This commentary originally on Nov. 12 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
In my writings over the past six months, I have expressed concern that the fiscal, economic, geopolitical and earnings cliffs would be in attendance over the balance of the year and into early 2013, serving to weigh down the U.S. stock market.
This summer, owing to economic and profit concerns, I took a contrarian view and opined on these pages (and expressed in my "Fast Money" appearances on CNBC) that stocks were fully priced and would likely hit a yearly high in the range of 1420-1425. The markets ignored my concerns and continued to move higher, as the S&P 500 rose to nearly 1480, fueled by a view that the data don't matter while those who worship at the altar of price momentum held court and seemed to dominate and control the markets.
I still remain deeply concerned about the earnings cliff, but recent signposts suggest a somewhat more reduced concern over the other cliffs and over the market risks served up by a rising tax rate on dividends and capital gains.
These signals, when combined with central bank easing around the world and the recent stock market slide, suggest that the current fears are overblown, that the rationale behind a meaningful market downside has been removed and that the market's risk/reward has improved.
I am more upbeat than I have been for quite some time, and, while not "over my skis" long, I have increased my net long exposure as a manifestation of that increased optimism.
If the economic, geopolitical and political backdrop continues in line with my expectations, I plan to expand my net long exposure on any further market weakness.
My fair market value calculation of the S&P 500 remains at 1415 -- it has been around this level since May -- compared to a cash close of 1380 as of Friday night. While stocks are about 3% cheap, many stocks are substantially more undervalued. Moreover, if I am correct about my observations in dismissing some of the concerns over the steepness of the fiscal cliff and of an economic slowdown (as well on tax rate changes on dividends and capital gains), there is likely to be an upside to my fair market value calculation in the months ahead.
Color me more optimistic. I am pleased to be back on the reservation, buying stocks and looking for more undervalued equities.
Once Bitten, Twice Shy
Fears of a deep fiscal cliff appear to have been the proximate cause for the market's profound weakness in the last week.
It is important to recognize, however, that the message of the 2012 election was moderation. From my perch, moderation equals compromise. Mr. Market and his participants might be now incorrectly playing the last war (which took place during the budget deliberations in August 2011).
I believe the fears are misplaced; I don't believe we will go over the fiscal cliff in a major way.
We are at the point of necessity, and my view is that both parties get this.
Sleeves will be rolled up in the next two months -- just as Republican Senator Graham and Democratic Senator Schumer are now working toward a broad agreement on immigration, a pro-economy/business compromise could be forthcoming with multiple concessions. Compared to the budget deliberations of August 2011, this time around neither party can risk the perception of being obstructionists in the negotiations. Americans clearly have voted with their feet, and they want and prefer compromise over drama.
I agree with Whitney Tilson's recent remarks on the fiscal cliff on CNBC:
It's a forcing mechanism that's going to cause both parties to touch their third rail. Republicans are going to have to touch the higher-taxes-on-the-wealthy third rail. Democrats are going to have to touch the entitlements third rail. And this "fiscal cliff" is a beautiful thing to make that happen.
There will be some fiscal drag in 2013, but, when all is said and done, it will likely be only 1%-2%. And a better-than-expected recovery in housing, a continuing rebound in consumer confidence and spending, and a return of some business confidence (manifested in improving hirings and capital spending) will serve to offset most of the lost growth.
To understand why I am of the view that the fiscal cliff will be materially avoided, we have to go back to the debt negotiations last summer and to the election results on Tuesday night.
The Debt Negotiations of 2011
Today both parties enter negotiations on the fiscal cliff with low approval ratings. This is not surprising as the Democrats and the Republicans have a recent history of disrupting domestic economic growth, adversely impacting business/consumer confidence and having caused a mini stock market crash in August 2011.
Fifteen months ago, neither the Democrats nor Republicans thought through the consequences of the partisanship. This time, they have clear knowledge of the potential adverse impact of stalled negotiations regarding the fiscal cliff.
Arguably, both parties are now damaged goods (though for different reasons) and have to prove that they can legislate for the common good rather than on partisan terms. They cannot afford to do otherwise; they are not likely to make the same mistake twice.
The 2012 Election
I have often written that our leaders have historically risen in times of crisis.
My bet is that having been disappointed once and with the domestic economic recovery still subpar, we won't be disappointed twice.
Again, the 2012 election was a win for the moderates on both sides of the pew. And moderation in the relationship, compromise and agreement between the two parties is my baseline expectation.
While the following New York Times editorial points to the Republicans' loss caused by party extremists, the Democratic Party's extreme left also held the responsibility for the closeness of the election until the very end.
