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What Investors Are Missing in the Sequester Fight

Friday, 1 Mar 2013 | 2:00 PM ET
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Wall Street has avoided the massive market turmoil that came with the "fiscal cliff" panic but is far from out of the danger posed by political turmoil.

Friday's deadline for mandated government spending cuts came and went with little stock market reaction, save for an early-session sell-off that quickly reversed itself.

Washington, though, still matters, despite the current high levels of investor complacency.

"The one thing about the markets is it doesn't matter until the day it matters. That's just the way markets work," said Quincy Krosby, chief market strategist at Prudential Annuities. "Look at every case we've gone through, whether it's subprime, the technology bubble, it doesn't matter. The markets can keep going up, but one day it is going to matter."

(Read More: Dow's Heavy Hitters Could Push Index to New High)

The mandated spending cuts, known as sequestration, technically went into effect Friday but likely will be felt only over a period of time as they take effect.

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Krosby cited the "Washington Monument" effect - a term referring to government shutdowns that don't hit home until actual operations are visibly impacted.

That was essentially the case with the sequestration start. Despite looming layoffs and threats from President Barack Obama over how severe the impact could be, the market went on its merry way, reversing a more than 100-point Dow drop at the beginning of trading.

Markets did retreat during a late-morning Obama news conference, but rebounded after the president vowed that he was not a "dictator," remains open to compromise and assured that the cuts would not trigger an armageddon scenario.

(Read More: Obama on Sequester: No Apocalypse, 'Just Dumb')

Bigger political deadlines await, though.

The continuing resolution that allows the government spending authority expires March 27. There is an April 15 budget deadline that, under the No Budget No Pay Act, will suspend congressional salaries unless a budget resolution is adopted, and the nation again will hit its borrowing limit in mid-May.

Until then, though, the market appears content to carry on as though the debt and deficit problem does not exist.

"If we actually did what we are supposed to do, it would hurt the market. It will take away from growth but it will set the stage for a country that has its books in order and instill some transparency in the market," Krosby said. "It will give investors the sense that the markets are not manipulated by the Federal Reserve or that some other countries are perfectly willing to come in and take care of our debt."

Despite the market rally to near its historic highs, there are sporadic signs that investors care about the mess in Washington.

(Read More: Cramer Says Washington Creating 'False Tells')

The American Association of Individual Investors' weekly survey saw bullish sentiment - expectations that the market will be higher in six months - take its biggest one-week drop since November 2010, falling from 57.6 percent to 40 percent.

Tobias Levkovich, Citigroup's chief U.S. equity strategist, said his long-term view of the market remains bullish but he believes the near term could get rocky because of political instability.

"Given potentially bitter fiscal policy battles linked to required tax and spending reforms in March, we expect some volatility in the next few weeks," he said.

That would be a change, as investor complacency now rules the market. Incremental improvements in economic data trump potentially crippling debt battles in Washington, renewed concerns over the European sovereign debt crisis and serious strains on the consumer from increased taxes and energy costs.

"Investors are underestimating the strain on the US consumer," said Michelle Meyer, U.S. economist at Bank of America Merrill Lynch. "There are positive factors, such as wealth appreciation and modest job growth, but the shock from the payroll-tax hike coupled with delayed tax refunds, rising gasoline prices and poor weather should result in a crippled consumer."

The day could be near, then, when Washington starts to matter again.

"The key would be, if you're not going to cut then how about really trying to create an environment for growth, real growth, and let the growth take care of the deficit," Krosby said. "Right now it's as if we're in purgatory - economic limbo."

That might be good enough for investors.

"The market doesn't really care. The market has discounted the dysfunction in Washington," Ed Keon, portfolio manager for Quantitative Management Associates, told CNBC. "It's hard to surprise the market on the downside,"

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