Markets Set To Rally?

Stocks have now advanced between 4-5% since their lows on November 15.  They are up against resistance but nowhere near overbought.  The question becomes where do we go from here.

The market staged a massive reversal yesterday.  Stocks went from generally down about 1% to closing up about the same amount by the end of the day.  Two things seemed to have engaged the animal spirits around mid morning.  The first was generally conciliatory talks coming out of Washington regarding the budget negotiations.  Also word leaked that the Federal Reserve was seriously thinking about doing another round of quantitative easing.  The reporter who brought this story, the Wall Street Journal's Jon Hilsenrath, is widely considered to be the current mouthpiece of the Federal Reserve.  Thus this story had the capacity to move things.  

Going forward while stocks may continue to react to the "fiscal cliff" debate, stocks seem to have the capacity to move higher between now and year end.  Economic data such as autos, housing starts and consumer spending continues to support a growing economy.  The elections have provided clarity and closure for the time being.   Stocks are also trading at reasonable valuations by our work.  Perhaps the most important consideration right now though is seasonal.  We are fast approaching year end and many institutional investors and hedge funds have underperformed in 2012.  One can assume that there will be pressure on them to chase performance in the last five weeks of the year.  In short things seem to be in place for a Santa Claus Rally between now and December 31st.  In response to this, we have generally taken down our cash positions in client accounts depending on our strategies and per individual client  risk/reward parameters.  We think stocks on a risk/reward basis turned much more attractive around mid month.  That's when we changed our intermediate market indicators and our shortest term indicators to NET MARKET POSITIVE.  

We are mindful that any setback in the negotiations in Washington could derail the markets.  I will also state that I don't believe that a complete deal is necessary by December 31st.  I think a stopgap measure with a promise for a more complete accord in the new year will be enough to placate investors.  Absent this and absent an unexpected event coming over the transom between now and year end, stock market action has the potential to be positive between now and then.  If for no other reason that the most important print of the year is the last one on the last trading day of the year.  Professional investors have a powerful incentive to move markets higher between now and then because that's how so many folks get paid.  That at the end may trump everything else.

Earnings in Pictures

From Chart of the Day.com:

"With fourth-quarter earnings largely in the books (over 97% of S&P 500 corporations have reported), today's chart provides some long-term perspective to the current earnings environment by focusing on 12-month, as reported S&P 500 earnings. Today's chart illustrates how earnings declined over 92% from its Q3 2007 peak to Q1 2009 low which brought inflation-adjusted earnings to near Great Depression lows. From its Q1 2009 low, S&P 500 earnings surged to a level that approached its credit bubble peak. Since Q4 2011, however, earnings have gone flat and have actually declined over the past two months. In the end, the latest data has inflation-adjusted earnings making new 13-month lows."

Comment:  This flattening of earnings has probably had more to do with the market stalling out this fall than any of the rhetoric about the fiscal cliff.  Markets will likely begin to advance again once the earnings picture clears up.

*Long ETFs related to the S&P 500 in client and personal accounts.  

Link:  Chart of the Day: Earnings

Earnings Estimates: 2013, 2014

Long time readers of this blog understand that one of the primary legs of our valuation matrix is the four quarter rolling earnings for the S&P 500 and the year end earnings estimates for the same index.  Dr. Ed Yardeni notes this morning that S&P 500 earnings estimates for 2013 seem to have stabilized.  He also throws out an early 2014 consensus earnings number:

".....2013 estimates edged down last week, but should start to stabilize around $113 through the end of the year and until the next earnings season during January. For industry analysts, the long term is 2014, and their estimate for that year edged up to $127 last week, a projected increase of about 12% y/y. So while forward earnings are showing signs of stalling recently, they should be moving to new highs again if 2014 estimates hold up." 

