I don’t know if this is just poor policy or political gamesmanship (why not both?), but the White House tried to get $13B allocated to go to Seniors as a cost of living (COLA) adjustment to Social Security. From a (responsible) public policy perspective, this is a poor idea. If consumer prices declined this year (deflation), then we should be reducing payments to seniors in the social security program. That’s the deal. Rates are tied. If we suffer deflation, but give seniors a raise, the rest of us will pay for it. Seniors are already getting far more than they should from social security and far more than anyone under age 60 will see. There is no room in our budget for pandering.

Lest my distinct minority of clients that is Democrat be offended by this criticism, I will remind you that the previous administration’s expansion of Medicare part D causes a budgetary deficit that is several orders of magnitude larger than what the current administration is trying to get through. Neither party demonstrates fiscal responsibility.

I assure you the reason for this brief article is not political rant – there is no shortage of angry opinionated people (that are frequently uninformed) – and you don’t pay me for it. No, the reason I point this paltry $13B out is because it speaks to the mindset of the White House. Either they have no grasp of our current budget shortfall (not likely. Not a lot of stupid people there.) or – I’m sorry to say – this is probably political gamesmanship. By that I mean the White House may be trying to put its loyal opposition in a position where they have to say no to something that seniors would have liked. No one wants to risk offending seniors because they are a large voting block. If my interpretation is correct, this is both tragic and pathetic.

If you are searching for relevancy to investing, here it is: the white house / congress will apparently keep acting irresponsible until they are no longer permitted to (just like the previous administration) by forces they cannot control. Enter the bond market. Eventually the bond market will throw up in response to public largesse. It may come from our own bond market, from China reducing its treasury purchases, from a ratings agency downgrading our sovereign bonds, or some combination thereof.

Rubber meets road here:

Of this I am sure: 2010 will see a violent market response to the US federal budget deficit. US bond, then equity markets will force our federal government to select from several unpalatable choices. Combined with 10%+ unemployment –and a more powerful 20% U6 unemployment figure next year, we are looking at all the components of a violent market sell off again.

But wait. We’ve had a ton of poor economic news and the market goes up. What’s different about next year?

- because we’ll have to sell another $1.4T (or more) in treasury’s AND some of this year’s treasury’s will be coming due — thus adding to the supply we need to sell. (Has anyone noticed that the Chinese bought mostly 1, 2, 3 year treasuries this year?)

- because continued / repeated fiscal gimmickry and largesse simply will not be affordable next year. Eventually the straw will break the camel’s back – even if it is only a $13B straw.

- because many people have a small safety net of savings or home equity they may use if they lose a job. Once that is used up, things get desperate, fast. There is a finite & short amount of time the economy can improve or go sideways while suffering historically high unemployment in parallel with falling home prices and personal safety net accounts are depleted. FYI: The Wall St Journal says (today) that US residential real estate will not likely bottom until late 2010 at the earliest.

Of course, that does not preclude a continued momentum rally (S&P500 goes from 1100 to 1200?) after we get a correction this fall (to S&P500 at 900 – 1000?). The VIX (index of volatility on the US equity market) is at ultra-low levels – just like it was in October 2007. When investors are complacent, the VIX hits lows and we shortly thereafter get a stock market sell-off. (to those that are interested, please google search Hyman Minsky on how stability breeds instability). These recent US market movements are noise on a trend-line that is down. In the grand scheme, all that will matter is capital preservation with measures attempts to make gains from a slide in the US dollar and/or international growth, and commodity price gains. Tactical moves on US equity will be attempted but large sustained positions are not warranted.

Speaking of commodities— oil staying at the current price will reduce US GDP growth by 1.5 – 2%. Think we’ll be able to overcome that headwind while we have anemic growth next year as we unwind federal stimulus programs? Worse: current oil ($80) prices will cost Europe and Japan even more in GDP growth. All the more reason to bet on natural gas inventories being drawn down and the price up –despite some volatility there too. And yes, continue to skip Japan and Europe.