EmailEntering 2012 we thought there was a reasonably high probability that the stock market would post a strong gain this year. There are still a few weeks to go and an all-important fiscal plan hangs in the balance, but so far the S&P 500 is up 12.7% year-to-date, excluding dividends.
Our view then was predicated on three factors:
- Stock prices were flat in 2011 despite earnings increasing 14%, suggesting there was ample room to play catch up if the market could temper its fears of worst-case scenarios unfolding
- The risk of a credit implosion in Europe and the residual impact on the global economy was overblown and
- US economic growth was building a stronger base and was accelerating
A year has made a lot of difference for equity investors in a good way. Unfortunately, we are not as hopeful about the market outlook entering 2013. Once again, we can point to three factors in particular driving our perspective:
- Economic growth is decelerating
- Fiscal austerity is just beginning in the US and there is too much complacency about its outcome and
- Earnings growth estimates are too high
Those factors may not conspire to produce a negative return for the stock market in 2013, yet they present real obstacles for achieving another strong gain and raise the importance of managing against downside risk.
Stay Balanced
With lingering uncertainty, and regular mood swings expected, a blended investment strategy for the equity component of one's portfolio could make sense entering 2013. That is, don't overweight or underweight cyclical and countercyclical sectors exclusively. Maintain a balanced mix, as that will allow for participation in upside moves and help mitigate losses in down markets.
Given the potential for a low-return investment environment, we see value in total return strategies. Dividend-growth stocks, and "Dividend Aristocrats" in particular, look appealing for their income-generating potential.
Some general approaches for investors aiming specifically to guard against downside risk for their equity portfolio include:
- Hedging through the use of options
- Reducing exposure to high-beta stocks
- Favoring stocks in countercyclical sectors (eg. health care, consumer staples, utilities, and telecom services), which should exhibit better relative strength in volatile periods
- Owning companies with strong balance sheets and the capacity to increase dividends in any environment
- Buying shorter-duration bonds and
- Raising cash
Trend Watching
There are some encouraging trends unfolding in the US economy. Housing starts, home sales, and home prices are rising; vehicle sales are surging; and consumer confidence is increasing.
At the same time, though, we are witnessing a deceleration in export/import growth, industrial production, core retail sales (which exclude auto, building material, and gasoline station sales), and manufacturing activity. Meanwhile, nondefense capital goods orders excluding aircraft -- a proxy for business investment -- and the labor force participation rate are actually declining.
A Strange View
Entering 2012 we didn't think underlying trends in the economic data presented a substantial risk to the stock market. That isn't the case as 2013 draws near.
The charts above show a number of weak trends that are offsetting the positive contribution from housing. In turn, they reflect the struggles of global economies, the weak level of business investment, and a difficult labor market.
Uncertainty about fiscal policy has been blamed by many businesses for a lack of investment in economic and labor capital. There is a strange presumption that businesses will start spending freely again if they simply have clarity on fiscal policy.
That doesn't make sense to us considering any clarity on fiscal policy will involve some combination of higher tax rates and lower spending. That combination will cut into consumers' disposable income and will reduce aggregate demand.
In the face of slower growth, or even the same subpar growth we saw in 2012, it doesn't stand to reason that businesses will spend freely in 2013 simply because a fiscal cliff compromise has been struck.
On a related note, there is a surprising level of complacency regarding the outcome of a fiscal cliff compromise. The prevailing expectation is that any compromise will represent a good compromise. We're not seeing it that way -- or at least we haven't been given any reason to see it differently.
The tax rate on capital gains and dividends is certain to go up. That might not be an abject negative for the stock market, but it certainly isn't a positive. In turn, any compromise that is struck will be oriented around taking things away from taxpayers, not giving them more. That course will inevitably lead to slower growth that will pose a threat to the housing market recovery, particularly if reduced demand forces companies to cut employment costs further.
Our forecast for 2013 GDP, which incorporates the CBO's alternative fiscal scenario, is for growth to be between 1.0% and 2.0%.
Slugging Through
The OECD is forecasting a 2.0% growth rate for the US in 2013. That is hyper growth relative to the 0.1% decline the OECD is forecasting for the euro area and it is strong growth relative to the 0.7% increase the OECD is projecting for Japan. The US comes up short though against China, which the OECD expects to register 8.5% GDP growth in 2013 versus estimated growth of 7.5% in 2012.
There are a lot of degrees of economic growth separation, yet the overbearing point is that much of the developed world is simply going to be slugging through, dealing with the adverse effects of fiscal austerity, challenging demographics, and political dealings that involve new leadership in China, the debt ceiling and fiscal reform in the US, and election battles in Italy and Germany to name a few.