While my earnings estimates for next year are in a state of flux, I still believe the consensus estimates that Yardeni highlights above are too high for both years.  Still for the sake of argument let's just assume that the S&P 500 could earn this over the next two years and let's also assume stocks would garner the same PE by the end of next year as they carry now, which is about a 13.  Then the S&P 500 would be worth 1469 next year and 1651 by the end of 2014 based on these estimates.    The S&P closed around 1410 last night.  Not saying this will happen by any stretch of the imagination but it is food for thought at the potential for stocks over the next couple of years if these numbers are remotely correct.  

*Long ETFs related to the S&P 500 in client and personal accounts.  

10 Stocks Account for 88% of all Gains.

This from Businessinsider.com:

"Morgan Stanley's US Equity Strategy team led by Adam Parker just published their 2013 outlook for the stock market.  They're calling for the S&P 500 to end next year at 1,434.  The massive research note included a lot of interesting information about the stock market including this: just 10 companies are accounting for 88 percent of all of the earnings growth in the S&P 500 this year.

For 2013, the sources of growth are expected to be much more diversified with the top 10 names driving just 34 percent of growth.  Still, the biggest names will play a big role next year. "Notably, Apple, Bank of America, Microsoft, GE, and Google are forecasted to be one-quarter of the entire S&P500’s earnings growth in 2013," writes Parker.

Link:   10 Stocks Account for 88% of EPS Growth

*All of these stocks are held in ETFs that we own in both client and personal accounts.  In addition certain clients of our firm own BAC, GE and AAPL.

Miraculum Dominae Nostrae

12-0!  Irish finish a perfect season after beating USC yesterday.  I can hear the peals of joy and laughter from my Grandparents in the wind!

“Buaidh no Bàs” 

Valuation

A little holiday reading:  Bloomberg: S&P 500 in Cheapest Bull Market Since Ronald Reagan

I'll leave you with this excerpt from the article and a thought:

"While the S&P 500 has doubled since Obama first took office, the index’s price-earnings ratio was lower than the 16.4 six-decade average for 38 of the rally’s 46 months, as earnings surged, data compiled by Bloomberg show. The multiple is up 35 percent since March 2009, compared with the average expansion of 55 percent in bull markets since 1962, Bloomberg data show. For the past 2 1/2 years, the S&P 500 hasn’t climbed higher than 16 times earnings, compared with the average ratio of 17.4 in past rallies.  The valuation rose to a high of 13.8 from 7.3 during the first 15 months of the 1982 advance that pushed the S&P 500 up 229 percent, according to data compiled by Bloomberg. In the 1990s rally led by technology companies, it almost doubled to 28.5 during the eight years."

A market that would trade at 16 times this years earnings would be worth 1660 on my year end 103.75 estimate.  Using a preliminary midpoint for next year would give you the potential to see stocks close at 1720.  I don't think we're going to be at 1660 by the end of this year and 1720 seems aggressive for next year.  However it does show you what stock's potential could be if we could ever get confidence to return to this market.  

See you Monday!

Long ETFs related to the S&P 500 in client and personal accounts.

A Bounce

Chart courtesy of finviz.com 

A 2% move in stock prices yesterday.  Stocks began rallying mid-day Friday on a more conciliatory tone out of Washington and carried this over into yesterday's open.  The rest of the week is going to be a low news environment due to the Thanksgiving holiday so stock have some room to digest this move without much coming from the politicians.  Today will be last real trading day of the week as Wednesday is a get away day for most people going to Grandma's house and Friday is a day to recover from food comas.  Friday is traditionally a day when stocks move higher but on low volume.  Stocks are still at oversold levels but most of what happens from here on end will depend on a political deal or at least the glimmer of one.  

Consider the rest of the week to likely be the calm before the storm.  

I will not be posting until Monday of next week unless there is a need to break in due to events.

