Jan 6, 2013


Year End 2012

Wow!  What a year!  At the beginning of 2012 we doubt that many people would have expected the S&P 500 to increase by over 13%, the yield on 10 year treasuries drop to 1.7%, and emerging market stocks to increase by 17%.  In spite of a middling economy, divisive election, Fiscal Cliff, recession in Europe, and chaos in DC, the markets performed spectacularly, climbing the proverbial Wall of Worry (OK-it’s not quite a proverb) to post outsized gains for the year.  

Domestic View
The business news flow from 2012 seemed to be dominated by three items:  the Presidential Election, the Fiscal Cliff, and of course the economy.  After a marked shift to the right in the 2010 mid-term elections, the country took a move back to the left in the 2012 general elections.  Does this most recent shift represent a mandate for the left or continued overall dissatisfaction with the political process?  Time will tell, but my view is that until the economy completely recovers, we should expect to continue to experience these shifts by the electorate as the ideologues lose out to those who just desire results from our leadership. 

This note began discussing the Fiscal Cliff in early 2010 after the two year extension of the Bush tax cuts, although it wasn't called the Fiscal Cliff then.  The mainstream media has recently picked up the theme and pounded it into the ground.  In case you need a reminder, the Fiscal Cliff is a series of expiring tax cuts and deductions coupled with modest spending cuts.  At the time of this writing, the situation has been partially addressed with the permanent extension of most of the Bush tax cuts, but another increase in spending of nearly 1/3 of a trillion dollars ($330 billion). It is certainly reasonable to assume that one or both parties might have preferred to allow the country to go off the cliff, although we feel it would be better characterized as a “slope” given the impact would have come over the course of 2013 as opposed to all at once.  The problem is basic:  we have $16 trillion in debt (projected to be $23.9 trillion by 2022) which is increasing by over $1 trillion per year and our politicians have no viable plan, cliff or no cliff, to address the mounting debt load faced by our country.  The American people must be willing to accept more pain if we are truly planning to address the problem, however, the bickering over the spending cuts included in the fiscal cliff discussions, which were just $65 billion per year, demonstrate the struggle we face going forward.  

The chart below shows the rapid rise in government expenditures combined with the slowdown in tax receipts as a result of the economic slowdown. 

The economy continues to muddle along, however, housing seems to be finally showing some life.  The impact of 3.3% mortgage rates is finally pulling buyers off the sidelines.  In this environment of low rates with a Fed that favors borrowers at the expense of savers, it is better to borrow long and lend short.  Taking advantage of these extremely low rates makes sense, and the housing market is benefiting as a result.  Home prices have stabilized and are moving up slightly, but have yet to recover to the levels of 2007.  As shown in the chart below, the Spring selling season is the key time for the housing market and should give us a glimpse into the sustainability of the housing recovery.

The Fed
The Fed announced that Quantitative Easing (QE) would now be virtually a permanent tool used to keep rates low.  We already had Operation Twist, which had been extended to year end at $45 billion per month, and in December the Fed added QE3, or as we like to say “QE To Infinity”, saying they would be buying $40 billion per month in securities until unemployment levels reached 6.5% from the present 7.7%.  At the present rate of job creation (remember, there are fewer people working full time today than in 2007), this should take 3-4 years.  As I’ve long maintained,  Federal Reserve Chairman Bernanke hasn’t seen a crisis that can’t be solved with low rates, and this one is no different.  Expect the Fed to keep their foot on the accelerator for a long time. 
The Fed’s balance sheet will soon cross $3 trillion, and, although not inflationary today, it certainly has the ability to fuel inflation when the economy finally turns and money velocity accelerates.  The chart below shows the decline in M2 velocity, which is keeping the economy soft but also allows the Fed to print money without stoking runaway inflation, for now.

Equity Markets
One of the primary reasons the markets have been soaring in the face of a feeble economic recovery has been the Fed.  An accommodative Fed has been the prime mover of markets.  Easy capital which isn’t in demand by the economy eventually finds its way into the markets.  Chairman Bernanke once wrote, and has mentioned in speeches, that the goal of Fed easing is to drive the equity markets up to create a “wealth effect” which will help consumers feel more confident in their spending.  The plan has partially worked as evidenced by the market’s strong results since the S&P 500 bottomed in March 2009; however, the “trickle down” hasn’t worked yet as consumer spending remains soft.  It’s interesting that this type of “trickle-down” economics has been discredited by the Obama administration, yet is the cornerstone of the recovery plan given their lack of fiscal policy over the past few years.  Further, it is precisely this trickle down theory favored by the Fed that has kept the budget deficit lower by over $300 billion per year due to lower government borrowing costs-again favoring debtors over savers.  

As mentioned earlier, equity markets performed masterfully in 2012, yet still remain fairly valued.  The chart below shows the PE of the market, by decade, over the past 50 years.  As you can see, the market isn’t expensive based upon historical averages, especially given today’s ultra-low rates. 

