Judging from Wednesday's 312-point drop in the Dow Jones Industrial Average, the equity market could be replacing the bond market as the new "vigilantes" who try to drive some sense into Washington, Schwab's chief investment strategist Liz Ann Sonders suggested in a conference call this morning.

Without making any outside-the-box predictions, Sonders noted that the election, which maintained the status quo, with Democrats controlling the White House, picking up a few Senate seats and the Republicans holding on to their dominant position in House, "provided no additional clarity."

Mike Townsend, vice president of legislative and regulatory affairs at Schwab, found the stalemate result of the election "surprising," given the overwhelming evidence that the American public is frustrated with Washington gridlock. The Democrat's gains in the Senate were considered "implausible" a year ago.

Today the path to resolving the fiscal cliff remains "as muddled as ever," Townsend said. Nobody appears willing to blink, making a grand bargain later this year unlikely. If Congress fails to pass a patch, the Alternative Minimum Tax (AMT) could hit 25-30 million Americans next April.

Sonders thinks the equity market could be in for rough sailing, recalling when budget negotiations collapsed in the summer of 2011. As LPL Financial's chief market strategist Jeff Kleintop has observed, a 10 percent correction in the Standard & Poor's 500 didn't bring the Beltway to its senses.

Despite these factors, recent signs point to an upswing in the American economy, Sonders said. Export growth figures indicate that third quarter GDP could be revised upwards from 2 percent to the 3 percent area. Consumer confidence, buoyed by lower gasoline prices and rising home prices, has been on a meaningful upswing.

But the fiscal cliff pain is likely to attack the stock market., not the bond market. Fed chairman Ben Bernanke has the tools to keep bond prices a lot calmer than stock prices.

If the fiscal cliff were resolved in a way that includes meaningful tax reform and starts to address entitlement reform, it would be "an incredible positive," Sonders said. But she doesn't have a lot of confidence in that materializing.


Were both sides unable to reach an agreement to even kick the can down the road for another year, a recession in 2013 could play out gradually, not suddenly, Sonders said. Noting that the recovery has been unusually weak, she remarked that it's hard to get badly hurt "falling out of a basement."