No one can know for sure what complex emotional chemistry tipped this election Obama's way, but here's my guess: In the end, it came down to a majority of Americans believing that whatever his faults, Obama was trying his hardest to fix what ails the country and that he had to do it with a Republican Party that, in its gut, did not want to meet him halfway but wanted him to fail -- so that it could swoop in and pick up the pieces. To this day, I find McConnell's declaration appalling. Consider all the problems we have faced in this country over the last four years -- from debt to adapting to globalization to unemployment to the challenges of climate change to terrorism -- and then roll over that statement: "The single most important thing we want to achieve is for President Obama to be a one-term president."
That, in my view, is what made the difference. The G.O.P. lost an election that, given the state of the economy, it should have won because of an excess of McConnell-like cynicism, a shortage of new ideas and an abundance of really bad ideas — about immigration, about climate, about how jobs are created and about abortion and other social issues.
It seems that many Americans went to the polls without much enthusiasm for either candidate, but, nevertheless, with a clear idea of whom they preferred. The majority seemed to be saying to Obama: "You didn't get it all right the first time, but we're going to give you a second chance...."
And that is why Obama's victory is so devastating for the G.O.P. A country with nearly 8 percent unemployment preferred to give the president a second chance rather than Mitt Romney a first one. The Republican Party today needs to have a real heart-to-heart with itself.
The G.O.P. has lost two presidential elections in a row because it forced its candidate to run so far to the loony right to get through the primaries, dominated by its ultraconservative base, that he could not get close enough back to the center to carry the national election. It is not enough for Republicans to tell their Democratic colleagues in private -- as some do -- "I wish I could help you, but our base is crazy." They need to have their own reformation. The center-right has got to have it out with the far-right, or it is going to be a minority party for a long time....
The votes have been counted. President Obama now needs to get to work to justify the second chance the country has given him, and the Republicans need to get to work understanding why that happened.
-- Thomas L. Friedman, "Hope and Change: Part 2," The New York Times (Nov. 7, 2012 op-ed)
Both parties find themselves in trouble, neither party is trusted (voter turnout was weak), and it appears they finally might/should recognize that the serious secular financial and economic problems should be addressed in a more bipartisan manner.
In the debt negotiations during the summer of 2011, the electorate was appalled by the partisanship and lost confidence in our leaders. They must earn that confidence back by resolving some of their differences. (They will have another two years before the 2014 elections to posture on a partisan basis.)
Republicans: The Republicans badly lost last week's election, an election they should have won. While maintaining control of the House, an unexpectedly poor showing in the Senate and a wider-than-expected loss in the presidency has seriously threatened the Grand Old Party. In the election, Republicans lost because they were hijacked by extremists. Incendiary remarks from Donald Trump, Ann Coulter, Richard Mourdock, Todd Akins and others contributed to the party's undoing -- even the much-admired Jack Welch's comments did more harm than good.
The Republican Party has been (perhaps correctly) branded by some as "the 'Mad Men' Party in a 'Modern Family' world." And Mitt Romney emerged out of the election as a dated Don Draper, who succumbed to the party's right wing and failed to broaden its tent. The Republican Party recognizes that voters have generally ratified the Democrats' agenda of higher taxes on the affluent and more spending on a handful of tangible domestic programs such as schools and infrastructure.
Speaker of the House John Boehner has the most important role in the Republican Party's negotiations. He wants compromise. But Paul Ryan, who will likely run for president in four years, will also play an important role. If Ryan delivers, he could cement his position within the party. If not, perhaps Chris Christie or Jeb Bush will emerge in the Republican primaries as an adversary.
If the Republicans, influenced by the Tea Party and others, go hard right and become obstructionists, they run the risk of heading toward extinction in the next several years as the demographic trends shift towards the opposing party.
Democrats: While the Democrats fared better than the Republicans and despite the Democrats' post-election glow, the electorate was adamantly and consistently more confident in Romney's ability to deal with the U.S. economic challenges. I believe, however, that Obama now clearly recognizes his weak economic management in his first four years in the presidency.
The Democrats won the 2012 election despite the weak economic stewardship as the minority is becoming the majority. Hispanics represented 10% of the votes in which Obama won by 71%-27%. Also, Obama clearly received a more favorable response from female voters, representing 54% of the voters in which he won by 55%-44%.
But make no mistake, Obama's economic stewardship continues under justifiable scrutiny and criticism. A 2% popular vote win was relatively thin. A compromise on the fiscal cliff will be the first step toward resuscitating that criticism. Intransigence of position will expose the Democratic Party to the emergence of a moderate Republican candidate for president in 2016.
I don't expect President Obama to go hard left and to pander to his party's extremists; he will likely lead his party and go down the middle with entitlements and tax reform. (Secretary of State Hillary Clinton is depending on it.)
