For the past year, I have heard many times about how the U.S. is the place in which to invest because "we are the cleanest shirt in a dirty neighborhood". So many analysts have made statements like this because the U.S. has been seeing enough economic growth to beat out other regions in the world. Europe in particular, has been a weak spot and while many analysts and investors believe in the strategy of avoiding foreign equities in favor of U.S. stocks, this line of thinking could soon be deeply flawed.
Let's go back about 2 or 3 years in time and consider where Europe and the United States stood. Both Europe and the United States were facing a weak economy and heavy debt loads, but the paths chosen were very different and have a lot to do with why the United States has a "cleaner shirt", for now. European countries with heavy debt loads were forced by their more responsible neighbors and the financial markets to immediately deal with the realities of overspending. Interest rates surged for countries like Italy, Spain, Greece and Portugal. The fear of a collapsing European banking system and economy drove global investors into U.S. Treasury bonds in a "flight to safety". This dynamic greatly benefited the United States and as some European sovereign interest rates soared, the borrowing rates for the U.S. Government plunged to record lows.
The extremely low interest rates gave the United States the ability to consider postponing the realities of overspending and massive debt levels, which is exactly what it did. Not only did extraordinarily low rates allow the U.S. to put off tough decisions on spending cuts, but it also allowed Obama to consider borrowing nearly $1 trillion more in order to stimulate the weak economy. By contrast, many European countries had no ability to borrow more for a stimulus plan, and skyrocketing interest expenses made an example of what it is like to run a country on an "adjustable rate mortgage". This meant that Europe was forced by the markets and by Germany to face reality and seek financial discipline much sooner than the United States. This has made a world of difference in how the economies in these two regions look today.
Just imagine what the economy in Europe and the United States might be looking like now if we reverse some of the variables. Let's say Germany agreed to Euro bonds which could have enabled the entire European Union to borrow at low rates. Had this been the case, it could have also borrowed nearly $1 trillion to create economic stimulus. By contrast, let's apply the opposite on the United States: instead of a stimulus package worth nearly $1 trillion in borrowed money, it cuts government spending by about the same amount, just so that it no longer spends more than it takes in annually from Federal tax revenues. Let's also say that the United States raises taxes so that it can finally start to pay down some of the debt. This scenario likely brings about a very different result to the American economy. Had we taken (or had been forced to take) Europe's austerity path, our economy would probably be looking a whole lot less like a "clean shirt".
The financial markets gave the U.S. more time to put off the inevitable, and President Obama was (politically) wise to postpone the tough decisions on debt and spending cuts until after he won re-election. Had he agreed to economy-crushing spending cuts and tax hikes, the unemployment level and other factors could have ended his hopes for a second term. Now it is crunch time for the "Fiscal Cliff" and many media outlets and analysts are optimistic that if a deal is reached, a major rally could occur and that the U.S. will continue to outperform other stock markets and economies. I think this optimism is totally unwarranted because solutions to resolve the fiscal cliff, massive debts, and chronic overspending are all going to be painful. The ongoing denial and belief by some that America is totally different, or in a much better debt position, that it can't see more unemployment, protests and riots, or interest rate hikes in the future, might be tested sooner than many realize.
Let's once again apply some European measures on the United States. Had Europe been able to postpone spending cuts and tax hikes up until now, because the various politicians wanted to avoid painful decisions and boost re-election chances, it is likely that the level of unemployment in Europe would be much lower and their economy might be much stronger. Rather than austerity, we might even be talking about Europe's relatively "clean shirt." But let's also say that Europeans even created a "Fiscal Cliff" situation whereby European leaders would be forced to find compromise by December 31, 2012, on spending cuts and tax increases. If that was the case and as long as European governments agreed on the cuts and taxes, would this eliminate the economic pain that has been seen? I ask this because the way the fiscal cliff is discussed by the media and many analysts, all we need is a deal and little to no pain will result. However, common sense says otherwise. Multiple media outlets, analysts and investors seem to believe that major spending cuts and tax hikes can somehow be taken in stride by America, even though these "austerity" measures have devastated the economy in Europe. What many in the media and the average American is missing is that there is no pain-free way out of this mess. The idea that as long as a deal is reached, all will be well and we will avoid Europe's fate is far too optimistic. Europe is a real working model on what happens when a country or region stops living off of borrowed money, cuts government spending and raises taxes. A deal on the Fiscal Cliff will not avoid this reality and it appears that the markets might be starting to realize this now.