Interestingly, investors seem to have eliminated bearishness from their present market view.  The Investor’s Intelligence bearish sentiment indicator is at its lowest point in 50 years.  My guess is the lack of bearishness is presumably due to the Fed backstopping assets with its balance sheet.  

Throughout 2012 sales growth slowed, and during the third quarter reporting season 61% of companies missed their sales estimates (chart below), the highest level since the peak of the crisis in 2008.  This rapid deterioration in sales has coincided with cautious consumer sentiment and business sentiment readings, and may contribute to economic weakness in the 1st half of 2013. 

Global Perspectives
Europe continues to limp along, and has officially entered a recession since our last note.  The weakness there has resulted in relatively modest priced equity securities and, quite possibly, some investing opportunities overseas.  

One bright spot in the global economy is China, which appears to be emerging from a long malaise.  The Shanghai Composite has begun rebounding after retracing all of the gains from the market bottom in early 2009.  The data points seem to be positive, although the country’s real estate market is still a concern.  

Japan, whose economic doldrums could be a precursor to the US, finally set an official inflation and exchange rate target, and will begin the task of devaluing its currency in an effort to stimulate the economy.  In the past the country’s central bank has made overtures towards devaluation, but never had the gumption to follow through.  The consensus seems to be that with a fixed inflation target of 2%, the central bank will print aggressively to get to that level without the fits and starts of the past 20 years.   sets inflation target of 2% and Yen exchange rate target of 90 yen/dollar(incomplete sentences …).  First time we might see movement.  Will they have gumption to stay the course?  

Emerging markets performed well in 2012, rising 17% for the year.  The big question is whether these less developed economies have decoupled from the US, China and Europe, and will they be able to grow in spite of anemic growth in the more developed economies?  

Debt and Bonds
Bond yields continue to fall as the Fed maintains its aggressive buying programs, which presently account for up to 90% of the debt issuance by the Treasury.  This type of purchasing has never been done in the past, and it will be interesting to see if the Fed can exit this strategy without causing major inflationary pressure or destruction to the dollar.  In spite of ultra-low rates and a 30year old bull market in bonds, investors continue to flock to bonds at the expense of equities.  The chart below, similar to the equity chart we discussed earlier, suggests that treasury bonds are close to three times more expensive than at any time over the past 50 years.  Buy high, sell higher? 

High yield bonds had another strong performance in 2012, and could be an area at risk should the economy slip into a recession in the first half of 2013.  Longer term high yield bonds should continue to perform well if the economy strengthens in the back half of the year and investors continue to migrate to this asset class to find the yields that are lacking in today’s treasury market.  

Municipal bonds are a staple of many investor’s portfolios due to the tax free nature of their returns, the relative safety of the investments, and the better yield that treasuries.  That foundation was tipped on its ear during 2012 as a number of municipalities across the country filed bankruptcy.  The perceived stability of cities, counties, and even states has come into question, and investors should be somewhat cautious about municipal bonds with at-risk revenue sources.  Additionally, one item that has been discussed during the DC negotiations has been limitations on deductions for individuals, including interest payments from municipal bonds, which would be a disaster for both the investing public as well as the borrowers, whose borrowing costs would rise as investors require better after tax returns.  

More specifically, in California the budget and business environment is more than a mess.  The ballot initiatives that were passed raise the marginal state tax rate on the highest earners to 12.3%, and Governor Moon Beam is about to release another Fantasyland budget.  My guess is that instead of proposing controlled spending or even (gasp) cuts, the new budget will incorporate the new tax revenues into even more spending.  The Governor will be surprised when higher earners either choose to stop earning into the penalty areas of income, where marginal rates will exceed 60%, or leave the state as many employers already have.  This could put California on a crash course with a default in the next few years. 

The college football season ends tomorrow with Alabama and Notre Dame battling for #1.  I'm already feeling a bit depressed, although my youngest son has recorded enough great games on the DVR to keep me busy until next season.  I was looking at the Orange County Register's list of the top recruits in the county, and was disturbed to see that NONE of them had committed to USC.  Orange County has been a hot bed for the Trojans for decades, and the place where they have obtained many of their great quarterbacks over the years (Marinovich, Palmer, Leinart, Sanchez, Barkley, and now, possibly Wittek).  When you can't recruit in your own backyard, you better be wary about the future.  Anyone in favor of Chip Kelly blowing off the Browns and Eagles for the Trojans?

I'd like to thank Jason Trennart of Strategas Research for allowing me to utilize his work for most of the charts in this note.  I'd also like to thank Falcon Point Capital for their sponsorship of my site during 2012. 

Happy New Year to you and your family, I look forward to seeing you in 2013.   

Quote of the Year
Eric Cornell, who won the Nobel Prize in Physics in 2001, told Reuters: “I attribute essentially all my success to the very large amount of chocolate that I consume. Personally I feel that milk chocolate makes you stupid… dark chocolate is the way to go. It’s one thing if you want a medicine or chemistry Nobel Prize but if you want a physics Nobel Prize it pretty much has got to be dark chocolate.”