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The big story yesterday was the S&P decision to put U.S. debt on watch with a negative outlook. This led to a strange trading day where stocks traded lower, bonds moved higher (!), the dollar strengthened, and the CDS spread on U.S. debt (measured in Euros) move up a few bps.

Nearly everyone discussing the markets was spinning the data for political purposes. I usually do not write on Mondays, since it takes me about six hours of work for my weekend preview, but I had a lot of email today requesting a reaction. There is mass confusion!

Let us start from strength.

Get Perspective From the Pulitzer Winner

I extend hearty congratulations to David Leonhardt on his well-deserved Pulitzer Prize. The deficit question was one of his important themes, and we all have a chance to learn from his work. Before leaping to some conclusion about the best public policy and what everyone in Washington is doing wrong, why not get a fact-based perspective. If we want to criticize those in power, we should have our own plan -- -right?

I understand that the readership of "A Dash" is very astute, but this is a good challenge. Before reading on, please check out the NYT puzzle on the deficit. Come up with your own solution. I guarantee that you will be surprised. This was set up before the Bush tax cut extension, but that is OK, especially now that Greenspan is calling for the end to these cuts.

Do you have your own answer? OK, you may now read on with more insight than you had five minutes ago.

My Approach

I know that most readers will not take a few minutes to learn about taxing and spending, so here is a shortcut.

The most helpful way to respond is with an Investor Guide. These are all conclusions that I have reached and would be willing to defend in a careful exchange of evidence. Having said this, I am not going to make the entire argument now. It is what I am thinking and acting upon, freely shared, but with no guarantees!

Propositions

Here is what I have concluded:

  1. The market reaction today made little sense. If U.S. debt is more questionable, bonds should trade lower. This did not happen. Various experts like bond guru Rick Santelli have contrived explanations about this, but the simplest is best: This was not real news for the bond market.
  2. The bond market is usually viewed as being more savvy than the stock market, especially by bears. What happened today?
  3. The S&P outlook is essentially correct. The window of opportunity for a major reduction in the deficit is quite small -- only a few months. The probability of success for deficit reduction is rather low. My own guess is probably less than 1/3.
  4. The economy might make enough progress to reduce the deficit in conjunction with more modest cuts.
  5. Progress in reducing the deficit will be quiet. You will not see it in the major headlines. If anything happens, it will be in quiet negotiations between the White House and Senate Republicans.
  6. If there is not rapid progress, we will drift into 2012 campaign mode, with accusations of blame all around. This might be the single most likely outcome.
  7. Joe Weisenthal is on the right track in this article, since the stock market has a fixation on the end of QE II. This is a better explanation than any of the spinning on Fox or CNBC.
  8. If you want to see how normal people view this issue (and you should) check out the coverage on PBS. The featured guest, Nick Perna, does a better job on the subject than anyone I saw all day.
  9. The most likely course of action will be short-term stimulus, long-term attention to debt. If you do not like this, you may invest accordingly.

Investment Implications

My initial take is that assertions of incipient austerity are completely wrong. I do not expect significant policy changes from today's news. The idea that this is a "warning shot" and that everyone will come to attention is the typical Wall Street self-centered myopia.

My conclusion is that the selling in sectors like defense stocks and health care is overdone. That is where I am shopping.

Stocks held or on buy watch: Wellpoint (WLP), UnitedHealth Group (UNH), Boeing (BA), Lucky Strike Explorations (LCK), and similar names.

Source: Playing S&P's Downgrade of U.S.: Shop Oversold Defense and Healthcare Sectors