Remarkably, analysts are still projecting double-digit earnings growth for the S&P 500 in 2013.
According to Thomson Reuters, operating earnings are expected to increase 11% in 2013. That would mark an acceleration from the 4.0% growth rate estimated for 2012, which is hard to believe given the growth outlook for the US and the eurozone in particular.
With first quarter earnings anticipated to increase just 4.0%, analysts are clearly expecting things to ramp up as 2013 unfolds. Hockey-stick forecasting by analysts and economists alike is common on Wall Street where the outlook six months from now is always cheery. Given the vagaries of life, it will behoove investors to take such forecasts with a grain of salt. In January, the fourth quarter 2012 consensus earnings growth estimate compiled by FactSet was 17%. Today it stands at 4.0%.
We expect the earnings growth estimate for 2013 to be lowered in coming months. It does not mesh with economic growth forecasts and it does not fit with the consensus expectation that revenue growth will be up just 3.8%.
Profits can only go up faster than revenue with an increase in profit margins. Double-digit earnings growth is expecting too much with profit margins near record levels and growth in the developed world in such a languid state.
Two Is Better Than One
The equity market, fortunately, has two things going for it: (1) the Federal Reserve and (2) valuation.
We consider the Fed to be the market's first line of defense, because the Fed is purposely trying to drive up equity values by holding down long-term interest rates with its quantitative easing program. The Fed hopes the low rates will drive investors into higher-yielding assets like stocks and drive increased economic activity that is good for increasing corporate profits.
There is plenty of debate in terms of how much economic impact the Fed's accommodative policy has had on the economy, yet there is little question that the increased liquidity provided by the Fed has bolstered stock market values and has served as an important safety net during times of heightened uncertainty.
The risk entering 2013 is that the market loses faith in the Fed's ability to save the economy and the market with its monetary policy. It says something disheartening to be sure that we are nearly four years out from QE1 and the Fed is still expanding its balance sheet in an attempt to jumpstart economic growth.
An actual earnings decline could shake the market's faith in the Fed as a safety net. We're not saying that will happen, just that it is an underappreciated risk at this juncture.
A Long-Term Opportunity
At its current level, the S&P 500 trades at 13.9x trailing twelve month earnings, which is a modest discount to its historical average. It trades at 12.5x estimated 2013 earnings, which is relatively cheap if one considers those estimates to be credible -- which we don't. Even if there was no earnings growth in 2013, the market wouldn't be grossly overvalued.
Still, with capital gains and dividend tax rates set to increase, revenue growth due to be sluggish, and profit margins near record levels, the willingness to pay a premium multiple for earnings will be restricted.
The low rates on Treasury securities and the interest rate risk presented by the Fed's monetary policy, however, should raise the appeal of owning equities for long-term investors. The valuation argument for that contingent is much more compelling than the one that applies for investors with a time horizon that doesn't stretch past the next 12 months.
The long-term assessment is based on the spread between the S&P 500 earnings yield and the 10-year note yield, often referred to as the equity risk premium. According to the Fed model, stocks are a better investment alternative than bonds when the earnings yield exceeds the 10-year note yield. The spread between the two is currently 614 bps versus a 10-year average of 340 bps.
What It All Means
It is tricky to craft an outlook for 2013 at this point since there isn't any clarity on fiscal policy. Nonetheless, we are fairly certain that growth is going to be curtailed by fiscal policy. The only question is by how much.
The start of 2013 will be problematic if we go over the fiscal cliff and/or we see another debt ceiling standoff in Congress. Policy risk is high right now from a fiscal and monetary standpoint. That rings true for the US and much of the developed world.
That point notwithstanding, we have to respect the fact that the market could continue to fall back on the Fed's support and push ahead in the face of weakening fundamentals.
There is a decent chance the market will rally sharply early in the year if a fiscal cliff compromise is reached and the debt ceiling is raised since that would remove some worst-case scenarios. Still, there is ample risk tied up in the market's complacent belief that a fiscal cliff compromise will only produce positive outcomes and that earnings growth will be stronger in 2013 than 2012.
We are not sanguine, like others are, about everything turning copasetic as soon as the second half of 2013 rolls around. We'd be pleased if that were the case, but one has to respect the risk that it won't be the case.
Right now we are concerned that the market, which was too pessimistic entering 2012, is too complacent entering 2013.
Fiscal austerity will bite, as we have seen in the eurozone, political friction will persist both here and abroad, and earnings growth is unlikely to measure up to currently high expectations.
2013 is loaded with potential to be a fundamentally disappointing year. That might not translate directly in terms of stock market returns given the Fed's influence, yet investors should take care nonetheless to manage against downside risk.
