Will Stocks Fall Off the Fiscal Cliff?
10/23/2012 11:52 am EST
Analysts are raising their predictions for the coming year. But if the scheduled tax hikes and spending cuts prove imminent, overseas assets could be the place to be, writes Jim Jubak, also of Jubak's Picks.
In recent days, you might have noticed that Wall Street analysts have been raising their predictions for 2013.
With the S&P 500 near its 2012 high at 1,460 on October 18, analysts had been calling for the index to challenge its all-time high of 1,565—set in 2007 just before the global financial crisis—next year. Following the stock market’s long tradition of making most investors look like idiots most of the time, the S&P 500 dropped by 1.7% the next day.
What I find oddest about these predictions, though, is not that they’re necessarily wrong, but that they ignore the facts of life in the financial markets for the last two-plus years—and one big factor you'll need to watch closely that could take US stocks out of the next move up.
Correlation and the Fiscal Cliff
The predictions I’ve seen put prospects for earnings growth at 7% to 11% in the fourth quarter of 2012, which, following a decline in earnings in the third quarter, would set up the market to move ahead in 2013.
Or they foresee continued low interest rates from the Federal Reserve and the extra liquidity being pumped into the economy and market by the Fed’s most recent program of quantitative easing. Or they argue that although the price-to-earnings multiple on the S&P 500 has climbed to 13.3, from 12 at the beginning of 2012, there’s still room for further advances because the multiple at the peak in 2007 was 15.2.
All those observations are true, but they’ve been beside the point recently. What’s oddest to me about these predictions is that so few take into account the peculiar macro-driven nature of the financial markets over the last couple of years.
Since basically the spring of 2010, when investors around the world started to focus on the possibility that Greece, Ireland, Portugal and more were facing default, financial markets have been dominated by big macro trends. And that has meant that they’ve moved in startling lockstep—what the market calls "correlation."
This means that the most important question for you now as you set up your portfolio for the coming year isn’t whether the US market might move up 9.2% by the end of 2013. It's whether this lockstep period might be coming to an end, and whether in 2013 other markets might be able to rise even when the US market doesn’t, or at least outperform a decent US market.
You’ll recognize the pattern I’m about to describe. After all, we’ve lived with it for roughly two years.
When fears about the Eurozone flared, global assets moved toward “safe havens" in the United States and Japan. To investors trying to hedge their risks, the effects could be disconcertingly widespread.
A stronger dollar, for example, could lead to a price drop in commodities (and commodity stocks) and even produce a retreat in the price of gold. Gold, an asset purchased to hedge against financial turmoil, falling because of financial turmoil? Go figure.
When it looked like one plan or another might succeed in heading off the Eurozone crisis, European stocks and bonds would rally. And so would other risk-on assets, such as stocks in emerging markets.
Add in such macro drivers as fears of a hard landing in China or a slowdown in US economic growth, and you don’t change the story—the price of assets still determined by macro trends—even if you make it more complicated.
I don’t see how any analyst can make a prediction for 2013 without taking the macro-driven nature of the past, current and, I’d argue, near-term future market into account. Global cash flows, major drivers of asset prices, are nervously trying to figure out the risk and reward of stakes in specific markets and asset classes.
The money that flowed into US markets as investors sought a safe haven during the Eurozone debt crisis has been a major factor in driving up the prices of US stocks and bonds in 2011 and 2012. A reversal of those flows would act as a brake on US asset prices, and encourage the appreciation of assets in the markets receiving those flows.
Macro trends won’t be the only determinants of asset prices in 2013, but decisions about allocations among markets and asset classes need to take our best projections of those macro trends into account.
To unravel those trends, and to get some insight into how markets are likely to be in the rest of 2012 and in 2013, I think the looming fiscal cliff in the United States is place to start.|pagebreak|
US at the Cliff's Edge
One of the most striking things about recent predictions for 2013 has been the assumption that the US just won’t drive off a fiscal cliff at the end of 2012 or the beginning of 2013.
Politicians in Washington, Wall Street assumes, won’t be so stupid, self-destructive and shortsighted as to let a combination of the expiration of the Bush tax cuts, the end of the reduction in Social Security taxes and the imposition of automatic budget cuts send the US economy back into recession.
I think the most likely outcome is indeed some kind of deal that prevents the US from pulling a Thelma and Louise. But we can be assured that the process won’t be easy, smooth, or quick.
There will be moments when a deal appears to be just around the corner and moments when it seems impossible. We know from the long-running cliffhanger that is the Eurozone debt crisis that the cumulative effect of this kind of melodrama is a gradual increase in nervousness and fear.
Also throw in, as I think we should, a couple of warnings from Standard & Poor’s and Moody’s about possible downgrades to the US' AA credit rating and some posturing by the partisans on the Democratic and Republican sides. (This is extremely likely if President Barack Obama wins re-election, and some Republicans decide it’s their job to make sure his second term doesn’t succeed.)
Given all that, it’s hard to see why investors would be willing to award the United States automatic “safe haven” status.
How big any gradual diminution of the “safe haven” premium will turn out to be over the next two quarters or so will depend not just on what does or doesn’t happen in the United States, but also on how macro trends unwind in both Europe and China. Remember that the market’s vote of confidence in the United States hasn’t been a vote for the absolute quality of US fundamentals, but instead a judgment on the relative quality of those fundamentals versus the Eurozone and China.