It is my expectation that both parties will likely move toward the center in the fiscal cliff negotiations and will reject the more extreme members of their respective parties in making concessions to each other.
The fears of a deep fiscal cliff are overblown.
Don't Worry About Taxmageddon
At the current time (and until Dec. 31, 2012), income derived from capital gains and dividends is taxed at a maximum rate of 15%. If Congress fails to act, the capital gains tax rate will rise from 15% to 20%, and the top dividend tax rate will more than double from 15% to 39.6%.
On Jan. 1, 2013, investment income will be subject to an additional Medicare hospital insurance tax rate of 3.8%, which will raise the top rate on dividend income to 43.4% and on capital gains to 23.8%.
How Meaningful Is the Market Impact of Rising Taxes on Capital Gains and Dividends?
For the purpose of argument, I am going to assume that the tax on dividends rises from 15% to 25%, as the Obama administration has indicated this is the desired level.
Let's be conservative and assume both the tax rate on dividends (up to 23.8%) and on capital gains is 25% in 2013.
Here is my calculus (and logic) behind why I believe these proposed tax rate hikes will have only a limited market impact.
- Assuming the tax rate on capital gains and dividends rises from 15% to 25%, 1.00 less the change in tax rates (15% to 25%) is 0.85 and 0.75 -- 0.85 divided by 0.75 is 13.3%.
- Assuming all investors are taxable, stocks would decline by 13.3%, but only 20% to 25% of trading is in taxable accounts -- -13.3% multiplied by 22.5% (20% to 25% above) equals 3.00%.
- Assuming all investors in taxable accounts act on the higher tax rates, stocks would decline by -3%, but all investors will not act on the tax rates increase, so the impact on stocks will be something less than -3%. (Credit Suisse's Garthwaite estimates the dividend and capital gains hike will reduce stock values by 2.5%.) How much less? I estimate at about only 1% (see below) -- in other words, a negligible impact (despite current investor fears).
I have a number of reasons why I take down the 3% impact to about only 1%, suggesting the fears of a tax-rate cliff (on dividends and capital gains) are overblown.
- Most individual taxable investors have long holding periods. The longer their investor perspective the less likely they will sell, even if tax rates are rising (and the less consequential the aggregate impact on the markets).
- Most really long-term investors would prefer not to sell at all and not to incur any tax.
- Many investors don't have capital gains.
- The distribution of unrealized gains is probably uneven. For example, the original investors in Facebook (FB) do have a huge decision to make -- not so much if you are an individual investor who paid $65 a share for Procter & Gamble (PG), which is now trading at $67 a share.
- The calculation above assumes something of an equal level of sophistication -- we all know that isn't the case. My guess is at least 50% of all taxable investors don't even know the capital gains and dividend tax rate is rising.
I have two other observations:
- I don't recall any good buy/decision I have made based solely on taxes; I suspect others have had a similar experience.
- Those who are selling high-dividend stocks (usually conservative or older investors) to take advantage of the change in the dividend tax rate would have particularly low propensity to sell. Why sell, pay taxes? How will they replace yield?
My bottom line is that far less than 50% of those taxable investors (probably closer to 25% at most) will take advantage of lower taxes in 2012 and sell before year-end.
At 50%, the aggregate market impact is about a 1.65% reduction in value of the U.S. stock market (50% of -3.3% equals -1.65%). If 25% of taxable investors sell, the aggregate negative impact on equities is only 0.825%.
Stated simply, these fears are overblown.
The Geopolitical Cliff Is Ebbing
It appears that the risk of an air strike by Israel on Iran's nuclear facilities has been recently reduced. Sanctions have already hurt Iran's economy. Social unrest has accompanied rapid inflation and a currency that has depreciated by nearly 50%.
Political change appears imminent, and the current leaders of the Iranian government even appear to be willing to engage in discussions possibly aimed to negotiate a pullback in its nuclear program. The last thing on Iran's agenda may be a nuclear bomb. Some have even speculated that the country is no closer to being able to produce a nuclear bomb than two years ago.
Meanwhile, the rulers of some of Iran's allies (e.g., Syria) are under siege and are increasingly isolated in the face their own domestic issues.
Global Economies Will Recover
While I am still in the camp that expects subpar global growth, recent indications are that a self-sustaining economic domestic recovery is in place and that the U.S. recessionistas are dead wrong.
The risks of a global economic cliff have receded.
Over the past four weeks, the rate of growth in global economic activity is slightly accelerating, and recent data is mostly exceeding consensus expectations. As I wrote in my first missive today, growth should continue into 2013, dependent upon how meaningfully and quickly the fiscal cliff is addressed. (On this I am more optimistic than most.)
As evidence of my remarks above, the Citigroup Economic Surprise Index points to stabilization/improvement in the three major regions of the globe:
- The U.S. Citi Surprise Index is at its highest reading in nine months.
