So, I am forced to pull myself together and come in from the fiscal cliff in order to sort things out.
First, I don’t think that the President’s re-election was already “priced in” to the market. I think that the next few days will be about the market re-pricing the long-term outlook for stocks. The blue investors think that we will be much better off in the short-run. The red investors think that, as Joe Biden said, “facts matter” and choices have consequences, and that the long-term consequences of fiscal irresponsibility will be negative. As with so many things about this election, I think that they’re both right.
In the next few days, I think that the long-term costs of living in a banana republic, running up deficits that may exceed $20 trillion before the President’s term is up, will come back to haunt us. I think that it is possible that Wednesday’s 313-point drop might not be the last down day we see, in the near-term. Hopefully that won’t happen, but I think that markets do try to price in stocks’ long-run earnings power and that the market’s judgment might be harsh.
On the other hand, I think that the near-term results might lead to a reasonably profitable 2013.
First, the market is already reasonably valued, so any material short-term sell-off should be limited by the fact that stocks will be getting cheap. Second, one way or the other we will get past the daunting “fiscal cliff” headlines, and the media will be more than happy to pronounce the problem solved and celebrate the President’s achievement. I think that the President will get pretty much what he wants in negotiations – not because he has a mandate from the voters, but because I believe that he is quite willing to ignore the handcuffs imposed by the debt ceiling altogether.
In years past, President Clinton was willing to consider the option of “just ignoring” the debt ceiling limitations. The President could just keep cutting checks. There isn’t a lot of recourse for using Executive Privilege as an excuse to ignore the rules that have bound others to responsible behavior. In the fall of 2011, President Clinton even went on record recommending that President Obama use this strategy. With re-election looming, the White House went a different direction. That time. Now that President Obama has secured another four years, I think that this president is perfectly willing to make the problem go away simply by ignoring it.
Furthermore, I think that the markets would love it.
The last thing that the markets want is for today’s slow-growth 2% Gross Domestic Product growth to take a 4% haircut, as many analysts predict would happen if we run off the fiscal cliff. If the President negotiates modest and imaginary spending cuts, or just ignores the debt ceiling completely, I think that the market would sigh in relief and the headlines would treat the President kindly. Conservatives would throw a fit. But strict constitutionalists are now just part of the 49%.
In the short run, Obamacare might reduce healthcare costs by paying doctors and vendors less, keeping a lid on inflation in that part of the economy. With worldwide economic growth contracting, inflation really isn’t a near-term problem. Ongoing fiscal stimulus will propel some parts of the economy forward, and deficits higher, providing a traditional short-term stimulus to economic activity.
Third, tax increases are coming. Obamacare-related increases have been coming down the pike for months. Businesses are already paying much higher unemployment taxes. Big government is going to require big taxes, for all. However, the economic costs of these tax increases may not be immediate, so 2013 might not feel the squeeze. Those bills will be paid later.
Also, the President’s re-election means that short-term interest rates are here to stay. The art of Fiscal Repression, mastered by Ben Bernanke in his economic thesis as a way to enrich Tim Geitner’s banking friends at the expense of retirees from coast to coast, is here to stay. This government can't afford to pay 4% interest rates on $16 trillion in debt. Financing deficits at 1% interest rates will hopefully keep the whole deck of cards standing upright. While the costs are hidden from view, the headline risk of "rising interest rates" is gone, at least until the bond market vigilantes say otherwise.
A late-2012 market sell-off might position the market well for a 2013 rally.
The long-run costs could be years out. That’s the good news. I’ll defer from listing those negative consequences, which have been filling up e-mail boxes for most of the past 6 months.
As your mailboxes will indicate, as trading confirms are being sent out, you will find that our equity portfolios have been raising cash. We started selling a few weeks before election day, and we have sold a bit more after the election as well. These trades were not made in anticipation of the election. They were made as a result of general market weakness. As a result of them, for better or worse, we now have a fair amount of cash on the sidelines. If the market does sell-off in the near-term, we have dry powder available to reinvest at more attractive levels, if we get them.
At present, the May-Investments Leading Economic Indicators have flattened out, after declining from July through September. If the indicators resume their downtrend, I will be more likely to keep more cash on the sidelines, for longer. If growth resumes or markets start to recover, we will be glad to take a look at investing in sectors that are acting well. At present, there are very few sectors whose “uptrend” hasn’t turned down. One of the few sectors that was acting well – coal stocks – sharply reversed post-election. We talk about getting out of the way of what’s not working, and right now very little is working well in the stock market, and we have become quite conservative, particularly given that we are still pretty close to market highs as I write this. If the market really does turn down, these sales will be very well timed.
If the market stabilizes, we will be happy to get back in to enjoy an upward trend.
We have raised a significant chunk of cash, not because of my forecast or view of the election results, but because the market turned around, just a few days before our “all is well” third quarter client letter was dropped in the mailbox. The problem, I guess, is that “flat markets” really aren’t flat. They are jagged and dangerous, with small increases matched by quick and ruthless declines.
My “forecast” is for a quick sell-off, which sets the stage for a decent market in 2013. Rather than structuring the portfolio so it aligns with my opinion, however, we are managing our risk exposure based on the way Mr. Market is treating investors. In the past weeks, the trends have been turning down. As a result, we have reduced the amount of risk we are willing to take.
Hopefully this correction, if that’s what we’re having, will – like the election robocalls - be over soon. While the market weighs in, however, we’ve moved some cash to the sidelines.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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