Here Comes The Pain

Includes: GLD, JRCCQ, MCD, SPY
by: Bret Jensen

It seems appropriate to start this article with a quote from Rocky III given my take on the current market direction.

Interviewer: What's your prediction for the fight?
Clubber Lang: My prediction?
Interviewer: Yes, your prediction.
[Clubber looks into camera]
Clubber Lang: Pain!

The market is in the middle of the most significant downturn since the swoon in the middle of second quarter. The "fiscal cliff" and the continuing worries in Europe are the two most cited causes for the pullback. However, I think there is much more to it than that. I believe we are heading to a very challenging 2013 and at least a 50% probability of a recession by 2014. Even if Republicans and Democrats can work together and at least kick the can down the road while they work out an agreement on how to work out the fiscal cliff, there will be many significant headwinds for 2013. Investors should maintain a healthy cash position as we should get some lower entry points in the months ahead. Using options to hedge your portfolio or selling covered calls to generate additional income also seem like prudent strategies here.

10 worries for the market outside the fiscal cliff and Europe:

  1. Superstorm Sandy looks like it will knock at least .5% off the GDP growth in the fourth quarter. Given the increasing cost estimates of the storm as well as extensive damage and the long recovery that is likely; this might be a conservative estimate. It will be interesting to see how this plays out in regards to job growth and consumer spending.
  2. Regardless of the final resolution of the fiscal cliff negotiations, it appears right now that neither side is pursuing an extension of the payroll tax holiday. This means each worker will have 2% less in their paycheck come January 1st. This amounts to $120B annually. Obviously this will impact consumer spending, especially on low end consumers. I would look for establishments that cater to that segment of the population to be especially impacted. Companies like McDonald's (NYSE:MCD), which is already experiencing lower same-store sales, will be facing an additional headwind.
  3. Capital gains taxes are scheduled to pop back up to 20% from 15% currently at the beginning of the year. In addition, high earners (those over 250,000 for a married couple) will pay another 3.8% for Obamacare. This 50% hike is one of the reasons stocks that have run up over the last year are getting hit hard right now as investors take advantage of 2012's lower capital gains taxes.
  4. Obamacare will start to bite throughout the economy as new taxes are imposed and as companies with less than 50 workers figure out how to avoid the $2,000 penalty per employee that kicks in at the end of the year. This applies to workers who work 30 hours or more and are not provided employer based insurance with certain criteria. This will lead to reduced job growth as expansion of part time workers (under 30 hours/week) to avoid penalties. Given the significant increases in part time employees during the last couple of monthly jobs reports, I think this is already happening.
  5. In addition, the costs and consequences of Obamacare are likely to be worse than the market expects. In order to get to a $1T ten year cost of the program, the administration did a piece of accounting contortion that would make Enron proud. It assumed 10 years of revenues and only six years of costs. It also assumed Congress would cut Medicare/Medicaid payments to health care provides by 27%, which simply will not happen. As a result costs and their impact to the budget will be much higher than expected as the act gets implemented. Also expect many companies to dump their employees into this program as it will be much cheaper than complying with the act, this will also raise costs.
  6. It is taken as a given that the E.P.A. will be even more aggressive with the coal industry in a second term, which makes the space non-investable. I would expect many coal companies to declare bankruptcy over the next few years with James River Coal (JRCC) being one of the first to go given its huge amount of debt. I would also look for increase regulation from the agency on fracking which could slow down one of the few sectors to add high paying jobs over the past five years.
  7. Second terms are inherently more problematic than initial presidential terms. Key people leave, energy and focus start to wane, and the press starts to cover scandals/gaffes more intensely. Power players in your party start to tune you out while they concentrate on their next election. Whether you look at FDR, Reagan or Clinton, this is true historically and across parties.
  8. One of the big items I am wary of is increasing inability of the Federal Reserve to prop up the market. QE1 substantially boosted all risk assets including stocks. QE2 arrested a substantial equity decline and also drove the markets higher. Risk assets are actually down across the board since QE3 was announced which tells me this source of stock market appreciation is played out.
  9. I don't think investors realize how much the Federal Reserve is responsible for the stock market's rise judging from the comments I get on these articles. Yes, the market is up some 40% since President Obama's 2008 election (around 60% if you start the clock at Inauguration Day). However, the market is measured by how much you can buy for an ounce of gold or silver is down substantially as gold is up more than 135% since the 2008 election and silver is up more than 200%. I have never been a gold bug but I understand the reasons to hold 5% to 10% of your portfolio in the gold ETF (NYSEARCA:GLD).
  10. Outside of domestic concerns, Japan contracted at a 3.5% annual rate in the last quarter. Having the third largest economy in the world contracting will continue to damper worldwide growth prospects.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.