Handling a Bewildering 2012 Forecast

 | Dec 28, 2011 | 7:15 AM EST
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The classic joke (in economic circles, anyway) is that President Harry Truman requested a one-handed economist -- because most economists always qualified their forecasts with, "On the other hand . . ."

As we look forward to 2012, I may occasionally hide behind that two-armed tool of prevarication, but only when it enlightens certain points that are critical to putting a winning investment strategy in place. So let's look at the key factors that are set to drive U.S. equity returns in the year ahead.

The good news is that the U.S. economy is growing. The bad news is, it is probably growing even more slowly than government statisticians realize. The third revision of third-quarter gross domestic product growth put the number at a bit less than 2%. That's still a positive number, mind you. The fourth quarter is forecast to be positive as well, with the consensus currently looking for 3.5% to 4%.

The dirty little secret is that nominal GDP is deflated by an inflation measure that probably understates true inflation by a material amount, so "real" growth is even slower. The GDP deflator is up 1.96% this year, which is materially lower than the consumer price index that you and I (in theory) experience at the store. In fact, CPI is also understating inflation, at least if you believe your grocery and gas expenses, so GDP really limped along in 2011.

Meanwhile, we're seeing competing Leading Indicators predicting either a solid economy, or a recession, in 2012. Take your pick! The Conference Board LEI are solidly positive, while Economic Cycle Research Institute went out on a limb this fall and called a recession in 2012 "inevitable." Check out this chart for the LEI Cage Match. At least we know one of these august organizations will be correct.

LEI -- Conference Board and ECRI
Source: dshort.com

When I am sufficiently confused, I turn to the one indicator that is incapable of lying: tax receipts. Everything else can be massaged, but tax receipts are real cash, and they are rarely misstated thanks to the consequences of doing so. Shadowstats tracks various tax series, and the one that most closely tracks employment isn't looking so good. Withholdings stopped growing this fall, indicating that hiring came to a halt. This foots with other data points, such as the recent news in California that receipts are $3.7 billion below plan, triggering automatic budget cuts. The best real-time indicator we have is thus flashing bright yellow.

Tax Receipts, 2000 to 2010
Source: Shadowstats

In similar fashion, the jobs situation is very slowly improving, but not at a pace that official statistics surmise. Of course, everyone is on to the trick of dropping people from the workforce so that the unemployment rate looks better. I can safely predict that, as long as the U.S. Bureau of Labor Statistics is working for a sitting president, unemployment rates will always improve in an election year. The hidden trick in employment is that real incomes continue to fall. So, even if employment improves, without more purchasing power the consumer economy remains in a funk.

This is the quandary for the "haves," or that top 1%, if you will -- this segment can no longer drive business growth by tricking consumers into loading up on debt to fund their purchasing power. Consumers are getting smart and paying down debt. This means corporations as a group need to make a tough choice. The first option is to accept margins below the all-time highs at they have been running in recent years and pay people more, so that those folks can afford to purchase what's produced. The second is to continue putting downward pressure on wages and sustain the high margins, but accept that growth will be lackluster.

Labor Non-Participation
Source: J.P. Morgan

Should we be surprised that this profit-led recovery, which is leaving behind the Average Joe, is depressing the outlooks of ordinary folks? The Michigan Consumer Sentiment survey is shows that the average person's expectation for economic improvement is at an all-time low, and is not improving. There is nothing here that would encourage consumers to increase spending -- especially if their income predictions are correct!

Expected Change in Family Income
Source: Reuters and University of Michigan

One positive development, relatively speaking, is that we're putting to rest the pipe dream that housing will start to revive the economy. The sector has definitely bottomed, with prices, sales and housing starts all stabilizing. But the overhang of foreclosures, real estate owned and so forth -- the so-called shadow inventory -- ensures that single-family housing will remain a neutral input into economic growth for several years to come. This matters because housing is consumption and, in order to grow, the U.S. economy needs capital channeled into productive investment such as factories and new ventures -- not into more consumption.

Shadow Inventory
Source: J.P. Morgan

Look at this chart, which shows investment as a percent of GDP hitting multi-generational lows. Consumers need more income to spend, as I noted above, and they need more savings to invest.

Net Investment
Source: The Atlantic

Against this backdrop of an indeterminate U.S. economic outlook we have the euro crisis. The reality in Europe is simple: Massive refunding needs are coming this year, these economies are slipping into recession and, in any case, there is no way the respective GDP growth numbers of these countries can support the debt they have incurred. The Spanish economic minister pointed out as much recently, calling for recession in the second-most-important country in the PIIGS -- that is, Portugal, Italy, Ireland, Greece and Spain.

Most of the weak European countries will default. Still, with the European Central Bank tacitly admitting it will now print, print, print in order to bail out the banking system, the "default" will come in the form of inflation. A good pair trade might be to short a basket of PIIGS sovereigns and also short the euro. The debt can only hold value if the ECB prints and devalues the euro. If the ECB doesn't monetize, the euro will hold up, but the debt will default. This chart illustrates the problem nicely.

European Interest Rates
Source: The Atlantic

The great thing about investing in stocks is that the macro environment may inflict some volatility, but ultimately it is about only two things: earnings and the multiple. As shown in the earlier chart (labor vs. profit) and this one below, corporate profits are fully recovered from the Panic of 2008.

U.S. Corporate Earnings
Source: Standard & Poor's and J.P. Morgan

Furthermore, because the rally off the March 2009 bottom has been driven by earnings, and not multiples, the market price-to-earnings ratio is very reasonable. U.S. interest rates are more likely to stay low than they are to increase, at least according to the Federal Reserve, so the multiple should be sustainable. With a stable P/E ratio and some modest earnings performance, equities should be able to post a positive return in 2012.

So, with two hands waving wildly divergent economic assessments, how does one invest in 2012? I see little reason to deviate from my strategy of the past couple years, which has been to focus on income. We may be in for years more of tepid capital gains, and history shows that the markets are capable of going a generation with no returns.

Nonetheless, if I own a high-yielding equity portfolio or, better yet, enhance my income with dividend rotation, then I can achieve reasonable cash returns on my portfolio. The dividend portfolio I write about regularly, in my Diary of a Dividend Diva column, will spin off about 10% in dividend distributions this year, similar to what it did in 2010. That is return you can take to the bank in any economic environment.

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