Friday's 'constructive' start to the 'Fiscal Cliff' negotiations seems to have raised hopes that the issue will be addressed in time. The market's positive response today and Friday reflect these expectations.
Notwithstanding the conciliatory tone of pronouncements from both sides, I view this air of optimism to be premature. The incentives for both sides are not aligned enough to push them towards a deal, big or small, in the time left. This doesn't mean a deal can't be reached, but it does mean that the odds of going over the cliff are not that small.
The 'Fiscal Cliff' deal, whenever it's reached, will no doubt be a catalyst for stock market gains. A lot will depend on the details of the deal. But I remain skeptical of the notion that stocks will move back towards and beyond the multi-year highs achieved earlier this year. There are plenty of other issues on the horizon that will take center stage once we put the Fiscal Cliff behind us, ranging from the end of the earnings cycle to the uncertain European situation and global growth concerns.
Bottom line, as important as the 'Fiscal Cliff' debate is to the market, it is hardly the only issue that we need to be ready for. And as I stated in this week's Roundtable Review: "Is There More Downside Left?", we haven't likely seen the lowest point of this pullback yet. In this write-up, I provide a rundown of the economic and earnings pictures and what they mean for the market in the coming days.
Sizing Up the Economic Picture
With the elections now behind us, one would hope that we will see less partisan spin on incoming economic data. But if recent post-Sandy data releases are a sign of things to come, then we will likely have to wait for quite a while before getting a clearer picture of the economy that is not distorted by the storm. We do know however that the U.S. economy has been in a 'muddle-through growth' mode of sub-2% GDP growth rates, plus or minus 20 to 30 basis points.
On the positive side, one has to acknowledge the improving outlook for the housing sector and gains on the consumer confidence front. Given the strong housing data lately, it is reasonable to expect that residential construction will be a bigger contributor to economic growth going forward than has been the case thus far in this recovery. The picture is a lot less reassuring on the industrial/manufacturing side, with business investments expected to be less of a growth contributor in the coming quarters.
Beyond U.S. shores, optimism about the China situation has been improving lately. Recent readings of China's exports and industrial production indicate some bottoming process underway, but the picture is far from clear at this stage. The growth picture for the other major emerging markets is equally uncertain. Europe is formally in a recession now and consensus expectations of stabilization in the regions economic outlook in the back half of 2013 will most likely not pan out.
A sub-2% quarterly GDP growth pace isn't that bad, provided we weren't faced with domestic imbalances and international growth questions. But we are faced with such questions, and that makes this growth profile quite vulnerable.
Sizing Up the Earnings Picture
We will know for sure in retrospect, but odds are quite high that the third quarter earnings season that is about to come to an end will be remembered as a turning point in the earnings cycle that got underway in 2009. This was the weakest quarterly earnings season since late 2009.
Consensus expectations for fourth quarter have come down, but they still seem to view the third quarter underperformance as a one-off event and not the end of the earnings cycle that I believe it represents. This view is more than confirmed by the low double-digit earnings growth expected in 2013. With margins already at peak levels and top-line gains hard to come by in a growth challenged world economy, it is difficult to envision where the 10%-plus earnings growth in 2013 will come from.
Through all the headwinds that the market faced since the post-recession recovery in 2009, it could always rely on the strength in corporate earnings. And when all else failed, this fundamental fuel powered it higher. Maybe the third quarter earnings season represents the growth bottom that the consensus believes it is. But it is hardly unreasonable and not without basis to take the opposite view and look ahead to a period of sub-par earnings growth in the coming quarters.
Putting It All Together
The 'Fiscal Cliff' is a big deal and so is another debt ceiling debate early next year. The market appears to be looking ahead to a relatively happier resolution to the issue, judging from its reaction over the last two trading sessions. One could reasonably disagree with this optimistic take. But as important as this unresolved issue is, it is hardly the only cloud on the horizon. Global growth, earnings and Europe will still be problems for this market even after we are done with the 'Cliff' issue.
Focus List Update
We didnt make any changes to the Focus List portfolio this week.
The 'Fiscal Cliff' debate and associated tax rate changes, particularly on capital gains, is cited as one of the reasons for the recent sell-off in a number of major stocks, particularly Apple (AAPL - Analyst Report). The reasoning seems to be that it's better to take the hefty capital gains at a lower rate now instead of later. Hard to tell at this stage how much that is at play in the Apple sell-off, but the argument does make sense. There is a good discussion about Apple shares on this RTI post by Tracey Ryniec: When Do You Buy Apple?
On a related note, the expected increase in dividend tax rates is a net negative for all dividend paying stocks, and we have a quite a few of these dividend payers in the Focus List. Even the master limited partnerships, who pay substantial amounts as distributions, have been under pressure lately. But it is far from clear at this stage if changes to dividend tax rates will have the same impact on MLPs as they do on regular companies. We have five MLPs in the Focus list Enterprise Products (EPD - Analyst Report), ONEOK Partners (OKS - Analyst Report), MarketWest Energy (MWE), Plains All American (PAA - Analyst Report), and Magellan (MMP - Analyst Report).
REITs are relatively better positioned for the expected tax rate change, as it will put them at the same footing as regular companies. We have three REITs in the Focus List Ventas (VTR - Analyst Report), PS Business Parks (PSB - Analyst Report) and Avalonbay Communities (AVB - Analyst Report). Unsurprisingly REITs have held up better in the post-election period relative to other dividend paying stocks.