The Market Will Give Washington DC A Week To Get It Together. Watch the Rhetoric

President Obama was reelected and the market tanked. He has not passed a budget in three years and Washington DC is polarized. The fiscal cliff is all that matters and both parties need to compromise. If an agreement is not reached, many analysts feel that GDP could fall 5% next year. Capital gains taxes will increase and investors are taking profits. Politicians have had 18 months to address this problem and they have been steadfast in their ideological beliefs. Standard & Poor's watched the debt ceiling debacle last year and they downgraded our credit rating. The prospects don't look good for a quick fix. Congress will barely reconvene and they will disappear for Thanksgiving. They will return for a few weeks and disappear for Christmas. Traders fear that lame ducks could dig their heels in. Obamacare will gradually kick in and corporations will hold off on hiring. Challenger Gray & Christmas cited that planned layoffs by corporations are on the rise. Defense contractors are in limbo and they don't know the extent of fiscal spending cuts. As dire as all this sounds, we need to keep our perspective. First of all, capital gains taxes will only go up 5% (from 15% to 20%). This alone should not spark a massive selloff. Politicians have witnessed the market decline and they know that action is required. There is always a chance that they will come up with a quick fix at the 12th hour. The recent market selloff seems a bit over-extended. Now that the warning shot has been fired, traders will want to see if Washington DC got the message. They will monitor the rhetoric for a week (maybe two) and act accordingly. If it seems like progress is being made and everyone is "playing nice in the sandbox", the market will bounce. If both parties dig their heels in, we will see a heavy wave of selling. All of the sequestration provisions won't be implemented, but we can expect higher taxes and spending cuts. Regardless of the magnitude, these actions will reduce economic activity. If the Republicans reject tax increases, Democrats could play "hardball". They have the upper hand. They can simply let all of the tax cuts expire in 2013. With some help from Treasury Secretary Geithner, they can postpone spending cuts. Harry Reid (Senate Majority Leader) is also trying to ban filibustering to weaken Republican objections. These actions are divisive and they contradict statements he made about reaching across the aisle. Greece will vote on an austerity plan Sunday and it should pass. If not, they won't get their bailout money and they will have to hold another election (very bearish if it happens). The first round of voting passed yesterday and I'm not expecting any surprises. European credit concerns should remain subdued through 2012. Spanish yields are creeping higher, but there's no need for concern - yet. China's economic activity is improving. They will have a leadership change next week and fiscal spending/monetary easing will provide a tailwind. Earnings guidance has been cautious for Q4 and I believe bad news is priced in. If politicians compromise (unlikely), the market will rally into year-end. If they argue and wait until the last minute, we will drift lower. I am long a handful of puts and I sold them this morning when I saw the reversal. I made a little money on them. I am selling out of the money put credit spreads on strong stocks. I believe the market could drift lower, but it won't tank. Traders will give politicians a chance to get their act together in the next week or two. I like the fact that the market was down overnight and it found support right on the open. Stocks rebounded and they want to move higher. Look for choppy trading today. I believe prices will stabilize over the next few days. . .

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