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If you have read Part 1 and Part 2 of this 2013 forecast you know that I see a rapid and steep recalibration in stock prices beginning in the first quarter of 2013. For the moment the momentum is higher and I don't discount the possibility of stocks testing the all time highs at 1576 on the S&P - a possible blow off top - before reality sets in and stocks rapidly recalibrate and the dramatic divergence between stock prices and economic reality correct.

Mind you I am not suggesting there is a high probability of this occurring. The truth is I can see a capitulation sell off occurring at any time. We are already up 6.2% on the S&P on the year and 12.7% from the November, 2012 lows. In part 1 of this series I made mention of the risk/reward in holding stocks for the all time highs. My best case scenario for 2013 is a range basis the S&P of 1600 on the high side and 1260 - the 2012 lows - as the low side.

I don't assign a high probability to either of these levels defining the 2013 range but again a best case scenario that offers 100 points in gains versus 200 points in risk is just not a good trade. Tops are extremely difficult to call and I have no crystal ball that tells me where we peak or when. A crystal ball isn't necessary to forecast a probable trading range for 2013 though. The divergence between stocks and the economic metrics we use to assess economic health leave little in the way of optimism for 2013. I will list those metrics for your consideration but first I want to repeat one more time a statement that I made regarding the nature of stock markets:

"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."

That is the nature of stock market participants. The evidence of this is abundant in pundit articles and comments. We tend to cling to the most modest of positives as proof that things have turned around and summarily discount the negatives. It usually requires a catalyst to shift sentiment and upside momentum. So, to the list of negatives that are being ignored:

  • Unemployment remains at 14.4% using the U6.
  • Housing starts - despite recent modest gains - remain in the cellar.
  • Underwater mortgages remain in the 20% of total range.
  • GDP is flat and expected to trend lower in coming quarters.
  • Deficit spending has averaged 9% of GDP for 4 years now and GDP has averaged about 2% -- an economy held together only as a result of massive government spending.
  • The inflation rate is falling.
  • The impact of QE is suffering from the law of diminishing returns.
  • Cash is continuing to be hoarded by banks, businesses and individuals.
  • Money velocity remains at 60 year lows.
  • Labor participation rate is at 30 year lows.
  • Disposable personal income is falling.
  • Disposable personal income will fall further in 2013 solely as a result of the discontinuation of the payroll tax cut holiday - about $125 billion by most estimates.
  • Consumer sentiment is once again falling.

I read an article recently that showed a chart of 4 major economic metrics that suggest we are well on our way to economic recovery. The chart uses the 2009 low as a start point and shows an upward trajectory for the 4 metrics from those 2009 lows. It is just that kind of buy side bias that bothers me.

There is no question we have shown modest gains since the end of the recession in some metrics but the key word here is modest and when using the absolute bottom as a start point one can create the false illusion that all is well and moving forward. To really see what has been achieved we must look at things through a wider lens. For instance, the longer term charts that provide a true perspective on the progress we have made since the recession.

The answer to the question of whether we are making progress then is some but not nearly enough when compared to the cost of achieving that progress - almost $6 trillion in fiscal stimulus and $3 trillion in monetary stimulus. So are we better off as we start 2013 than we were at the start of 2012?

In some areas we are modestly better and in others modestly worse and collectively at about the same place we were a year ago at this time with a few exceptions. As to the exceptions, we have expanded the public debt by another $1.4 trillion and we have moved into the 5th year of the "liquidity trap" that took over sentiment at the onset of the recession.

All the evidence suggests more of the same for 2013 but what really drives stocks are corporate profits. To get a good idea on where we are going in 2013 we need to take a look at some key metrics relating to corporate profits and of course corporate revenues as the top line tends to be a better measure of market movement than the bottom line profits.

The charts below reflects the 3 month moving average of the monthly returns of the S&P 500 stocks and the 3 month moving average of the S&P 500 closing price:


(Click to enlarge)


(Click to enlarge)

From about August 2010 on the margins and the S&P price correlate closely relating to peaks and valleys. What is most compelling though is that the valleys on the S&P close are much more shallow than the corresponding valleys on the margins chart. Consider that the S&P close is at an all time high while the margin chart shows a number that is just a fraction in the black and very close to turning negative. It is just these kinds of divergences that a good analyst looks for to ascertain future price direction.

One of two things is going to happen. We are going to get a very sharp spike higher in margins or a sharp and steep down move in stocks. Divergences present opportunity in that they always correct in time.

Of some significance is the fact that the margins chart shows that we are very close to the same level we were in June-July of 2011 and we also are approaching the same matter of the debt ceiling that precipitated the steep and rapid sell off in 2011. Consider also that we must now contend with the debt ceiling and whether or not the "sequestration" cuts will kick in.

Few seem to consider the fact that the "sequestration cuts" happen automatically without both the Senate and the House agreeing to suspend implementation. These particular cuts in spending were determined in 2011 and are now law. It's hard to see the spending cut hawks agreeing to further extensions of these cuts and the truth is they don't have too in order to get their way.

The spending cut hawks are holding a royal flush on this and necessarily must fold their winning hand if these cuts are avoided. One can argue that they will fold on this as it almost assuredly will result in recession. I agree that it will result in recession but I also believe we can't postpone fiscal responsibility for another year.

All the metrics we have looked at save housing and unemployment are negative and the very modest improvements in these two areas in no way counter the negatives in the other metrics. Again, it is too little and too late.

Let's take a look at one more chart - this time per share sales. The correlation between sales per share and the S&P 500 are again reasonably close.


