The lone “red flag” that is on the horizon is the May-Investments Leading Economic Indicator, which weakened in the fall, and dipped again right at year-end, perhaps in conjunction with the fears surrounding the “fiscal cliff.” The tax increases, in and of themselves, are not as worrisome as the fears that surrounded the debate. Investors feared a 40 percent tax on dividends, but it didn’t happen. People feared an increase in the capital gains tax above 15 percent, but the vast majority of filers will pay the old rate. Most of the tax increase was limited to “fat cats,” who will see their tax rates jump pretty significantly by the time you factor in the total impact from increased tax rates, capital gains taxes, phasing out of deductions, and additional Obamacare tax burdens. All told, however, the $60 billion raised isn’t that significant. In fact, about a week later, roughly that same amount of additional spending was pushed through Congress for Hurricane Sandy relief.
The “new normal” in Washington looks a lot like the spending binge we’ve been on for the last two decades. In the long run, this spending is an issue. In the short run, however, the market has little reason to fear contractionary fiscal policy.
It is true that there are some “new” facets to this upcoming “normal,” but it merely represents the ever-present “change” that provides both a hurdle and an opportunity to investors. While not chosen thematically, companies in the May-Investments core portfolio are well positioned to benefit from many of the same changes about which many conservative Western Colorado voters complain. Dodd-Frank, which is limiting borrower choice and forcing small lenders out of the market, should lead to market share gains for the mega-lender we recently purchased. The same natural gas glut that is keeping a lid on local economic growth is a boon for energy companies we own in Pennsylvania and North Dakota. Solar subsidies and the political push for renewables may be inflating the budget deficit, but they also create opportunities for vendors that sell solar components to major utility companies and for electronics vendors whose components hook these systems up to the grid.
While investors have complained about empty product pipelines at the major pharmaceutical companies, hurt by drug approval processes that take ever longer, our biotech companies are focusing on developing and cashing out on the launch of new products purchased by the big companies for distribution in their marketing system. While stock guys complain that no one cares about equities anymore, annuity vendors are growing nicely by providing “income for life” solutions for the millions of baby boomers transitioning from the accumulation phase to retirement’s distribution phase of investing.
During the 12 months following the 2011 Economic Forecast, the stock market provided many investors with double digit returns, largely for the reasons that we had anticipated. Corporate earnings grew a bit, but much of the appreciation came from an increase in the market Price/Earnings multiple from 12.8-times earnings (in January of 2012) to 14.3-times in 2013. In 2013, it wouldn’t shock us if the P/E ratio continued to improve, on top of another small increase in corporate earnings, which could again provide investors with another nice year of appreciation in equities. In the meantime, cash equivalents provide little return and bonds could force losses on investors if interest rates rise much.
2012’s 4th Quarter Gross Domestic Product (GDP) growth will be reported in about a week and we believe that our year-ago forecast for 2 percent real GDP growth will be on target. It is likely that consumer spending will be a little weaker than anticipated – largely due to the year-end spending pause as consumers weighed the impact of the fiscal cliff – but foreign trade and U.S. government spending are both likely to be a little stronger than expected. For 2013, we are forecasting slow growth, but slightly faster than a year ago. The 2013 forecast for 2.5% growth in GDP factors in slightly slower consumer spending, resulting from tax increases impacting both very high and very low wage consumers, but offsetting this would be greater business confidence now that the divisive and tumultuous 2012 political campaign is behind us. Companies have the financial resources to increase their rate of investment and we believe that they will do so as 2013 continues our slow move back toward normalcy.
Of course, “normal” does not mean a problem-free, peaceful, predictable status quo. Uncertainty, after all, is normal. For us, we think it means that markets will continue to move beyond crisis mode, price volatility will stay low, asset class correlations will diverge so we move away from the politically driven risk-on/risk-off trading environment of 2008-2012. In a normal environment, there are both winners and losers and it is no longer just a question of “fully invested” or “in cash.”
Normalcy is a figment of our faulty memory. Markets climb a wall of worry. Once things have appreciated, the anxieties experienced on the way up are mostly forgotten. If we are right and 2013 takes us one step closer to normal, it doesn’t mean that our political problems will be resolved, that our economic concerns will melt away, or that robust global growth is just around the corner. However, it is an improvement from the dark days of the Great Recession, not too long ago, and we were happy to again be able to provide a positive outlook at our annual forecasting event.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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