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.