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In Part 1 of this three-part series, I set forth three possible scenarios for 2013. In Part 2 I will summarize those scenarios and then attempt to fine tune my market call a little further by considering the possibility of a catalyst that may end up being the deciding factor on how 2013 develops.

I see the upside of the 2013 trading range reaching and possibly exceeding the all-time highs at 1576 on the S&P. A 15% gain from the 2012 close would put the S&P at 1607 and I see nothing that would justify exceeding those levels for 2013. Furthermore, I am not assigning a high degree of probability to reaching those levels but at the moment momentum is solidly with the bulls and that could propel stocks higher in the short term.

On the downside I see three possible lows, the 2012 low on the S&P at 1260; the 2011 lows at 1070; and the 2009 lows at 670. Many will discount my extreme call back to the 2009 lows but I think the possibility exists for just such a sell-off based purely on the fundamentals. As I stated in Part 1, we are in a pickle and few seem willing to give credence to the very serious nature of the problems facing us as we enter 2013.

In the end what matters is market sentiment as that is what moves markets. Stock market sentiment in recent weeks has been driven by the following fundamental considerations:

  1. We will avoid the austerity measures posed by the debt and deficit spending dilemma.
  2. The Fed will not be able to control inflation.
  3. The economy is finally turning around as evidenced by modest improvement in the unemployment situation and an upturn in housing metrics.

We will discuss each of these in order.

Can Congress reach a deal that satisfies market participants and averts recession?

Unless the answer to 2 and 3 above is that the Fed will lose control of inflation and we are definitely moving forward in the housing and unemployment areas then the answer to the matter of averting recession is an emphatic no we cannot. Assuming the status quo on the inflation and unemployment front recession is almost a certainty.

Here's why - we have managed a very modest growth in GDP for the last four years only as the result of unprecedented deficit spending that has propelled our debt to $16.5 trillion. That is up from $10.7 trillion at the end of 2008. That is $5.8 trillion in four years or $1.45 trillion a year on average.

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The chart above doesn't look great but it certainly does show what almost everyone claims - a very modest but positive rate of GDP growth. The problem is no one seems to be willing to admit that it is only through deficit spending that we are able to accomplish this very modest performance.

Again, assuming the status quo with regard to inflation and unemployment, we will need every bit of the stimulus being provided by the creation of new debt and deficit spending to prop up the economy once again in 2013. Consider that the deficit portion of fiscal stimulus represents approximately 9% of GDP using a GDP number of roughly $16 trillion and a deficit average of $1.4 trillion.

Using the numbers above it is easy enough to see that the economy is surviving only on life support provided by massive deficit spending. The following excerpt from Part 1 of this series seems worth repeating:

The fact is we want the markets to move higher, we expect the markets to move higher, we invest on the basis that the markets will move higher and we bias our reporting of economic data toward the buy side. In other words we emphasize the good data and discount the bad data. We frame our perceptions around what we want to happen and build arguments that will support those perceptions necessarily discounting the negative.

In support of this point consider this - almost all pundits refer to the fact that we are running $1 trillion deficits and have been for several years. Are we to assume that the difference between $1.4 trillion and $1 trillion is merely a rounding error. Lest we forget, it was in July and August of 2011 that we last addressed the debt ceiling. At that time a two-part agreement was reached. The first part was a $900 billion dollar increase to the debt ceiling to meet immediate needs.

The second part was a $1.2 trillion dollar addition based on an arrangement that required spending cuts equal to the additional debt. The "Super Committee" failed to agree on the spending cuts thereby creating an across-the-board cut referred to as the "sequestration cuts." The point though is that we have spent $2.1 trillion from August of 2011 to December of 2012. That is 17 months and works out to an average of $123.5 billion a month or $1.482 trillion a year. Some rounding error, huh?

Some will argue that it just doesn't matter. After all we can just keep on printing, borrowing and spending . The dollar is valued around the globe and the Fed will provide the necessary money to just keep on buying as the Treasury keeps on printing -- a corner on the bond market if you will.

