prices, may be losing their effectiveness. Even if the US sidesteps the fiscal cliff, earnings have stopped growing and might not do so next year if global economic activity is weighed down by a recession in Europe and a slowdown in China. And there is unlikely to be much, if any, upside from profit margins since they are near previous cyclical peaks. Stocks may appear cheap but should remain so, since the outlook for long-term economic growth is weak according to commentaries by pundits including Bill Gross, Robert Gordon, Jeremy Grantham and Kenneth Rogoff. In brief, the long-term outlook for growth is poor because debt levels are too high and productivity too low. Maybe so but the US economy has proven remarkably resilient. The information technology revolution that started in the 1990s is likely to provide countless innovations in the fields of energy, healthcare, education, robotics and many more. The global economy should also prove resilient as Europe slowly recovers from its recession and China grows at a faster pace. There should be enough growth to boost revenues and earnings for the S&P 500 companies by 5-7 per cent. Valuation multiples should rise next year. If so, then the bull market should continue - sooner rather than later if there is a deal to avoid the fiscal cliff. If not, there is likely to be a correction that should provide lots of good buying opportunities. After the fiscal cliff issue is resolved one way or another, there will be plenty of other issues to worry about - and they may set the stage for more relief rallies. Edward Yardeni is president and chief investment strategist at Yardeni Research