While many Americans might look at unemployment rates of up to 25%, a poor economy or violent protests in Europe and think that "it's not going to happen here", they could be sorely mistaken. While the United States has some distinct advantages over Europe, such as the ability to print dollars and just one government to bring to agreement rather than many, it is unlikely that the U.S. economy can avoid the pain that European-style austerity could bring. Many Americans have been led to believe during the course of the campaign that by simply raising taxes on the wealthy, our debt issues will be put on the right track or even solved, but this is false. The Simpson-Bowles Debt Commission has looked at the possible solutions and it is clear that only $80 to $90 billion will be raised on an annual basis by raising taxes on the rich. That barely puts a dent in the deficit that is running about $1 trillion per year and a total U.S. debt level of nearly $16 trillion. I believe the average American has been misled by politicians in both parties about the gravity of the U.S. debt load and the level of spending cuts that will be necessary to make the country fiscally sound. It's not just the rich who will pay more in taxes in the future, but the middle class as well. Entitlement programs will also need to be cut way more than most people realize. Our government has failed to implement fiscal discipline for years and it has created a long list of essentially bankrupt programs and institutions which include, Social Security, Medicare, Fannie Mae, Freddie Mac, the Post Office, student loans, and others. If the average American were to run their finances as some of our leaders have, they would likely be declared bankrupt and be put in jail for running a giant Ponzi scheme. When the U.S. faces up to the reality of spending cuts and tax increases, our economy is likely to look a whole lot more like Europe's. That is why it is important to position your portfolio before that happens.
Even though the S&P 500 (SPY) and many other indexes have declined by about 5% since the election, there is still time to position your portfolio for the next few years. U.S. stocks and the economy are poised to see the "clean shirt" effect evaporate as painful spending cut decisions loom, even with a Fiscal Cliff deal. While many will view this article as total gloom and doom, I am not predicting the end of the world, but at a minimum, a recession is extremely likely in 2013.
Investors who have significant exposure to the markets should consider the recent 5% decline as a warning shot across the bow. When both market leaders like Apple (AAPL) and economically sensitive stocks like Caterpillar (CAT) plunge in value, in just a short time, investors have to consider that this is a potential canary in the coal mine of what's to come and not simply a minor market dip based on short-term jitters over Washington politics.
With all this in mind, it makes sense to keep significant amounts of cash or cash equivalents on hand and wait out the inevitable pain that is coming. It does not mean that all stocks must be sold. Companies with strong balance sheets and growth potential in a stagnant to down-trending economy could still make sense. It makes sense to avoid momentum stocks with highly inflated valuations, housing stocks which have seen a major rally that could unwind in a recession, as well as industrial and economically sensitive stocks like General Electric (GE). Companies like Sirius XM Radio (SIRI) which have high debt loads and sensitivity to auto sales should also be avoided.
After the markets have seen a major correction, and the economy has absorbed the impact of spending cuts and tax increases, it will make sense to buy value stocks with strong balance sheets, dividend-payers, and stocks in companies that can weather a tough economy, like McDonald's (MCD), but only after it drops further, perhaps to around $75 or less. Finally, this strategy should be supplemented by taking advantage of short-term trading opportunities that allow investors to profit from company-specific, seasonal or general market ups and downs. For example, the market is currently oversold and could bounce soon. This might give investors a tradable rally that is worth selling into. Also, seasonal tax-loss selling will soon give investors a chance to buy depressed stocks which could rally into January.
In summary, the purpose of this article is not to suggest that investors should sell all their stocks and buy a bunker. It is to consider the impact of the coming spending cuts and tax increases on our economy. It is to realize that austerity is a word that is likely to be used to describe not just Europe, but also the United States in the future. It is to suggest that staying fully invested (even in dividend-payers) makes little sense, especially when a stock can drop more in one day or one week than it will pay out in yield over the next year or two. Investors should be taking a hard look at their portfolios and risk levels, raise cash where needed, and be ready for much better buying opportunities in the future.