Stocks plunge as debt reduction talks fail

NEW YORK -- In the latest sign that political dysfunction is morphing into a major liability for financial markets and the economy, Wall Street reacted harshly to the failure of a special Congressional panel to strike a deficit-cutting deal by dumping stocks and branding the so-called supercommittee as "kryptonite" and a "super failure."

In what amounts to a vote of no confidence in elected leaders' ability to get the nation's shaky finances in order, investors reacted harshly to the supercommittee's inability to compromise and come up with at least $1.2 trillion in budget savings in the next 10 years.

And while markets didn't have high hopes for a so-called Grand Deal, they seemed to be caught off guard by the supercommittee's complete failure.

"The expectations for the supercommittee were extremely low," says Bruce Bittles, chief investment strategist at R.W. Baird. "But obviously not low enough."

The Dow Jones industrial average tumbled 248.85 points, or 2.1%, to 11,547.31, putting it back into the red for the year for the first time in a month.

The Standard & Poor's 500 index dropped 22.67, or 1.9%, to 1192.98 and the Nasdaq composite index fell 49.36, or 1.9%, to 2523.14.

In an update to clients this morning, Andrew Busch, a public policy strategist at BMO Capital Markets, summed up the special panel's impact on markets this way: "Super Committee Kryptonite." Kryptonite, of course, is the fictional radioactive element that's the Achilles heel of comic strip hero Superman.

Citigroup's economist Steven Wieting called the panel's impasse "another squandered opportunity" to bring clarity to the nation's fiscal outlook. Citigroup's investment strategist Tobias Levkovich dubbed it "Super Failure?" in a note to clients.

Reaction in financial markets to the latest round of political gamesmanship was similar to the market swoon back in August following the messy partisan bickering about the debt ceiling and the eventual downgrade of the nation's gold-plated triple-A credit rating. The timing of the supercommittee's impasse comes at a perilous time as the world grapples with a massive debt overhang.

Also on Monday, fears of financial contagion in Europe continued to swirl after ratings agency Moody's Investors Service said it may change its outlook on France's AAA rating from stable to negative in coming months, a news nugget that suggests Europe's debt crisis is worsening.

Investors are facing the new, uncomfortable reality that uncertainty over deficit and tax policy will now likely extend into the 2012 election season, a timetable shift that will put added pressure on the nation's nascent economic recovery, analysts say.

Wall Street fears that the inability of lawmakers to address the nation's growing deficit problem in a timely and politically orderly manner could prompt the leading credit rating agencies to further downgrade the nation's once-pristine credit rating. Back in August, Standard & Poor's downgraded the nation's credit to AA+, the first time in history the nation's credit received such a ding. The downgrade, coupled with the public spat between Democrats and Republicans over raising the debt ceiling, caused a massive investor shift away from risk that sent the Dow down more than 2,000 points in a two-week span ending in early August.

On a positive note, Congress built in automatic cuts of $1.2 trillion — which Congress dubs "sequestration" — that kick in in 2013 in the event that the supercommittee failed to agree on a bipartisan plan. That fact could minimize another quick credit downgrade for the USA, says Colin Moore, chief investment officer at Columbia Management.

"I feel the greatest short-term risk to further downgrades is the possibility of tampering with or altering the sequestration amounts," says Moore. "The $1.2 trillion is already included in the 2013 budget calculation and, therefore, their removal or reduction would be a concern."

In the longer term, the U.S. risks further downgrades if it can't bring its deficits under control, Moore adds. But he doesn't expect any downgrades until at least after the November 2012 election.

Again, the notion that political gridlock is good for markets may be overstated in the current environment, as action is needed to fix the nation's money problems before they get worse.

"The supercommittee's failure proves one more time that our political institutions lack a mechanism for doing much of anything," says Chuck Carlson, CEO of Horizon Investment Services.

The inability of Republicans to consider hefty tax increases to help trim the deficit, coupled with Democrats' unwillingness to approve major cuts to entitlement programs without the GOP budging on tax increases, means these major decisions will be debated in the upcoming election year.

"The issues of new taxes and entitlement cuts most likely are going to be key factors in the 2012 elections," Levkovich wrote in a research note Monday. He added that it is likely the big issues will be tackled by the next administration at the White House in 2013-2014.

The supercommittee also did not deal with the issue of whether the 2% payroll tax cut will be extended in January for 2013, nor did they address whether unemployment benefits will also be extended, says Bittles.

If neither of those pro-growth steps are taken, it could hurt the economy and also increase the odds that it will fall back into recession, despite the better-than-expected data in recent weeks, says Bittles.

"Some economists say not extending payroll tax cuts and unemployment benefits could (affect) economic growth by one or two percentage points," says Bittles. With the initial GDP reading for the just-ended third quarter coming in at just 2.5%, a further slowdown presents greater risk of a double dip, especially given Europe's ongoing woes. "Confidence is being destroyed and Washington's inaction may cause our economy to go into recession in the next 12 months."

There is hope on Wall Street that both of these issues will be addressed by Congress when they return to Washington after the Thanksgiving recess, analysts say.

Still, Carlson says that despite the failure of the supercommittee to meet its highly publicized deadline, Congress will take small incremental steps to help boost the economy. Carlson also says that the negative market reaction is not that surprising, given that the recent volatility has been driven by fast-finger traders that react to second-to-second headlines and whose investment stance can pivot 180 degrees as news shifts.

"The tenor of everything these days tends to be catastrophic," Carlson says.