Happy Thanksgiving everyone!

an tSionna {11.19.12}

From Chart of the Day:

Ongoing concern over the so-called 'fiscal cliff' has encouraged a pullback in stock prices. For some perspective, today's chart illustrates the overall trend of the stock market (as measured by the Nasdaq Composite) since 2000. As today's chart illustrates, the post-financial crisis rally of the Nasdaq (which began in early 2009) was significant enough to make new post dot-com bust highs. However, the sharp selloff of the past two months has resulted in the Nasdaq breaking below its 3.5-year, upward sloping support trendline. 

Link:  Chart of the Day.

Short Term

Reflecting action in client accounts we will move our shortest term indicators up to Net Market Positive.  We intimated that we might make this change last week.  You can go here  for  a definition of this term.  

I will add a caveat to both of my recent indicator changes.  My upgrades are predicated on what my money flow indicators are showing.   However, money flow analysis is just one portion of the investment matrix.  The other indicators are market ratings, valuation and fundamental analysis.  All of these have also moved to levels where probability suggests markets have the potential to rally.  This however is based on a common perception among investors that somehow the fiscal cliff will be averted.  This is the dominant belief on Wall Street after Friday's meeting between congressional leaders and the President.  The one thing that is bothering me is that often times the most common perception is wrong.  

I'm changing my indicators largely based on what we have recently done for clients.  I will let you know in advance that I will call an audible and change these ratings if it begins to look like the powers in Washington can't climb above politics and fix this thing.  

By the way I am dubious that a complete solution can be found in the "Lame Duck" session.  I think a patch will be  put in place in effect giving Washington perhaps six-nine months to come up with a permanent fix.  That's not a deal killer in my book.  It is the reality of how things work in Washington.

Why $250,000 May Not Be Rich

From The Fiscal Times.com:

"THE $250,000 CONUNDRUM 

By most measures, a $250,000 household income is substantial. It is five times the national average, and just 2.9 percent of couples earn that much or more. “For the average person in this country, a $250,000 household income is an unattainably high annual sum – they’ll never see it,” says Roberton Williams, an analyst at the Tax Policy Center, a nonpartisan think tank in Washington, D.C. 

$250,000 is a lot of money – especially if you live in, say Peoria, Illinois. But if you live in or around New York City, Los Angeles, San Francisco, Boston, Chicago or Dallas, you’re not rich – you’re simply what’s known as “upper middle class.” It all comes down to cost of living, a metric that is not considered when the Census Bureau of the Bureau of Labor Statistics calculates the mean earnings of working Americans. 

The cost of living in New York, for example, is 105.7 percent higher than living in Peoria, according to Salary.com. New York employers make up some of that difference by typically paying 29.9 percent more than employers in Peoria for the same job with the same type of company."

Go read the entire article here: Tax Hikes over 250K End of the Upper Middle Class.  This is why I think if the Bush tax cuts expire for higher income earners they will be reinstated for the Upper Middle Class under some number, perhaps closer to a half million.  {Maybe $350K +}.  To many of the people that are affected by any potential change live in cities with huge Democratic constituencies.  They foot the bills for a lot of politicians and their voices are going to be heard on this.  

Thoughts on Valuation, Money Flows

The S&P 500 closed last night at 1375.  That represents about a 7% decline from the market highs back in mid-September.  At this level stocks are trading about 13.25 times our end of the year $103.75 S&P 500 earnings.  Consensus estimates for 2013 stand somewhere between $111-115 per share.  I believe "Street" estimates are too high and I am using an earnings cone for next year between $107 and $111 per share.   I'll note that Wall Street started last year with much higher earnings expectations than I carried and the have come back to my level all year.  For purpose of this analysis I will use the lower end of my 2013 earnings cone and assume that the S&P 500 will earn closer to the lower end of the range next year.  I'll go into why I think that in a future post.

At current levels as stated above stocks trade at 13.25 my 2012 estimate and carry a 7.5% earnings yield {the inverse of its PE}.  The yield on the index is about 2%.  Assuming stocks can trade around a 14 multiple by year's end, the S&P 500 has the potential to trade up to a range between 1430-1460.  Note I say has the potential to trade up to this level, not necessarily that stocks will trade up there.  No guarantees.  Stocks are currently oversold enough by my work to stage some sort of a rally.    Seasonal trading also is favorable at this time of the year.  Any sort of resolution out of Washington regarding the "Fiscal Cliff" could provide the spark for a rally.  Conversely evidence that it is back to business as usual in Washington could place continued pressure on equities.

