Despite lots of comments about willingness to compromise, the markets will look for hard proof from Congress and the White House that some progress is being made as the year-end deadline on the fiscal cliff approaches. There have been talks between the White House and Republicans, but there were no visible signs by Friday of a deal that would bring about a compromise on taxes or spending.
Stocks in the past week were flattish and slightly lower, with the S&P 500 down 0.3 percent for the week to 1413 and the Dow down 0.2 percent at 13,135. The S&P 500 is still up more than 4 percent since its mid-November low and more than 12 percent higher for the year.
"You get to two weeks before the end of the year, and it's go time," said Gina Martin Adams, institutional equity strategist at Wells Fargo Securities. "Either they're doing something now or not, and you're going to see the market reflect that."
Traders work on the floor of the New York Stock Exchange on December 10, 2012 in New York City.
Some market participants believe there will be no deal by year end, but many expect it to be resolved early in the new year if that is the case. Forty-six percent of the economists and market participants surveyed by CNBC's Steve Liesman recently said they do not expect the U.S. to go over the cliff, but 41 percent do, and another 13 percent said they were unsure.
Deutsche Bank Chief U.S. Equities Strategist David Bianco said one scenario is that all changes in taxes are temporarily held off while agreement is reached on which tax breaks to extend.
"Our base-case scenario is that if we don't have something that's going to the CBO (Congressional Budget Office) to be scored by late next week, I think the market starts losing patience, and we go under 1400," on the S&P, he said. Bianco doesn't see it sliding below 1350 unless Washington keeps "botching this thing up."
"If it goes into next year and a lot of taxes go into effect, then we watch to see if we go into recession, and if we do, then the S&P could fall to 1200, even if it's a mild one," he said.
Adams said it's tough to say how the market will react in the next couple of weeks, since it has been trading surprisingly well. "The week between Christmas and New Year's is anyone's guess. There will be five people trading stocks, no one in the office, but they could be dumping entire positions," she said. "I have no visibility into year end. I think the market is holding up better than anticipated because no one wants to trade on policy alone."
The fiscal cliff is the more than $500 billion slam to the economy that would come after Jan. 1 when dozens of tax breaks expire and automatic spending cuts begin. Some of the expected taxes subject to change include the capital-gains tax, which could revert to 20 percent and 23.8 percent for the wealthiest Americans, and the dividend tax, which could go from 15 percent to 3.8 percent above the highest tax rates for the wealthiest investors.
"I have a 1500 12-month target, and if there's no deal by December 31, that will be our year-end target. The details of the deal determines where our target is. If we have a dividend tax rate of 25 percent or less we'll go to 1600," Bianco said.
"If the tax drag is more than 1.25 percent of GDP which means almost everything is put back on. If that occurs we'll just stay at 1500," he said.
Besides the cliff talks, there is a relatively heavy calendar of December data, including the Empire state survey and Philadelphia Fed survey, as well as jobless claims, which will all be watched to see if the effects of Sandy are beginning to fade. There is also housing data, with the homebuilders survey, housing starts and existing home sales, all expected to point to the trend of improving housing.
Bianco said industry may begin to contribute to the economy again, joining the consumer, which has been the stronger factor in recent months. "We think business spending and U.S. exports are going to be the first thing to start recovering," he said.
If the economy does not fall off the "cliff," monetary policy could be supportive of commodities prices. "We think technology spending will improve next year," he said, adding Europe should stabilize and China appears to be turning.
"I think the best reward for the risk we're up against here are in technology and industrial," he said. "We do expect a (cliff) deal, but there's going to be some tax drag next year both on lower income households and higher income households because we think the payroll tax is going to be, or partially going to be, returned."
Adams is not as optimistic for stocks, and she has a target of just 1390 for the S&P next year.
"Investors are just kind of sitting on their hands. You can take both sides. Why would you want to sell stocks right now if you don't know where we're going based on policy? And why would you want to buy stocks either," she said. "I think there's a pretty high risk that we get higher capital gains taxes, and we get clarity, or don't get clarity, and there could be selling into the end of the year. The market seems to think this is not an issue, and that policy makers will kick the can, and fair enough because that's what they did last time."
She said she expects the earnings story to be a negative in the beginning of the year and not show improvement until the second quarter. She also expects the fiscal situation to be a drag on private-sector activity.
"I think the private sector would like to find some growth prospects and is more willing to seek out opportunities…but the public sector weight is pretty tremendous, and there is a link between public sector debt and private sector activity," Adams said. "If that impediment is removed, you could possibility see much better private-sector growth. That impediment alone is clearly restraining confidence."
The week ahead also brings the quadruple expiration of futures and options, and for the bond market, there are 2-, 3- and 7-year auctions, as well as a 5-year TIPs auction Thursday.
Even with the auctions, focus will be on Washington. "It's the make or break week for the fiscal cliff negotiations as far as the market is concerned," said Ian Lyngen, senior Treasury strategist at CRT Capital.
"The Christmas week will be a challenging week for Washington if they don't have a workable deal in place by the 21st," said Lyngen. "People will be nervous about what the first quarter growth will look like."
http://www.cnbc.com/id/100316793
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