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Wednesday marks the deadline of the “super committee” to come up with its recommendations to cut at least $1.2 Trillion from the budget deficits over the next 10 years.  In reality, though, the deadline is on Monday, since the CBO needs time to score it.  

As I predicted as soon as the debt-ceiling agreement which created the committee was reached, this effort has been a total failure. The two sides are simply too far dug in. The GOP put a few deduction limitations on the table, but only if all the Bush tax cuts are made permanent. The Democrats have offered significant cuts to entitlements, but only if the GOP gives in on higher effective taxes on the upper income brackets.  

As a result of the failure, the word of the year for 2012 is going to be “sequestration.” Those are the automatic cuts of $1.2 Trillion that go into effect starting in 2013. About half of the spending cuts would come from Defense, and half will come from non-defense discretionary spending. Social Security and food stamps are protected from the cuts, and Medicare and Medicaid are largely protected.

This is simply a meat cleaver approach, and was designed to be as unpalatable as possible, so that the members of the “super committee” would have an incentive to come to an agreement. There will be a lot of action on Capital Hill in 2012 trying to defuse the trigger that Congress set up for itself.

Any such effort, though, would probably have to go through the Senate under ordinary rules, meaning that a filibuster could, and probably would, stop it. Thus the most likely outcome is that the sequestration will go into effect. While there is a lot of fat that can be trimmed from the Pentagon, the meat-cleaver approach is not a wise one from a national security point of view.

Some Taxes Would Go Up, and the Deficit Would Worsen

The failure of the committee to come to an agreement probably also means that the effort to extend the payroll tax cut into 2012 will fail. That means a 2% reduction in the after tax incomes of anyone earning less than $106,800 in 2012 relative to 2011.

If nothing is done, fiscal policy is going to become very concretionary in 2012. Even if Europe somehow miraculously gets its act together, the impact of the higher taxes and other austerity measures has the potential to stop all of the positive economic momentum we have been seeing in the recent numbers.

It would probably reduce overall economic growth by about 1.5% for 2012, which would mean that we would be skating very close to a new recession in early 2012.  If the financial system freezes up due to Europe as well, it will be a one-two punch that will knock the economy out. And a new recession would lead to higher, not lower, deficits.

Other Data to Digest

In addition to the super committee news, there will also be some very important economic data to digest this week before we get to the turkey. Existing home sales are expected to slip a bit more in October. There the real key is not the level of sales, but the level of sales relative to inventories. That will tell us if the slide in used home prices is coming to an end.

We get the second look at the GDP data for the third quarter on Tuesday. While there is not expected to be a change in the overall growth rate of 2.5%, the composition of the growth will probably shift, and shift for the better, with more coming from net exports and consumer spending, offset by an even bigger drag from inventory investment. The minutes of the November 2nd Fed meeting also come out on Tuesday, which could provide some insight into why the Fed decided against doing anything at their last meeting.

On Wednesday we get the Personal Income and Personal Spending report. Both are expected to rise by 0.3%, meaning that the savings rate will stabilize at the very low level of just 3.6%. A falling savings rate gooses the economy in the short term, but is not healthy over the long term, and in recent months has fallen significantly.

Eventually spending growth has to be supported by income growth. In September income rose just 0.1% and spending was up 0.6%. The sources of income are almost as important as the total growth of income, and of late the sources have not been great. What meager income growth there is has been flowing to the top of the income distribution, and is not widely dispersed.

We also get New Orders for Durable Goods, which are expected to decline by 1.0% on top of a 0.6% decline in September, but mostly due to the very volatile transportation equipment sector. Excluding transportation, orders are expected to be unchanged after surging 1.8% last month. Next month, though, it is likely that the transportation equipment segment will surge as Boeing (BA - Analyst Report) just got some very large orders from the Middle East.

The rest of the week is free of economic data, just food and football on Thursday and crazy shopping on Friday. I hope everyone has a tasty turkey and is safe in their travels.

I’m still holding on to my 1325 forecast for a year-end S&P 500 level. That is the forecast I made back in late July, down from my start of the year forecast of 1400. We will most certainly not get there in a straight line. But a 9.1% move is worth playing for, so I would be buying the dips along the way.

Valuations are simply too compelling at these levels and at least for now, the economic picture is improving here at home. If we got evidence that Europe is going to actually get ahead of the curve or if it looks likely that the payroll tax cut is going to be extended, I would get much more bullish.

Based on the current expectations of $104.95 worth of earnings for 2012, that level would only be a P/E of 12.6x, or an earnings yield of 7.92%. That is more than twice the yield you get on the 30-year T-bond, and more than three times what you get on the 10-year. Of the 392 S&P 500 firms that pay a dividend (and hence where yield is a valuation criteria) 58.2% pay more than the 10-year, and 32.7% pay more than the 30-year.

Dividends tend to grow over time; the coupon payments on a T-note never do. Long-term investors should feel like a kid in a candy store in this environment, even if we do face substantial macroeconomic uncertainties.

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