Using a $107 earnings assumption for 2013, stocks trade with a 12.85 PE and a 7.78% earnings yield.  Assuming stocks have the potential to trade with a 14-15 PE on these earnings, then stocks have the ability to trade up to 1500-1600 by year end 2013.  That is a possible gain between 9-15% by then.    Not saying we're going to get there but I'll note I consider my 2013 assumptions conservative unless Washington screws things up.  

*Long ETFs related to the S&P 500 in client and personal accounts.

A Change

Reflecting what we have done in recently in client accounts, we will move our intermediate indicators up to NET MARKET POSITIVE.  We will leave our short term indicators at NET MARKET NEUTRAL for the time being.  We lowered our indicators back on 08.08.12.  You can go here for a definition of these terms.  The S&P 500 is down about 2% since August 8th, 2012 and is down about 7% from its highs back in mid-September.

Please remember that our ratings only reflect what we are doing for our clients based on our understanding of their unique risk/reward criteria and are not intended to be any sort of market timing mechanism.  Further you should not take this upgrade to mean that we believe that a market rally is on the horizon.  We have no way to predict such an event and thus have no opinion in that regard.  

*Long ETFs related to the S&P 500 in client and personal accounts.    

US Energy Production

According to an article over at the Financial Times.com  and citing the International Energy Agency {IEA}, the US is slated to become the largest energy producer in the world.  According to the article, the IEA's energy prediction "underscores how the drilling boom that has unlocked North America's vast reserves of hard-to-get-at oil and gas is changing the world's oil balance

Go read the whole article over at the Financial Times here: Us set to become biggest oil producer.

Notre Dame vs. Boston College.

Big game tonight.  An oldie but goodie!

na heireannaigh a bhantiarna na Notre Dame!

Oversold

I know I said I wouldn't be posting but here's a quick update.  Markets are set to open lower.  The only thing that seems to matter is the Fiscal Cliff and whether our elected leaders will do anything to keep us from going over its edge.  I'll discuss this next week.  Today what I wanted to point out is that stocks are becoming attractive on both the basis of valuation and on money flows.  A bad market  today could lead to a change our market indicators in the near future.  Remember we have been NET MARKET NEUTRAL since 08.08.12.  Will be interesting to see how they act by the close.

Election Post Mortem

I believe that the United States is not so much a collection of states as it is an amalgamation of different regions.  This is not an original observation.  The idea was as far as I know was originally advanced by Joel Garreau in 1981 with his book The Nine Nations of North America.  David Hackett Fischer in his 1989 book Albion's Seed, provided similar observations as to how the development of the origional American colonies was shaped by immagration from four distinct regions of England.  This idea was picked up again in 2011 when Colin Woodard published a book titled American Nations.  

Over the years I've played around with this idea a bit {what can I say, I'm a history buff!} and put my own stamp on what I think these different regions might actually look like.  Time is too short today to go into this idea in any detail but just for the heck of it I put a rough copy of the regions in North America as I see them over a New York times map showing how each county voted Tuesday.  Red is Romney, Blue is Obama.   In short Romney won three of the 10 regions.  He won the interior of the country and lost the coasts.  He also lost the major metropolitan districts of the Great Lakes Region which is why he lost Illinois, Minnesota, Wisconsin, Michigan and most important to him Ohio.   He also heavily lost the region I'll call New Mexico.  This is important because it is one of the fastest growing regions in the country and looks to be expanding up the front range of the Rocky Mountains.  

This won't make any of us a dime today but I think it does help explain some of what happened on Tuesday.

