Weighing The Week Ahead: Clarity Coming On Key Challenges?

After several weeks of noise -- from both data and politicians -- it may finally be time for some clarity. I have predicted this with my theme for the last few weeks, and we are starting to see the results:

• The Fed -- aggressive policy, clearly stated, but still not well understood (more below).
• US economic data -- the Sandy weakness is proving temporary.
• China -- signs of an end to the slow slide, and not a hard landing.
• Housing -- several signs of a bottom and some for a real bounce.
• Europe -- none of the really bad things happening, but further delays in a final solution.
• The fiscal cliff -- the biggest unresolved issue.

The problem with this list is that the fiscal cliff issues are so important that we really need some answers -- and soon! As I wrote in my first installment of "Cliff Notes," there has been little real information so far. I refuse to join in the daily discussion of non-events, but it will now start to get interesting. I will write more installments of Cliff Notes as circumstances warrant.

For the purpose of our weekly review, I will simplify this in two dimensions -- content and timing.

Content

Many issues have been lumped together as part of the Fiscal Cliff discussion, just as last year's debt ceiling debate turned a routine matter into a threat to US credibility. I am putting all of the issues into two categories

1. Tax matters -- Bush-era rates, AMT, doc fix, inheritance, capital gains, and dividends.
2. Long-term deficit issues -- Sequestration, entitlements, payroll tax "holiday," higher retirement age, higher Medicare age, and the like.

There are also issues concerning the renewal of long-term unemployment benefits and whether the debt ceiling will be a regular pinata for Congress. These might be taken up in either group. The first group is most important to the economy since it would have an immediate effect.

Timing
I have predicted that this issue would go to the last possible moment. How is that defined? I am reminded of my college days when I lived in Indiana. The State legislature was Constitutionally required to pass a budget by a certain date. Each year the legislative session ended, with no further options possible. They regularly missed the deadline, although they were always close. The Sergeant-at-Arms would go to the back of the chamber and stop the grandfather clock, halting it a little before midnight. Time stood still! Eventually the budget was passed, meeting the official deadline.

There are four possible deadlines to consider:

1. This week, allowing a Christmas break.
2. Before the end of the year.
3. In the first few days of the new Congressional session.
4. Weeks or months later.

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The timing track for tax matters is more urgent than for deficit matters.

I'll offer my own take on what to expect on the fiscal cliff in the conclusion. Let us first do our regular review of last week's news and data.

Background on "Weighing the Week Ahead"

There are many good lists of upcoming events. One source I especially like is the weekly post from the WSJ's new investor resource page -- a starting point for the long-term investor. (Comments and suggestions welcome. I am trying to be helpful and I love feedback).

Final Thoughts on the Cliff
After weeks of no movement, this might now become a fast-breaking story. I'll do more Cliff Notes summaries as indicated.

So far the story has developed as I expected. Some are changing their odds since nothing has happened. This is fine for those following all of the commentary, but silly if you did not expect any action in the first place!

There has not been much polling of members or advance work --- "whipping" in Congressional parlance. This means little since positions are pretty well known on these issues.

My forecast calls for a resolution of the tax issues before any real economic impact occurs. Republican constituents are most dramatically affected by the AMT and the doc fix. Every poll shows that the GOP will be held accountable. Over 80% of Congressional insiders expect higher taxes on the rich in 2013. It is only a matter of when and how the tax policy will be changed. The publicized sticking point of rates for those with incomes over $250,000 is subject to compromise on the level of income, the exact rate, and adding some limits on deductions. Both sides can claim victory in a compromise.

If the GOP can bargain this for an attractive commitment on spending cuts, we could see something major before Friday. This would not include the "details" that everyone is foolishly discussing. Any agreement will involve guidelines with various Congressional committees to work out the implementation. For those who never took a class about Congress, think of it this way. Management is making some kind of across-the-board spending cut and looking to departments for specific proposals. This is a rough approximation for Congress. It could be stated more strongly since in this case the departments consist of various fiefdoms, all jealously protecting long-held power.

If there is nothing before Friday, we will see Congress in session for a final week of the year. No one wants this. The GOP might even vote "present" in the House to get the tax matters passed.

If the GOP cannot get an attractive deal on the deficit issues, those will be taken up next year with the debt ceiling as the key leverage point.

Investing Implication
Since opinion is widely divided on the fiscal cliff issues, the market should move significantly when we know the outcome. Much will depend on whether a two-part agreement (tax matters now, deficit matters soon) is effectively communicated.

It is also options expiration week, so things could get interesting.

Written By: Jeff Miller