It seems that most financial pundits and quite a few investors are solely focusing on the resolution of the Fiscal Cliff these days. They seem to believe that once we get past this impasse, we will be welcomed into the land of milk and honey and the market will rise substantially in 2013. First, I doubt we will see any meaningful package of measures that will actually address the deficit adequately, as we are still having the wrong conversation. Tax revenue is down 3% since 2007, spending is up 35%; yet all conversation is around how to boost taxes with little thought on how to cut spending. I think the most likely outcome is some sort of "kick the can" action, with minor tax boosts now with talk of a grand bargain later that will never come. Second, even if we resolve the fiscal cliff in a more direct manner, I think the market has plenty of other items to worry about going into 2013.
The last economic engine of the European Union, Germany is on the brink of recession. The German Central Bank just slashed its GDP growth forecast to .4% for 2013 from a previous estimate of 1.6%. Industrial production in October was down 3.7% Y/Y. I would also keep a close eye on the health of the global shipping industry. German banks have more than double debt outstanding to shipping companies than they do to the governments of Greece, Portugal and Spain combined. It has the potential to be a minor "black swan" should conditions continue to deteriorate in global shipping.
This comes after Mario Draghi slashed the EU GDP growth rate to .3% for 2013 from .5%. The European unemployment rate hit a record 11.7% in October. The Greek debt crisis is hardly solved, and will be a drag on the overall EU economy for years to come. In short, Europe is likely to be an overall negative for the markets for the foreseeable future.
New Regulatory Drags
Citicorp (C) recently announced it will lay off 11,000 people in order to bring its cost structure in line. Dodd-Frank regulations will make banking more expensive and less lucrative. Given the stock market's positive reaction to the layoff announcement, expect other banks to accelerate their efforts. Ironically, it is the bank tellers and loan officers that are getting the pink slip, not the investment bankers the regulations were intended to punish.
Darden (DRI) has backed off testing a program to move more employees to part-time status to avoid the mandates that are part of Obamacare due to negative publicity. However, when the law goes into effect, it is likely to have a major impact to restaurant margins and profits. It is one of the core reasons I believe the restaurant industry will be one of the worst industries to invest in over the next few years, and why I am short highflying Pandora Bread (PNRA).
Anemic Job Growth Will Continue
Although the unemployment rate continues to fall, the rate itself is misleading. True, the economy created 146,000 jobs in November. Unfortunately, 350,000 people dropped out of the workforce during the month. This continues a four-year trend, and if labor force participation rates were stable to 2008, the unemployment rate would be just under 11%. Given the new regulatory drags cited above and the generous welfare/unemployment benefits currently in force, I would look for dropouts to outnumber new jobs created for 2013 and 2014. Government generosity has had some unintended consequences over the last two generations, which have accelerated over the past five years. One example of this is the percentage of working age population on social security disability in 1960, which was just .65%. For October 2012, this percentage stood at over 5%. Obviously, this has negative connotations for productivity, government spending and the deficit in the long run if trends continue.
One of the main props of the market over the past three years has been directly due to the easing actions of the Federal Reserve, which has more than tripled its balance sheet. These efforts are having less and less of an effect, judging by the mild reaction of the market to QE3 so far. In addition, this "easy money" is begetting its own bubbles (record corporate debt issuance, student loans that now stand above $1T, etc.) that we will have to deal with it at some point in the future. In addition, the Federal Reserve does not have much ammo left should the economy turn down.
Profit margins at S&P companies are near historical highs, and it is hard to see them increasing in 2013 due to extra regulatory costs and tepid world demand. In addition, most companies have already cut to the bone and have little fat left to cut to increase margins. Earnings estimates for 2013 have already come down from where they were several months ago. A lot of these estimates are built on the premise that these margins will continue to increase. I think they have further to fall and without multiple expansion, it is hard to see the market rising significantly in 2013.
Given my outlook, I have 5% of my portfolio in short positions, which I will increase if/when we get the next false rally. I also have 20% of my portfolio in cash waiting for better entry points. Another 20% of my allocation is in high yielding MLPs in the energy infrastructure space. The continued expansion of domestic energy production is one of the few economic bright spots of the past five years, and I think this will continue over the medium term. My favorites in the area include PVR Partners (PVR) and Martin Midstream Partners (MMLP).
Be careful out there. For more on my view of the next four years, click here.