After seeing the market drop almost non-stop since the election, we finally saw a 200 point "relief rally", however, none of the major issues dragging the markets lower have been resolved. A rally based on short covering or relief are not uncommon and these should be used as an opportunity to sell stocks. There are so many issues weighing down on the market and the reality is that no easy solutions are in sight. There is a common belief that all we need is a deal or a "can-kick" on the fiscal cliff, but this is ridiculous.
The reality is that if the U.S. Government continues to postpone the mounting debts it continues to accumulate, the markets could turn against U.S. Treasury debt. Even if the bond market continues to give more time, the stock market could sell-off in the event that President Obama and Congress kick the can and put off decisions for a few more months. That is because it will create additional uncertainty as to how spending cuts and tax hikes will be resolved, and a lack of clarity means businesses and consumers will hunker down and possibly drive the economy into recession.
If there is a deal on the fiscal cliff, that could also pose a serious headwind for the economy because government spending cuts and tax increases rarely lead to economic growth. Just consider that nearly $1 trillion was spent as a stimulus package to boost the economy for the past couple of years, spending cuts and takes hikes would be like "anti-stimulus"programs. Now, President Obama is asking for major tax increases and Republicans want real spending cuts. This nation currently has about $16 trillion of debt and that continues to grow by about $1 trillion per year. Sooner or later, this is a ticking time bomb. When the country finally cuts spending and raises taxes so that it does not run annual deficits, this will lead to the type of pain that has been inflicted on many European countries. It could come with a fiscal cliff deal, or it could come later, but if you have any doubt on what happens when a country raises taxes and cuts spending, just look at the economy in Italy, Spain, Greece, and Portugal. That is why the U.S. could be facing austerity and a recession, in the near future.
A fiscal cliff deal is needed by December 31, in order to avoid automatic spending cuts and major tax increases. Investors also need to consider that the U.S. could also reach the "debt ceiling" which is right around $16.4 trillion and that could be hit soon, and potentially lead to a default in early 2013. All these issues led to the first-ever credit downgrade for the United States in 2011, and ratings agencies like Moody's have recently warned that another downgrade could come soon if appropriate measures are not taken.
If the debt issues in the United States aren't enough to get investors to lighten up on stocks, just consider the multiple issues that are also taking down growth.
France was just downgraded by ratings agencies and the situation in Europe is getting worse. A deepening recession in Europe will hurt U.S. multinationals. Many American companies like McDonald's (MCD) and Caterpillar (CAT) were already seeing reduced demand from Europe in the third quarter, and it could get worse in Q4. In another downturn, multinationals like General Electric (GE) could be hard hit by weakness in Europe and a potential U.S. recession since it has heavy industrial and financial market exposure. A recent CNBC article sums up the gravity of the French downgrade and European situation:
"The downgrade is extremely significant considering there has been a lot of talk about the U.S. being downgraded as well. The first image that comes to mind is a line of dominos all standing upright, and one of them now tipping," Ben Lichtenstein, president at Tradersaudio.com told CNBC Asia's "Squawk Box" on Tuesday, adding that the spotlight could turn to Germany next.
Super storm Sandy will likely impact the fourth quarter for many companies. A recent CNBC article points out the concerns of James Paulsen, who is the chief investment strategist at Wells Capital Management. He states: "The problem we're going to have here is the Sandy data is going to be so bad, how do you interpret it…I think the combo is going to keep it hard to sustain much of a rally (in stocks)."
In summary, many serious issues are likely to persist and that means upside for the stock market is possibly quite limited, while the downside is potentially significant, especially if a few events combine to create a perfect storm for the U.S. economy and stock market. Investors who have too much exposure to equities should consider developing a more defensive stance, and also consider short-term trading opportunities in cash-rich companies like Apple (AAPL) that can still grow in a weak global economy, but buy and hold investing is not likely to pay off for investors in the coming months.