As to my predictions.  Here is what I thought had the greatest probability of occurring:  

Most likely scenario {55% probability of occurring}.

I still say President Obama by a nose, 277 electoral votes to 261.  I think Obama wins the three states that seem to matter the most.  You can see my analysis here.

Wisconsin 2-3%

Iowa 2-3%

Ohio by less than 1%.

That should be enough.  I think the popular vote goes to the President by a percent or two.

As to the actual results, the election is not final yet in terms of the popular vote and Florida has not been awarded to either candidate.  President Obama has 303 electoral votes and is leading in Florida.  He won the popular vote with about 50.5%.  He won in Ohio by about 2%, Wisconsin by 6%, Iowa by 6%.  If Obama holds onto Florida I will have put that state in the wrong column. Virginia was the other State I missed, although the winner there only won by about 50,000 votes.

Markets sold off hard yesterday partly on the election results {not sure how people could have been that surprised}, partly on news out of Europe and partly on concerns over whether the new Congress and President can sit down and bargain over the fiscal cliff.  Markets are flat to slightly higher today and stocks are becoming oversold enough for a bounce if the overhang out of Washington can get some kind of resolution soon.

I'll be out traveling tomorrow but will be back here Monday.  Irrespective of yesterday and which side immerged as the winner, the best news for investors is that we have clarity as to the results.  We're done with the election now and can start focusing on the road ahead.

A Few Final Thoughts

A few final thoughts regarding the election:

*All of the media attention in the past few weeks has focused on Ohio.  Virginia though has the potential to deal Romney a huge blow early in the evening if it casts its votes for the President.

*Hurricane Sandy probably will have little impact on the election except perhaps in Pennsylvania. Should the hurricane suppress  the vote in the Philadelphia region it could be an advantage in this state. Tellingly, some polls suggest that the President and Gov. Romney are now tied here.

*However, wins this thing some pollsters are going to have egg on their face.  Dick Morris  thinks that Gov. Romney will win 325 electoral votes and garner 55% of the popular vote.  Nate Silver over at blog fivethirtyeight gives the President a 91% probability of being reelected.  Both of these gentlemen cannot be right.  

*Barry Ritholtz over at the Big Picture has an excellent article regarding an an investors guide to the elections.  It is a very good summation of the investment implications of a win for both candidates.  

*I think there is a high probability {greater than 50%} that we may not know for several days/weeks who has won this election.  I think some of these battleground states may be so close that recounts and court challenges are a real possibility.  I've said that markets won't like this uncertainty and in general that is still my belief.  But markets may be assuaged from tanking if we have a high probability of knowing who's ahead by some time tomorrow even if recounts occur.

*Finally it is my baseline projection that President Obama will be narrowly reelected. Keep in mind that even election professionals don't have a real handle on how today will play out.  However, the feel of everything since the weekend suggests another possibility, that undecideds have broken decisively for one of the candidates.  If that is the case than the feel is that the election has broken for Gov. Romney.  No numbers suggest this.  It is simply a gut call.  We'll have a better idea by this time tomorrow.

NOW GO VOTE!  Especially you young people!  Our process of electing everybody from presidents to dog catcher is often messy and mean.  This election cycle has perhaps hit new lows in the modern era for how far down in the mud candidates and their parties are willing to wallow in order to win.  But the ability to elect your leaders is one of the greatest gifts handed down to us by the founding fathers in our Constitution.  Regardless of your take on all of this, go pull a lever today.  Remember, a lot of brave men and women have died defending your basic right to do this simple act.  Go vote for their sake if nothing else.

God Bless America!

I Went Back To Ohio

Ohio Presidential Election Map By County 2008

{Red=Counties carried by Sen. McCain}

{Blue=President Obama}

I grew up on the Indiana/Ohio border and went to law school in Toledo, Ohio.  My mother still lives in the home where I grew up {that's the x on the map shown above} and I have a lot of friends that live in Ohio.  While I don't pretend to be an expert on everything that makes Ohio tick I know something about how they vote.  Assuming that Ohio is going to be THE pivotal state in this election then these are the trends that I'd look for tonight to get some idea of who's going to win.  Obama won Ohio in 2008 by about 207,000 votes and won 51.2% of the popular vote to John McCain's 47.2%*. No Republican has won the Presidency without winning Ohio.