- The Asian Citi Surprise Index is at its best reading since February 2011.
- The EU Citi Surprise Index, though still weak, has risen from -100 in June 2012 to -27 now.
Indeed, among the developed countries, the U.S. is shining. Here is a list of domestic positives that are accumulating:
- Jobless claims are declining, and jobs growth is accelerating. October payrolls increased to a net 171,000 jobs (compared to an estimate of only 125,000), private sector hirings were the most since February (helped by an unexpected increase in manufacturing hiring), and the previous two months' hirings were revised much higher.
- Both the manufacturing and service sector PMIs have risen to above 50.
- Housing has clearly bottomed and is recovering in price and in activity -- arguably, the U.S. residential real estate market is embarking on a multiyear and durable recovery.
- The domestic automobile market is exhibiting a stronger recovery than many anticipated, and the 10.5-year age of the cars on the road suggests still-large pent-up demand.
- Retail sales are humming. October consumer confidence rose to 72.2, up from 68.4 in September -- the best since February 2008. It rose further in November. The University of Michigan confidence figure advanced to 84.9 -- that's the fourth straight monthly increase and the highest reading since mid-2007.
- Hurricane Sandy was just a terrible tragedy for many, but the rebuilding effort will result in incremental growth in the first half of 2013.
- Inflation and inflationary expectations are stable.
- Short-term interest rates are anchored at zero (though longer-term interest rates are likely to rise).
China's economy: The October non-manufacturing index rose from 53.7 in September to 55.5. This strong data follows the October China manufacturing index, which, for the first time in three months, rose above 50. Further, China's industrial production accelerated in September, and retail sales grew at the best pace since April.
October Chinese consumer inflation rose by only +1.7% year over year compared to estimates of +1.9% and +1.9% in September. This was the slowest rise in almost three years, as food inflation slowed dramatically to only +1.8%. (September print was +2.5%.) A low inflation rate is important as it allows the central bank the ability to ease further. That said, retail sales (+14.5%) and industrial production (+9.6%) accelerated in October, so no near-term moves are likely. The low rate of consumer inflation gives the People's Bank of China the leeway to ease further, however, recent data (industrial production/retail sales) accelerated last month, which allows the central bank to watch/wait and see.
We must now conclude that the eight-quarter slowdown in China's economic growth is over and that a slight acceleration in growth is occurring. It is now unlikely that meaningful monetary easing moves will be needed or employed in China, though monetary policy remains friendly. This is a clear positive for U.S. equities, as we can now scratch off a Chinese hard landing as a concern because the accumulated data are convincing. Importantly, a modestly strengthening Chinese economy reduces the risk that global economic growth will hit a wall or stall speed.
Eurozone economy: The EU is still mired in a recession with no signs of improvement next year, but expectations are low (so no surprise to risk markets). On the positive side, the ECB will continue to provide liquidity as policymakers finally have begun to work together in an attempt to form a banking union that provides a deposit insurance program and some sort of central authority that will assess countries' abilities and intentions to meet deficit goals.
I am not under the illusion that the heavy lifting is over -- it has just started -- and that there won't be substantive and painful bumps along the road toward structural change. Among the major reasons for this changing view was that the economic cliff looked less scary, with high-frequency economic statistics in the U.S. and China having improved.
The eurozone is still mired in recession, but last week's European economic data suggest that, even in that region, stabilization might be occurring. The final EU composite of the October manufacturing and service indices came in at 45.7 compared to the estimate of 45.8 (and 46.1 in September). While this composite is the lowest in over three years, the index has been relatively stable in the last eight months and consistent with real GDP (quarter over quarter) of only -0.2%. The important point is that the decline in business activity in Europe, though demonstrating slightly below-zero growth, is no longer accelerating.
It is not out of the question that the European economies are now undergoing a bottoming process. Indeed, small incremental economic growth could be possible in Europe by the last half of 2013.
In conclusion, with the U.S. and Chinese economies demonstrating a reacceleration in growth and with some stabilization in EU growth, there is now evidence that global economic growth is slowly reversing the first half of 2012's weakness.
Fears of an economic cliff are overblown.
But the Earnings Cliff Remains
I have tried to respond to the hyperbole of the cliffs with hard-hitting analysis and solid logic of argument, which has led me to a contrarian view on the cliffs' impacts on the equity market.
While I remain concerned about the prospects for U.S. corporate profits, one out of four cliffs ain't bad.
In my view, the earnings cliff creates a limit and ceiling (1450-1470) to the near-term upside to U.S. equities into early 2013, but I see the S&P 500 moving toward that ceiling as it becomes more clear that the cliff fears are overblown.