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Market needs to plunge to force Congress to act

October 8, 2013: 12:21 PM ET

The market tanked five years ago after investors underestimated how dumb Congress can be. That may happen again.

The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, Abbott Laboratories and AbbVie, La Monica does not own positions in any individual stocks.

Amazingly enough, investors still don't appear to be too scared about a potential debt default by the United States.

And unless traders start showing some real fear, Congress may not act until after significant damage is already done.

The Dow is down about 5% from the all-time high it hit shortly after Labor Day. The broader S&P 500 is just 3% below its record -- also from early September.

Given that the market has been hotter than Peyton Manning (okay, nothing is that hot) for most of the year, it's not surprising that stocks have cooled during the past month.

Even if there was no government shutdown/debt limit drama in Washington, investors would still have reason to take a break from buying. After all, there are concerns about earnings and whether stocks are overpriced.

But this dribs and drabs sell-off is a sign that investors still expect our nation's least and dimmest on Capitol Hill to eventually reach a last-minute deal to raise the debt ceiling. Why worry if you think, a la Bob Marley, that every little thing is gonna be all right?

Related: Hedge funds say to wake us up when the U.S. defaults

I get lots of research notes e-mailed to me from Wall Street strategists and institutional investment firms. There is nearly no sense of alarm about the dysfunction in DC. Here's a sampling of some headlines:

  • TIAA-CREF: Markets are Cautious but not Chaotic Despite Government Gridlock
  • Glenmede: A silver lining to the shutdown?
  • U.S. Trust: Shutting Down Washington: A Familiar Movie with a Predictable Ending
  • Garzarelli Capital: Indicators Still Bullish Even With Government Shutdown

This is problematic. If lawmakers feel Wall Street is not concerned about the debt ceiling, then politicians may erroneously conclude that they don't need to act with a sense of urgency to avoid a potential default. Investor complacency + partisan pigheadedness = a disaster waiting to happen.

Remember what happened to stocks a little more than five years ago?

After the bankruptcy of Lehman Brothers in September 2008 -- which was quickly followed by the failure of Washington Mutual, fire sale of Wachovia, near collapse of AIG (AIG) and concerns that several other major financial firms could go belly up -- Congress was faced with a simple task.

Approve a bill that would lead to a $700 billion rescue/bailout of the nation's banking system.

The bill was backed by President Bush as well as House Speaker Nancy Pelosi. In other words, the leaders of both the Republican and Democratic parties at that time. Most investing experts felt the legislation would easily pass in the House. Who would want to vote against something that could lead to another depression?

The House rejected the bill on September 29, 2008. The Dow fell nearly 778 points as a result, a stunning 7% plunge that still ranks as the worst one-day point loss in the Dow's history. The Senate wound up passing a revised version of the bill on October 1, and the House followed suit two days later.

Sadly, we may need another cataclysmic sell-off like that to wake up Washington. Investors made the mistake five years ago of assuming that politicians would not be so dumb as to willingly throw the nation's economy off a cliff.

"The likelihood of a default still seems remote, but only so because the underlying assumption is: Politicians cannot possibly be foolish enough to let that happen, can they? However, it cannot be dismissed entirely," wrote David Joy, chief market strategist with Ameriprise Financial, in a report Monday.

Related: What's up with the debt ceiling?

So if we get closer to October 17 (just nine days away!) without any significant signs of progress, then maybe investors should send Congress a message and dump stocks en masse before we have to find out what a default would look like.

And maybe that will happen. CNNMoney's Fear and Greed Index, which looks at the volatility gauge known as the VIX (VIX), along with six other indicators of market sentiment, has finally dipped into Extreme Fear mode -- a level it's been flirting with for the past few weeks.

Still, the index is now hovering around 21. It only needs to go up 4 points to be back in "normal" Fear.

To put this in perspective, the Fear & Greed Index was barely above zero (it can't go any lower than that) shortly after Standard & Poor's downgraded the credit rating of the United States in August 2011 -- the last time Congress flirted with default.

Related: Bond investors refuse to panic despite default fears

In other words, investors still aren't as terrified as they should be. And that's troublesome.

Politicians cannot afford to roll the dice and hope that the market will continue to act as if nothing's wrong. Investors have a funny way of showing their disapproval when people don't do what's expected.

But the market may not react as if anything is wrong until the unthinkable happens and the U.S. defaults.

So someone has to blink. Investors still may have some faith in our elected officials to do the right thing just in the nick of time. I don't. That's why we might need a preemptive "TARP moment" to shock some sense into Congress.

Halloween may have to come early for Wall Street and Washington.

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Paul Lamonica
Paul R. La Monica
Assistant Managing Editor, CNNMoney

Paul R. La Monica is an assistant managing editor at CNNMoney. He is the author of the site's daily column, The Buzz, and also tweets throughout the day about the markets and economy @LaMonicaBuzz. La Monica also oversees the site's economic, markets and technology coverage.

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