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Don't Get Caught on the Wrong Side of the Fiscal Cliff Trade

Updated with Moody's reaction to fiscal cliff deal in 16th and 17th paragraphs.

NEW YORK ( TheStreet) -- Markets are bringing in the New Year with a record stock surge on news lawmakers won't push the U.S. economy over the so-called fiscal cliff.

Wednesday's stock rally, which stands as one of the sharpest opens to a year on record, may tell some investors that the worst case scenario of a fiscal cliff-driven recession is out of the cards and prove nearly two months of wrangling over a deal in the wake of President Obama's re-election was a non-story for Wall Street traders, as stocks rose modestly.

Still, investors cheering the late night Tuesday deal should be weary of being caught on the wrong side of the fiscal cliff, even after the New Year's Day deal.

Investors cheering the cliff are pushing the likes of consumer tech giant Apple (AAPL - Get Report), fast flying mega-cap lender Bank of America (BAC - Get Report) and luxury goods retailer Saks (SKS) higher. When Wednesday's trading ends, the question will be whether optimism will be borne out in earnings?

As the House of Representatives began voting on the cliff deal, Peter Tchir, founder of TF Market Advisors, was unenthusiastic about a resolution. "[So] what," Tchir wrote in a note to clients that stressed most workers will see smaller paychecks and budget cuts such as sequestration still loom in a "dysfunctional" Congress.

"Most people will get smaller paychecks next year... Why is everyone cheering what is a tax hike?" adds Tchir in the client note, which notes that corporations face a stiff challenge in improving upon first quarter 2012 earnings. "Last year we had some monster data and some great weather in Q1. Hard to say how much of that was seasonal adjustments, but we may see some negative impact if last year's Q1 numbers were overstated," he adds.

Notably, income taxes will rise on the nation's top earners and a majority of workers will see a payroll tax hit in the wake of the deal. Meanwhile, weak holiday season for retailers leading up to the 25th hour deal in Congress indicate the uncertainty surrounding the cliff may have already taken a toll on businesses, which could be reflected in the first few quarters of 2013.

"There will be no self-inflicted US recession this year and investors are quickly moving to discount that fact in response,' wrote Andrew Wilkinson, chief economic strategist at Miller Tabak & Co., in a note to clients.

Still, investors appeared to do a good job discounting that any resolution to the fiscal cliff would be messy, short-sighted and last-minute. From the President Obama's November re-election to Monday's close ahead of New Years, the S&P 500 was virtually unchanged. That muted reaction even reflected no deal by market close of the ball drop in Times Square.

Diane Swonk, the chief economist at Mesirow Financial is optimistic that with the cliff in the rear view mirror, the U.S. economy may post strong growth by the end of 2013.

While Swonk sees the prospect of 3.5% to 4% growth, those figures are expected to hit in the back half of the year. She goes on to note on Twitter that the uncertainty of the deal did have a fundamental impact on holiday season retail sales.

"Washington adding insult to injury by not creating level of certainty; saw impact in holiday spending," wrote Swonk on Twitter.

So what risks remain?

As TheStreet mentioned leading up Wednesday, there's the risk that even after Congress passed what is seen as a short term deal, rating agencies are yet to cast their vote on the deal.

Notably, the Tax Policy Center calculates that over ten years, Wednesday's package will add nearly $4 trillion to the U.S. budget deficit. Prior to the deal, ratings agencies like Moody's warned of ratings downgrades on any resolution that doesn't solve the government's budget imbalance over the long run. A protracted debt ceiling standoff could also force ratings agencies into action, as they did in 2011.

Any ratings downgrades would hammer financial sector shares, meanwhile uncertainty leading into year-end has cooled M&A, trading and underwriting volumes that are key for Wall Street profits. "With little prospect of any meaningful action to address the medium-term budget problems, we suspect that the US will suffer further credit rating downgrades this year," writes Paul Ashworth of Capital Economics, in a Wednesday note.

On Wednesday, Moody's said in a note that further measures to lower future budget deficits will be needed to upgrade the U.S. government's debt outlook from 'Negative' to 'Stable,' where the prospect of a downgrade would recede as a threat. Moody's calculates that Tuesday's deal would cause the government debt-to-GDP (gross domestic product) ratio to rise to 80% in 2014 and stabilize at 70% of GDP for the next decade, an unsuitable debt dynamic for an Aaa rating.

"The debt trajectory resulting from this process is likely to determine whether the Aaa rating is returned to a stable outlook or downgraded to Aa1," wrote Moody's, in a note that reiterates the agency's September outlook and stresses an expectation that debt ceiling wrangling will prompt spending cuts.

Meanwhile, retail sales-exposed names like Apple and Saks may yet suffer from tax hikes on the wealthy and a big payroll hit for most workers.

"If 2013 were to be a "normal" year, U.S. equity returns would likely be good, but not great, as the S&P 500 would record a gain in the mid-to-upper single digits," writes S&P Capital IQ chief equity strategist Sam Stovall. "As we enter 2013, we already know that this will be anything but a normal year," Stovall adds.

"Even though the change in tax policy was agreed upon, much of the heavy lifting of spending cuts has been postponed until the latter part of the [first quarter]. Wall Street will likely savor the resolution for the time being, but experience renewed investment agita before the quarter is out, offering better entry levels as the year progresses," Stovall concludes.

Yes investors who escaped falling off the fiscal cliff. That doesn't mean continued saber rattling in Congress and a simultaneous tax hit won't create boulders that could hit the U.S. economy and corporate earnings in the first half of 2013.

-- Written by Antoine Gara in New York

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