So if the squabbling in the US over a solution to the fiscal cliff rises in volume at the same time that the Eurozone and China look relatively less risky, we could see a fairly high flow of investment cash into European and Chinese financial assets.
And how likely is it that Europe and China will seem less risky over the next few months? Notice the exact wording of my question. I’m not looking for an actual solution to the deep-seated problems of the European currency union, or a rebalancing of the Chinese economy and reform of the Chinese banking system.
Instead, I’m trying to gauge whether we’ll see temporarily convincing short-term moves that raise confidence in those two economies. And the answer to the question, when it’s phrased that way, is that an increase in short-term confidence is likely in the next two months.
Optimism on Europe, China
November is likely to bring a formal request from Spain for the European Central Bank to start a program of buying Spanish government debt, as well as a disbursement of the next payment of cash to the Greek government from the European rescue fund.
Neither of these acts will solve the Eurozone debt crisis in the longer term. I think Greece will need another writedown of its debt sometime in 2013, and this time the ECB will have to swallow the bitter medicine and participate in the writedown.
And I think bond-buying support for Spanish government debt won’t significantly add to Spain’s economic growth, reduce the country’s horrific unemployment rate, save its regional governments from what amounts to bankruptcy, or make the huge amounts of bad real-estate debt disappear from the balance sheets of Spanish banks. All these efforts will do is buy time.
But—and this is the crucial aspect, from an investor’s point of view—November’s actions will reduce fears that the eurozone is about to blow up and that Greece and/or Spain is about to be thrown out of the club and into international default. That may not bring cash flooding back into European assets—the eurozone economies will still be near recession levels of growth—but it will be enough to reduce the demand for US assets as a hedge against a European disaster.
China is in an analogous position. Its financial markets have rallied in the last six weeks on a belief that the third quarter marks a bottom for China’s economic growth rate.
Recent weeks have brought retail-sales, export and money-supply numbers suggesting that August may have been the low and that September has brought a modest recovery. The fear of a hard landing for China’s economy will recede as long as we don’t get data that turn current hopes into disappointment.
What’s the effect of all this on the markets?
- The dollar weakens against the euro. That’s good for commodity prices, which are likely to move up on hopes for Chinese economic growth. It also leaves room for gold to advance on a decline in the US currency and fears over the US fiscal cliff.
- Emerging-market stocks will look more attractive as fears that the eurozone debt crisis will blow up ease, temporarily, to a simmer from a boil.
- China stocks in particular and emerging-market stocks in general should get a boost as fear of a Chinese hard landing diminishes and as hope rises that China’s growth rate has bottomed.
- Better-than-expected economic growth in the United States will, of course, improve the prospects of US stocks. But to investors who fear the US fiscal cliff, non-US companies that export to the United States might be a better way to play this extra growth.
How Scary Is the Cliff?
The exact way this plays out across global markets depends largely on how scary the US fiscal cliff starts to seem.
If it’s very scary, I think we’ll see a continuation of the recent trend of most markets and assets moving together. If the US looks like it’s headed off a fiscal cliff, I think it will be hard to imagine other markets moving up. The one asset I’d expect to do well in this scenario is gold, which would rally on fear and the fall in the US dollar.
If, however, the US scenario is only moderately scary, I think we will see some markets move out of strict correlation. A moderately scary crisis is enough to make investors think about whether the potential of a 9.2% gain in US equities (that’s the distance to the 1,565 top of 2007 from the October 19 S&P close of 1,433) makes up for the risk of a credit downgrade, a fiscal logjam in Congress, or an irresponsible compromise that rattles credit markets.
When the bullish analysts on Wall Street are offering you only a 9.2% potential gain from current prices, it doesn’t take much fear to make the offer unattractive.
And in this case, emerging-market stocks would make an attractive alternative—if growth in China looks like it has stopped tumbling. Certainly the potential upside is more attractive.
The Shanghai Composite Index is down 38.1% from July 2009 and down 63.2% from its November 2007 high. That’s enough potential—if macro trends don't make any risk look too risky—to make China and other emerging markets attractive in any less-than-really-scary global scenario.
The Moves to Make
In practical terms, what does that suggest you do?
Check your portfolio’s exposure to gold and other precious metals. Gold has done reasonably well this year, with the SPDR Gold Shares (GLD) exchange traded fund up 9.86% as of the close on October 19. But that does trail the S&P 500 so far this year (up 15.96%). I think those relative performances could reverse in 2013, with gold leading the S&P.
I don’t think you need to move out of all your US positions by any means. But I would concentrate on sectors that show some ability to outgrow the general US economy right now. Two I’d suggest:
- Housing and housing-related stocks, which are big beneficiaries from the Fed’s newest round of quantitative easing.
- Technology shares, which have been battered by bad earnings news from PC sector leaders Intel (INTC) and Microsoft (MSFT). This week brings a quarterly earnings report from Apple (AAPL), which will go a long way to determining the near-term chances of a technology rally.
A little further down the road, check to see how scary the US fiscal cliff crisis seems to be. The scarier it is, the more you should look for safety in your US stock portfolio. I’d look to dividend payers and consumer stocks, especially if they’ve been crushed lately, like McDonald’s (MCD) was last week.
At the same time, I’d be slowly adding positions in China, Brazil and other emerging markets. My column "4 Good (and 5 Bad) China Stocks" gives you some suggestions on stocks to look at and how to stage any buying in that market. I’ll be taking a similar look at Brazil in the next week or so.JUBAX), may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple and McDonald’s as of the end of June.