1.  Montgomery County.  Basically the Dayton area.  Obama carried this county by 18 thousand votes. Look to see if his margin of victory is the same or larger.  A lower win here is a positive for Romney.  

2.  Hamilton County.  {Cincinnati}  Long a traditional Republican stronghold.  Obama won here by 6% points in 2008.  If this county doesn't swing back towards the Romney, the Republicans will likely face a long night in the Buckeye State.

3.  Industrial Counties of Northern Ohio.  Counties along Lake Erie.  {Toledo, Cleveland, Akron, Youngstown}.  Heart of Ohio's rust belt.  Strong connections to the auto industry and thus long ties to organized labor.  By my calculation, Obama carried this region by about 440,000 votes in 2008 and provided nearly all of his margin of victory in the state.  Romney has virtually no chance in this region but a lower turnout could help his cause as could increased Republican/independent enthusiasm for his candidacy.  In my opinion the President is in trouble in Ohio if he comes out of this region with less than a 300-350,000 vote lead.    He's really in trouble if he has a lead of less than 200,000 votes.  If the subtle issue of race is going to make a difference it could be in some of these white blue collar cities and towns.  

4.  Athens County {Home to Ohio University}  Obama won here with 66% of the vote and a 10,000 vote cushion.  In an year where every vote counts a couple of percentage points or 2-3,000 votes could be important.

5.  Franklin County {Columbus & Ohio State University}.  Obama won 59% of the vote here or nearly 100,000 votes, his 2nd highest margin of victory in the state after Cuyahoga County {Cleveland}.  This is about 6 percentage points better or nearly 50,000 votes better than John Kerry  who won here in 2004 and about 8 percentage points better or  nearly 100,000 votes better than Al Gore who won this county in 2000.  The GOP ought to be able to make some inroads here as this is a more conservative region of the state.  Romney could potentially pick up 30-50,000 votes here.  If he does not then I think it will be hard for him to carry the state.

6.  Eastern Ohio.  Not a lot of votes here.  Area has been trending Republican as has neighboring West Virginia and western Pennsylvania.  Romney could pick up a few thousand votes here.

7.  The rest of the state or all that real estate in Red.  At its heart most of Ohio beyond the northern tier is a conservative state.  The southeast is similar in terms of real estate, ancestry, and industry to Kentucky, West Virginia and western Pennsylvania.  The western part of the state is farm country and is similar in make-up to Indiana next door.  Obama will not win these counties.  Republicans will need to squeeze every vote possible from these places in order to cut into the lead that the northern part of the state gives the President.  If Romney isn't winning in these places on average in the upper 50-low 60% range then he will be unable to win the state.  If the subtle issue of Gov. Romney's religion is going to have any effect it will be down here in the Southern tier.

And there you have your guide to Ohio.  It might not matter.  Late polls seem to be giving the President a slight edge in Virginia or Romney may actually squeak by in Pennsylvania.  But all indications seem to show that Ohio is important especially to the Republicans.  We'll have to just wait and see.

*Source  New York Times 2008 interactive election results by county.

And The Winner Will Be......

Today I'll put my undergraduate degree in Political Science from DePauw University to work and throw out four scenarios and my probabilities as to each an outcome on Tuesday.  Each is worth what you pay to read it here.

Most likely scenario {55% probability of occurring}.

I still say President Obama by a nose, 277 electoral votes to 261.  I think Obama wins the three states that seem to matter the most.  You can see my analysis here.

Wisconsin 2-3%

Iowa 2-3%

Ohio by less than 1%.

That should be enough.  I think the popular vote goes to the President by a percent or two.