(Click to enlarge)


(Click to enlarge)

The divergence here is not so significant but it does reflect a flattening of the top line sales numbers after a drop in the first quarter of 2012. At the same time the S&P close has continued to rise as the recent highs set in January are not reflected in the chart above.

These two charts are only relevant in my opinion in that the rate of ascent is producing less upside with each successive leg higher on the S&P close and the top line sales per share number is finally starting to flat line after being steadily higher from the first quarter of 2009.

The chart below is also interesting and tends to support 2 of my points - we are still in a liquidity trap where cash hoarding is the dominant theme and the law of diminishing returns is in full play as each new QE has less impact than the one before.


(Click to enlarge)

Many argue that the steady decline in volume that is occurring while the S&P continues higher and higher is not relevant today. In other words, in order to support our bull side bias we must necessarily discard a major axiom of stock market forecasting - that is a move up on weak volume is not sustainable.

The truth is a move up on weak volume where almost no significant correction occurs is indicative of a market that is being manipulated - a corner on the market that produces steady gains that far exceeds justifiable levels. Granted a 4 year corner seems a little extreme but the fact remains that is what has occurred.

Few doubt that the Fed has attempted to manipulate stock prices and in fact Fed Chairman Ben Bernanke has made no secret of his desire to create a "wealth effect" through stimulus and he has achieved that end so far. The truth is there are statutes against attempts to manipulate stock or commodity prices if the actor is in the private sector. No attempt to corner a market that I am aware of ever resulted in a positive outcome. The Fed's effort to manipulate stocks in this instance will be no different.

An argument that I have made for some time now is that money expansion and velocity must occur in order to produce GDP growth and at some point corporate America will not be able to maintain top line sales or margins without both M2 increase and money velocity increase.

Action

M2

Savings

M2 - Savings

QE1 start - 11/08

7.995

4.032

3.963

QE 1 end -3/10

8.502

4.963

3.539

QE 2 start - 11/10

8.747

5.297

3.450

QE 2 end - 6/11

9.165

5.717

3.448

QE3 start - 9/12

10.127

6.455

3.672

11/12

10.250

6.569

3.681

The table above establishes that a "liquidity trap" continues to keep money velocity at 50 year lows as cash hoarding continues. The table demonstrates that M2 hasn't added to M2 as much as most think. Even more troublesome is the fact that the saving component of M2 has increased by $2.527 trillion as M2 has increased by only $2.255 trillion.

For those who fail too see the significance of the cash hoarding that is occurring and continues to this day - money in savings isn't being used to buy goods and services in the economy. Furthermore, a look at M2 growth correlates well with both excess reserve balances -- money not being used to expand M2 through private sector loans - and the amount of new money created by the Fed with QE1, QE2 and QE3.

How we have sustained positive GDP for the last 4 years

The point is a simple one - without GDP growth corporate sales and margins are most assuredly going to shrink in 2013. So where do we get that GDP growth. Since the recession we have managed to keep GDP in positive territory only through fiscal stimulus.

Consider we have increased debt by $5.8 trillion which means the federal government has borrowed and spent $1.4 trillion a year on average and it is reasonable to assume that a 1:1 ratio of spending to GDP was created. In other words, absent the $1.4 trillion a year --- a number that represents approximately 9% of GDP - GDP would have been in negative territory in each of the last 4 years.

The simple truth is that the Fed hasn't managed a significant increase in M2. All they managed to do is fund the purchase of new debt that has funded the economy to the tune of about 9% a year. What's disturbing at this point is the matter of curbing spending. We can't know for sure how all this works out in the coming months. What we must consider though is how much longer we can remain on this course.

We may get a compromise that produces no spending cuts and a continuation of the status quo but how will market participants see that or for that matter how will those that hold U.S. debt see that? As I have said over and over our economy is on life support and not capable of maintaining positive GDP if the fiscal stimulus is withdrawn.

What makes the problem decidedly worse as we start 2013 is that we now recognize that failed monetary policy has left us with no choice. We either continue with current borrow and spend policies until the market forces us to accept fiscal responsibility or we deal with the matter now. We are at a tipping point and there is really nothing that bodes well for 2013.

A market call for 2013 and beyond

The chart below of the Dow helps me make this forecast. I can see a scenario developing where we enter recession in 2013 and that will increase unemployment further and shrink corporate revenues and profits. Stocks will move sharply lower -- probably taking out the 2011 lows. This process is admittedly subjective but I can see a fall by year end to the 8500 to 9500 area on the Dow.

This will precipitate the much needed completion of the deleveraging that was postponed in 2008 - 09 with massive monetary and fiscal stimulus. Thereafter, we may have a knee jerk rally before moving lower as reality sets in. I can see two ultimate lows - one the 2002 low in the 7500 area and the other being the 2009 low in the 6500 area.

I suspect we will then have a few years working in a trading range as we work through the deleveraging process. Interest rates will spike forcing a move to reduce public debt as carry costs become very burdensome. Deflation is the logical outcome here which will make dealing with the massive public debt troublesome as the revenue side of the equation will be severely hampered.
(Click to enlarge)

Again, this is admittedly subjective but it seems reasonable that we would bottom out in the 7500 area on the Dow and after a year or two of consolidation we would complete the formation of the right shoulder of an inverted head and shoulder formation. A second scenario would be a test of the 2009 low at 6500 creating a double bottom formation.

Some may see that as extreme but consider that we have made no significant improvement in any metric used to measure economic health. