10/22/2012 8:45 PM ET|
Will US stocks fall off fiscal cliff?
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.
In recent days, you might have noticed that Wall Street analysts have been raising their predictions for 2013.
With the Standard & Poor's 500 Stock Index ($INX) near its 2012 high at 1,460 on Oct. 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 U.S. 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 past 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 others 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 U.S. 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 U.S. market doesn't, or at least outperform a decent U.S. 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 U.S. 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 U.S. markets as investors sought a safe haven during the eurozone debt crisis has been a major factor in driving up the prices of U.S. stocks and bonds in 2011 and 2012. A reversal of those flows would act as a brake on U.S. 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 the place to start.
U.S. at the cliff's edge
One of the most striking things about recent predictions for 2013 has been the assumption that the U.S. just won't drive off a fiscal cliff at the end of 2012 or at 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 U.S. economy back into recession.
I think the most likely outcome is indeed some kind of deal that prevents the U.S. 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 Investors Service about possible downgrades to the U.S. AA credit rating and some posturing by partisans on the Democratic and Republican sides. (The latter scenario 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 U.S. fundamentals, but instead a judgment on the relative quality of those fundamentals versus the eurozone and China.
So if the squabbling in the U.S. 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.
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