Equity markets sank sharply last week as the European debt crisis worsened and the US super committee failed to come to an agreement. Because the political problems in the United States and the crisis in Europe could result in a nearly endless array of outcomes, investors are faced with a high degree of uncertainty. As a result, unless and until more clarity emerges, markets are likely to remain somewhat trendless in the near term.

While much of the focus on the euro crisis has been on Greece and its risk of defaulting, in recent weeks, that focus has shifted to a general lack of liquidity within the European debt markets as banks struggle to maintain credit ratings. Many large global banks are attempting to sell or reduce their exposures to troubled European sovereign debt, and the selling pressures are triggering a new surge in government bond interest rates. This, in turn, has been forcing more countries into higher debt burdens and bigger deficits.

At this point, it has become clear that the measures taken so far to stem the crisis have not been sufficient. In our view, it will probably require the creation of something like a commonly issued euro bond to contain the debt crisis. Although Germany has so far resisted that possibility, there are growing indications that such a solution may well be forthcoming.

Regardless of what happens in the debt crisis itself, a recession in Europe now seems a foregone conclusion. Should policymakers be able to come to an effective resolution soon, the recession is likely to be shallow, but risks are growing that the recession could be deeper. It is an open question as to how much a European recession would impact the United States and other global markets. The main risk comes in the form of the intertwined nature of the global credit markets since severe European bank deleveraging could negatively impact US credit availability as well.

The failure of the super committee to provide a plan to reduce the deficit was certainly disappointing, but it would be a mistake to put too much stock in that specific incident. The deadline imposed by Congress was an arbitrary one and the automatic cuts set to take place as a result of the non-decision will not occur until January 2013. As a result, Congress still has an opportunity to address deficit reduction, but of course the fact that all of this is occurring with the backdrop of the 2012 elections means that uncertainty levels are elevated.

In our view, the more important question is whether or not Congress will be able to extend the payroll tax cuts and unemployment benefits set to expire at the end of this year. Should they be unsuccessful in doing so, it would likely create a significant fiscal headwind in 2012.

Somewhat lost amid all of the euro debt and US political headlines has been the fact that US economic data has continued a gradual improvement. The November payrolls report is set to be released this Friday and indications are that it will be decent. True, last week it was reported that third-quarter gross domestic product (GDP) growth was revised lower, but the inventory reduction that occurred may help set the stage for a stronger fourth quarter. At this point, fourth-quarter GDP looks to come in at 3% or possibly higher based on improved profits, a better labor market, increased capital expenditures and a low cyclical starting point for inventories.

Economic acceleration should create firmer footing for stocks, but for the time being, we believe markets will remain focused on the short-term headlines. Of all of the factors affecting the markets (US politics, the economic slowdown in China, etc.) the most critical remains the European debt crisis. Stocks are likely to remain range bound (trading between the 1,100 and 1,250 level for the S&P 500) for now, but should policymakers be successful in gaining some traction, markets could see some better results.

Thank you for your continued confidence in Martone Capital Management. We welcome your comments and questions.

William A. Martone - President CLU, ChFC

Michael C. Martone - Registered Principal

www.martonecapital.com

William Martone is President and Senior Portfolio Manager of Martone Capital Management, Inc., which was founded in 1994. Bill has almost 40 years of experience in the financial services industry and manages portfolios for both individual investors and pension funds using multiple investment strategies. Bill is a Chartered Financial Consultant, Chartered Life Underwriter, and New York State Registered Investment Advisor. He is frequently quoted in the Westchester Journal Business News as well as other publications. Martone Capital Management was featured on CNNfn.