Consider this -- we are running at about 2% growth on GDP while injecting borrowed money into the economy at the rate of 9% of GDP using the real deficit figure. 2% of GDP is $320 billion and would leave us flat on GDP if we did in fact reduce the deficit by the $320 billion. We would still be running a deficit of $1.162 trillion and we would end up with no GDP growth at all for the money.

I have argued that the problem with Congress is not a matter of partisan bickering but a matter of no viable solution to the problem. In truth, the best solution in the near term is the one in play right now but as all will concede it is not sustainable.

Congress raised taxes on those in the $400,000 plus category and in so doing created a projected increase in revenue of $60 billion for the coming year. The Obama camp has stated that it is happy with the revenue side of the equation and now we need to move on to the spending side by simply raising the debt ceiling once again. In other words no spending cuts and a continuation of deficits running at a rate equal to 9% of GDP.

The truth is any spending cuts at all and we go into recession. This is also true - such irresponsibility is wholly unsustainable and we have reached a tipping point. You can spin this any way you want but the truth is -- as I have already stated -- we are in a pickle and no solution exists that avoids recession.

Will the Fed lose control producing high rates of inflation?

Many set forth this premise and I admit to struggling with the logic. High rates of inflation are problematic but perhaps not nearly as problematic as a deflationary spiral at a time when unemployment still remains above 14% using U6 and the labor participation rate is at a 50-year low.

Of course the Fed would much prefer combating inflation over the alternative. Rhetoric aside, the Fed has done all it can to induce inflation. Consider that it has sat on a ZIRP policy for several years now and injected $3 trillion into the economy through QE. Are we to assume it has done that only to permit deficit spending to continue on its upward trajectory until it becomes unsustainable?

In other words, are we to conclude that the Fed didn't want to create inflation with its monetary policy, preferring instead to buy up all the debt the Treasury issues and to do so in a way that keeps the carry costs low by cornering the bond market. That is an ill-conceived plan if I ever heard one. Of course it wants inflation.

Consider this - an inflation rate of 6% would go straight to GDP. As it stands at the moment it is deficit spending that is adding 9% to GDP. Would it not be better if we could maintain the status quo with a 6% inflation rate and a 2/3rd's reduction in the annual deficit? Or better yet, reduce the deficit by 1/3rd and use the other 1/3rd for some kind of jobs program that would put people back to work?

This is classic Keynesian economic theory - expand the money supply during periods of economic contraction and in so doing increase the rate of inflation, which in turn drives GDP growth and that drives job creation, which further drives GDP growth. That is what the Fed has tried to do and failed as the chart below illustrates:

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Notice that each successive QE has produced less and less in the inflation department. QE1 moved us from a -2% to about 2.5%, a 4.5% increase in the inflation rate. QE2 produced about 2.75%. QE3 produced less than 1% and the most recent initiative no increase at all. The theory of diminishing returns is in full play here and must be very disconcerting to Bernanke and his FOMC colleagues.

There are many who weigh in on this subject and they are convinced that inflation is just around the corner. I say let us hope so as it is our only solution to the dilemma we are faced with. However, as a Keynesian I must remind readers that Keynes did define the dilemma we are in.

Karen Murdarsi, in her article, "Keynes and the Liquidity Trap", explains in an easy to understand way what Keynes meant by liquidity trap:

Why did Keynes believe that government spending was the way to break the cycle? To answer that we need to look at the other ways of controlling the economy.

1) The government (or the central bank) can try to reduce the 'price' of money by lowering interest rates. The laws of supply and demand say that low demand reduces the price of goods to a level where people want to buy them. In the case of money that would mean reducing the cost of borrowing, i.e. interest rates. The trouble is that in a recession, people may be so unwilling to borrow and invest that it is impossible to reduce the price far enough. Once interest is at zero, there's nowhere else to go.

