This commentary originally appeared at 8:41 a.m. EST on Jan. 14 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
"Beware of false prophets, which come to you in sheep's clothing, but inwardly they are ravening wolves."
-- The Holy Bible, Matt. 7:15 (King James Version)
Markets move based on how events transpire relative to consensus expectations, and it is my view that many commonly held and more upbeat expectations for 2013 are too optimistic -- perhaps substantially so.
To be sure, Mr. Market's momentum from the end of 2012 and year-to-date 2013 has been impressive, but Mr. Market is often fickle and the wolf could emerge out of the sheep's clothing.
With higher share prices has come a degree of investor optimism that is all too often associated with previous tops.
Most recently, the failure of the fiscal cliff debate to accomplish much of anything has been ignored by investors. I am now convinced that hyper-partisanship will prevent meaningful budget cutting legislation in the months ahead.
This is a profound negative, as it relates to our economy and our investments.
From my perch, the current degree of bullishness (among other reasons) is founded on the notions that:
- there is a global monetary put that limits the market's downside;
- fund flows will move out of bonds and into stocks (and reverse the trend in place since 2007);
- equities are cheap relative to interest rates;
- the economic recovery is healthy and self-sustaining;
- the growth in corporate profits will continue apace;
- corporate balance sheets are pristine; and
- the housing market will have an above-average 2013 (capable of offsetting some of the Washington induced drag).
While some of these factors have merit, I believe, nonetheless, that there is less than meets the eye to the current equity market advance.
Market participants, for now, are ignoring conspicuous headwinds and rationalizing the irrational.
So, I wanted to start the week by describing what I see as the most powerful headwinds and suggest that the high for S&P 500 in 2013 might be accomplished in the first two weeks of the year.
An Aging Advance
The economic recovery is aging (it is now four years old), and the bull market is maturing (of a similar age). These advances are typical of the life of the previous ones -- both in terms of duration and magnitude. In terms of economic growth, consider that, according to Zero Hedge, fourth-quarter 2012 real GDP estimates were ratcheted down last week:
- Goldman Sachs reduced from +1.8% to +1.3%.
- JPMorgan has gone from +1.5% to +0.8%.
- RBS decreased from +1.5% to +0.7%.
- Nomura went from +2% to +1.3%.
Unsustainable Fiscal Policy
The U.S. is running trillions of dollars in deficits while maintaining zero interest rates -- these are unsustainable policy strategies. The inevitable reversals of these policies will undoubtedly result in slower growth, rising interest rates and less attractive valuations.
The Earnings Cliff Is Upon Us
The fiscal drag may be understated both on domestic economic growth and profit expectations. Though the drag from the fiscal cliff agreement appears to many to be a manageable $250 billion-$280 billion (or less than -0.80% taken off U.S. GDP), the actual multiplier of this drag is greater than most are projecting (over -1.5%).
Consensus domestic economic growth expectations may be overstated. Moreover, there should be additional drags from spending cuts in the upcoming debates. Consensus real GDP growth in the U.S. is about +2.5% -- I expect no better than +1.5%.
In terms of S&P profits, the "V" in profits and profit margins since 2008 is likely over. Already margins in fourth quarter 2012 are expected to drop from 9.5% to 9.1% sequentially. Consensus 2013 S&P profits are about $107 a share, top-down estimates are about $108 a share, and bottom-up estimates are north of $112 a share. I live at $95-$97 a share, which, if accurate, will be a big disappointment (and will almost negate the possibility of multiple expansion, which has become the meme of strategists).
The early fourth-quarter earnings report card is unimpressive. For example, Wells Fargo (WFC) had a slight penny beat, but its effective tax rate fell from 34% to 27% and mortgage originations slipped by $15 billion, to $125 billion sequentially.
The Interest Rate Cliff May Lie Ahead
Bonds, which have been in a 30-year bull market, are likely to be poor investments in the years ahead -- perhaps much worse than most believe. The consensus appears to be that the 10-year will rise no higher in yield than 2.25%-2.50% in 2013-- based in part on continued deleveraging, slow growth and a friendly Fed (which will effectively repress long rates). It is important to recognize, however, that there is a limit to how much interest rates can rise before other asset prices are negatively impacted, as long-term interest rates are the discount rate upon which future profits are valued.
A Reallocation out of Bonds Into Stocks Is Not a Certainty
There are numerous reasons why a broad reallocation is a premature thesis. Mutual funds are generally nearly always fully invested (with little cash in reserve), and large pension plans are slow-moving and usually respond only after a clear trend change has been in place for a while. Individual investors have been victimized by the screwflation of the middle class -- with middle class wages being outpaced by the costs of the necessities of life, this demographic has a lower propensity to invest in equities than at other times in history.
The business media has breathlessly chronicled over $19 billion of inflows in the latest week, but that number includes ETFs. The real number is $8.9 billion. This is the largest inflow since March 2000. That was the pinnacle of the tech bubble -- remember what the market did after that month?
Washington Does Not Instill Confidence
As well, it is also my view that the trajectory of economic growth in 2013 (and corporate profits) will also be adversely impacted by the manner in which businesses and consumers react to the tax hikes and the growing animosity and contentiousness in Washington, D.C., in the months ahead. Indeed, I fully expect the upcoming deliberations between the revenge-lusting Republicans in the House and the equally dogmatic and partisan incumbent President and Democratic Senate to not result in any meaningful cut in spending or entitlements reform. I do, however, expect these negotiations to have a direct and distinct adverse impact on economic growth, confidence and profits.
A dysfunctional Washington sows the seeds for reduced consumer and business confidence and risk-aversion, which could lead to slower economic growth. Our economy has never been more reliant on policy. The dependency on our economy and on business and consumer confidence to Washington's ability to compromise and deliver intelligent policy will prove, at the very least, unsettling to the markets in the year ahead. At worst, it will undermine the economic expansion by putting us in lockdown mode.
The Consumer Is Spent-Up, Not Pent-Up
In 2013 we will likely discover that there is a limit to the consumer in the face of our dysfunctional leaders' inability to deliver a grand bargain. A payroll tax increase, higher top income tax rates and the Obamacare surcharge, coupled with disappointing capital spending and weak hirings, represent the brunt of the domestic growth shortfall that I envision relative to consensus expectations.
Policy Alternatives Are Diminishing
U.S. monetary policy is now effectively shooting blanks, and fiscal policy, out of the necessity of a bulging budget deficit, will now switch to be a drag on growth. Moreover, the likely reluctance and inertia by our leaders in addressing our budget could continue to turn off the individual investor class to stocks this year.
Valuation Is Volatile
Valuations are not demanding but, at the same time, are certainly not undemanding.
My ursine tone is also a reflection that, by most measures, the U.S. stock market is not meaningfully undervalued (against consensus forecasts) and that given the dynamic of the headwinds of slowing economic growth, a poor profit outlook and the developing weakness of policy are unlikely to be revalued upward in 2013 (as many strategists suggest).
Should my well-below-consensus corporate profits forecast be realized, current valuations could be viewed as more demanding than is generally assumed. And kicking the fiscal can down the road is not supportive of a 15x P/E ratio.