One of the candidates wins big- 300 electoral votes or more.  {35% probability}.

One cannot ignore that over the weekend the race has broken big for one or the other candidates.   I can make a case that this has occurred for either of the candidates.  Obama looking more presidential for example after Hurricane Sandy, bigger crowds for Romney at rallies as an indicator of heightened support.  Hard to say how this will go.  Doesn't feel to my like this has occurred.  If it has though my sense is that it will break for the President.

A surprise that nobody expects.  {35% probability}

Everybody has focused on the battleground states but quietly it seems that Michigan and Pennsylvania have come back into play.  Of these two it strikes me that Gov. Romney has a better chance in Pennsylvania.  It could be that enthusiasm for Gov. Romney rises in the western part of the state and that  voter turnout in the Philadelphia region which may have been impacted by the hurricane.  If Gov. Romney can somehow steal Pennsylvania and carry out the rest as projected he will be the next President.   Likewise if the President can peal Virginia away from what most expect to be a red state this cycle then  he will probably win.  

One final thing to watch.  Two states {Nebraska and Maine} divide their electors by popular vote.  Normally this does not matter but in a closely packed election such as this they may come into play.

A hung election.  {25% probability}

Here's what I said on Friday:  

"The one thing I do not think that markets have factored is the possibility that we wake up on November 7^th with no idea who’s the winner. If we look like we are in for a reprise of the 2000 election, then I think stocks will move lower and we will have to become more defensive minded in our portfolio strategies."

My gut tells me though that the election is going to be decided in Ohio.  I have a bit of insight on how the "Buckeye State" may vote tomorrow as I grew up on the Indiana/Ohio border  and went to law school in Toledo,  Ohio.  I will give you my tells on Ohio tomorrow.

Of course I could be wrong on all fronts.  What is so strange about this election is that nobody really knows what's going to happen tomorrow, probably not even the campaigns themselves.  Markets are in a holding pattern until we get more information as to who wins.

Coming Monday

On Monday I'll post my Presidential predictions via the electoral college.  I've a pretty good idea of how I think it will break out but I want to see how the weekend goes before I put my final calculations out there.

A Look Out Over The Next Few Months

This is a copy of the letter I sent to my clients yesterday.

Recent events give me an excuse to discuss where the markets might be headed over the next few months.  Stocks made their 2012 highs back in September and have slowly ground about 4% lower since then.  I believe there are four reasons for this.  These are disappointing corporate earnings, the elections, concerns over the budget issues surrounding the so-called “fiscal cliff” and most recently the hurricane. 

I’ll address the storm first.  I have a little history with hurricanes having experienced Bob while in Rhode Island in 1991 and seeing the aftermath of Katrina through service projects in both 2006 and 2007.  I have also spent some time talking to people who either live in the affected area or have spent time  there. My initial read is that the economic damage while extensive is not as severe as it could have been or as bad as most experts thought a few days ago.  I realize that I am saying this while 900 miles away in Chicago.  I also don’t want not to minimize the affects of the storm at the local or regional level.  If you lost property or you’re trapped in an apartment above ground in lower Manhattan without electricity or if you’re a family member of one of the 74 people who to date have died in the storm, you won’t agree with me. I’m also prepared to change my view should the evidence warrant.  For now my overall economic take is that Sandy, while a devastating event is probably not the national economic hit that it could have been. 

Further it is likely that the cleanup and infrastructure repairs will stimulate economic growth in the region longer term.  There is some controversy to this viewpoint and not all economists would agree with me.  But I’m hearing early estimates that it might take 20 billion just to repair the subways in New York City alone.  A public works undertaking such as that is a huge job producing investment. It is the kind of infrastructure spending that the public wants and politicians adore. This doesn’t even begin to take into account all the other work that needs to get done now in the region.  There will likely be some short-term hits to economic numbers from the storm but this sort of investment spending is likely to receive bi-partisan support and add to economic growth in 2013.