2) The government (or bank) could increase the money supply - they could literally (or electronically) print more money. The idea is that this money will work its way around the economy, allowing people to spend and invest more, and increasing employment. The trouble is that when times are bad people want to hold on to their money. They don't want to invest it in stocks which might fail, or spend money on goods and services when they fear it will leave them short later. They feel safer holding on to money in 'liquid' form (cash) which means that all the new money released is hoarded by nervous banks and savers, and does nothing for the wider economy. This is what Keynes identified as "the liquidity trap."

All indications are that we have remained in a "liquidity trap" for over four years now. Cash hoarding began at the onset of the recession and it has continued to be the dominant reason for continued high unemployment, low GDP and no significant inflation. The relevant economic metrics that demonstrate this inconvenient truth include the following:

  • The savings component of M2 has far outpaced M2 growth.
  • Excess bank reserves are at record highs.
  • Corporate cash balances are also at record highs
  • Money velocity is at a 50 year low.

Consider the following charts:

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None of these charts suggests inflation. To the contrary, each of the charts reflected above indicate an economy that remains in a "liquidity trap." There has been a lot of conversation in recent weeks that the Fed might be in a situation where it can't control inflation but in truth, inflation is what it wants. Again, it is at the heart of Keynesian economic theory - the solution to our economic woes.

Cash hoarding has been the dominant theme since the Fed first introduced ZIRP and QE and it continues to be the dominant theme. Banks aren't lending and individuals and corporations are saving. That is what the data continues to tell us despite the recent increase in inflation rhetoric.

Here's the uncomfortable truth - without inflation we are going into recession and that means the dollar will gain in value. A look at the chart below shows that as GDP fell and we entered into recession in the 3rd quarter of 2008 the dollar spiked higher moving up almost 20% before QE1 reversed GDP. The dollar then dropped only to move higher again even as GDP began to increase - an indication that QE and ZIRP did not produce the intended results.

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In a recession deleveraging will begin to accelerate as loans are paid off voluntarily or by force as foreclosures begin to increase. A loan payoff reduces bank deposits thus shrinking M2 and a contraction in M2 will necessarily force the dollar to move higher.

It comes down to this - either sentiment shifts and we stop hoarding cash and start spending, which will drive demand for goods and services and in so doing drive demand for labor, which will then drive demand for more goods and services - or we continue to hoard cash. The most recent consumer sentiment numbers suggest that such a shift in sentiment is not occurring.

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Are we on the verge of a housing recovery and a pick up in employment?

The one area that bodes a little better in terms of real economic growth is the fact that the unemployment numbers are improving but the improvement is so modest that it can hardly be called a trend. Using the U6 number unemployment levels remain at 14.4% and the labor participation rate remains at 30-year lows.

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In spite of the modest gains in the unemployment numbers the chart above suggests those gains are being offset by income declines thus nullifying any positive gains as it relates to increased GDP growth.

Let's move on to the recovery in housing:

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Again, we are seeing modest gains in this area but not enough to significantly impact GDP growth. Additionally the overhang of underwater mortgages remains a serious problem. The truth is a recession could have a dramatic impact on housing inventories as foreclosure rates move higher. The bottom line here is that it is probably too little and too late.

Considering the various metrics set forth here in conjunction with the fundamentals and the debt ceiling debate that will pick up steam in the next few weeks it is hard to see much more upside and all the makings are in place for a sentiment shifting catalyst that can easily shake stockholders' complacency in the coming weeks. We are working in an environment where monetary and fiscal policy are experiencing the law of diminishing returns as each successive policy move has less effect than the previous one and stocks at current levels are at a significant divergence from other metrics.

I think there is ample reason to conclude that a catalyst will soon surface as we move into the contentious and partisan battle relating to the new fiscal cliffs created at the time Congress dodged the bullet on the original "fiscal cliff." That said, there are a few more things to consider. First, stocks are priced based on earnings expectations. It can be argued that we have seen stock prices and profits continue to rise in spite of the fact that none of the metrics mentioned here has provided much in the way of support. The final part of this three-part series will delve into expectations going forward on the earnings and profit margins front.

Source: Using Common Sense And Logic To Forecast 2013 - Part 2