The MSCI Global benchmark is up more than thirteen percent year to date. Global markets are up about ten percent since the debt downgrade last August. According to money managers, the impending fiscal cliff is the top concern of investors, followed by the risk of a disorderly break-up of the Euro.
The jobless rate continues to slowly improve. The U.S. private sector is generating about 125,000 new jobs a month over the last twelve months. At this rate, the jobless rate could fall below six percent sometime in 2014, much more quickly than the Federal Reserve currently anticipates.
Much of the nation’s unemployment is concentrated in the construction sector. In some parts of the country, construction activity is picking up. Here in Austin, housing starts are thirty-seven percent higher this year versus last year. Chairman Bernanke recently announced a modification to the Fed’s quantitative easing policy. QE3 calls for the Federal Reserve Bank to purchase mortgage backed loans. The goal of this policy maneuver is to force mortgage rates lower. If this succeeds, home ownership will become increasingly affordable, and construction activity will continue to pick-up, boosting the overall economy.
Analysts expect earnings to grow by about twelve percent over the next year. The S&P 500 is currently valued at about 85% its long-term valuation. If the economy continues to normalize, it seems likely that the market will also normalize at average historic valuation levels. This revaluation, plus the earnings growth means that the market is not fully valued until it’s about 30% higher than today.
It’s been fourteen months since Standard & Poor’s and Moody’s downgraded U.S. debt. The day following the downgrade, the S&P 500 traded at 1119. Today, it closed at 1441, 28% above the post-downgrade low. The chorus of doom and gloom was deafening a year ago, but somehow, the economy continues to muddle along, while earnings for U.S. companies continue to improve.
The two most immediate risks to the slow but steady gains in stocks are the fiscal cliff, and the European debt crisis. Today, the vast majority of professional money managers feel that the risks of going over the fiscal cliff are greater than the break-up of the Euro. In case you’ve avoided all news media for the past six months (who could blame you?) the fiscal cliff is the result of the deal made last fall during the debate over increasing the debt ceiling.
If Congress can’t make an alternate agreement, among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. Additionally, spending cuts will begin to go into effect. According to Barron’s, over 1,000 government programs – including the defense budget and Medicare are in line for deep, automatic cuts.
If the current laws go into effect in 2013, the impact on the economy will be substantial. Higher taxes and spending cuts would reduce the deficit by $560 billion. But, the Congressional Budget Office (CBO) estimates that the 2013 laws would reduce GDP by four percent and increase unemployment by 1%.
The markets act as an enforcement mechanism on the politicians. Incumbent politicians are very sensitive to the mood of the markets. Almost four years ago exactly, in October 2008, the House rejected the first TARP bailout proposal. The markets dropped thirty percent in two weeks. This was a sickening drop that eventually led to policies that would stabilize the market.
As far-fetched as it seems, it’s still possible that Congress and the President can find ground for mutual agreement. It seems fairly obvious that our current situation calls for a long-term plan to manage our deficit. If they can agree on a long-term solution, we don’t have to inflict excess, unnecessary punishment on a fragile economy. It’s in pretty much everyone’s interest that they come up with a long-term solution.
It’s going to be an interesting few months. There is no shortage of market moving events between now and next spring. Europe seems to have the constructs and policies in place that will allow the creditor nations, led by Germany, to take more control over the fiscal policies of the debtor nations while the European Central Bank stands by with a fire hose of liquidity to put out any emerging banking or government debt crises.
The S&P 500 fell to 900, 60% lower than today. Only in the last few months did we finally exceed the pre-crash highs of 2008. Today, the S&P 500 is less than ten percent from an all-time high. We have positioned your portfolio in high quality, undervalued, global companies that will hold up if we go over the fiscal cliff, or if Europe takes a turn for the worse.
As long as events aren’t boiling over, the market has proven its ability to advance. The improvement in earnings growth due to low employment costs and low interest rates increases the value of the company. The Federal Reserve claims it will keep interest rates low into 2015. As long as they are manipulating interests rate lower, corporate profits will stay elevated.
If we can avoid a major policy mistake over the next few months, the market should be set up to rally substantially in 2013. It’s been a long road back from the lows of 2008 and 2009, but the market and economy continue to adapt to the “new normal.” This is the historic pattern. Each crisis is different, except that they all are eventually resolved.