As to the economy itself, global economic activity has slowed since the spring, reducing the reported revenues of many companies with foreign exposure.  Rising costs have meant that profit margins have been trending lower for the first time since 2008.   Investors have anticipated much of this as baseline earnings expectations have been declining since the spring.  However, corporations have been cautious in their foreword guidance this earnings season and that has also brought pressure on stocks. 

The issues of the election and the “fiscal cliff”-the budgetary cuts that are scheduled to take effect in January should Congress and the President remain deadlocked over spending and taxes-are related.  Stocks have anticipated for months that the President will be reelected.  As of this writing the electoral odds still favor this outcome.  The markets also believe that if President Obama wins the chances for a budget deal increases, as both sides will be forced to make concessions.  The thinking goes that Republicans will be unable to continue an obstructionist legislative policy in the hopes of waiting the President out of office.  The President will have no political capital and will be forced to deal as well.  If he is reelected, he will do so with the thinnest of margins with potentially a majority of the electorate voting for Gov. Romney. Markets will likely view a Romney victory as more business friendly and the probable result in this event is a stock rally.  The one thing I do not think that markets have factored is the possibility that we wake up on November 7^th with no idea who’s the winner. If we look like we are in for a reprise of the 2000 election, then I think stocks will move lower and we will have to become more defensive minded in our portfolio strategies.  In any event I expect stocks to remain range bound or to trend slightly lower until the election is resolved.  

Those that are familiar with my firm's disciplines know that our work is based on something we call our playbook. It is situational analysis based on historical market results.  We study money flows along with the disciplines of fundamental and valuation analysis to see how markets have responded to similar historical events.  It gives us different scenarios regarding market activity.  We use thisplaybook to formulate our game plan.  The game plan is a tactical and strategic allocation of assets based on what the playbook tells us has historically occurred.  Based on this, my current baseline expectation out to year-end is for President Obama to be reelected.  Gov. Romney needs the equivalent of an electoral grand slam which seems unlikely.  I believe a stopgap budget compromise will be enacted in the "Lame Duck" session of Congress that moves the most egregious aspects of the “fiscal cliff” further out into 2013.  Economic data, even factoring in the events of the recent hurricane, are suggestive of an economy that is growing between 1.75-2.5% GDP.  

Markets have spent much of the past two months churning around.  This has led to many stocks and indices becoming oversold. While this condition is not as extreme as we sometimes witness, it is from a level where probability suggests that equities have the potential to rally once some of the uncertainties mentioned above are removed.  In this scenario I think stocks have the potential to appreciate between 3-6% over the next few months.  An advance to these levels would place us back to where we were at the end of September.  The probability of this type of rally increases in my opinion if  Gov. Romney wins next Tuesday. 

Please note that my baseline scenario is an estimate of future events and there is no guarantee it will occur.  There are several things that could derail what is admittedly a fairly rosy outlook.  The first and most glaring is that the election becomes an undecided thing, something that is likely to end in litigation and possibly the unprecedented step in the modern era of being decided in the House of Representatives.  In that case probability suggests that stocks could decline 5-10% from current prices. I say this because markets hate uncertainty and because a protracted fight for the Presidency makes short-term attention to the budget sequestration issues doubtful.  This outcome {a protracted fight beyond a few days after the election} would cause me to become more defensive minded in our portfolio structure.  The other thing that could warrant a change in my view is evidence of economic growth that comes in below our baseline expectations or a further slowdown in earnings than most are looking for at this time.  That is a longer-term view however as it lends itself more towards our forward assumptions into next year.  I am perhaps a bit more optimistic about 2013 than some others on Wall Street.  I understand that there are economic challenges and corporate growth could be a bit subdued in the first half of the year.    At the same time there are positive aspects to the economy that don't receive much attention in the press that could add to economic growth and stock advancement in 2013. I will start discussing our basis for this over at our blog Solas! in the coming weeks.  I will be back to you early next year for our outlook and investment orientation for 2013.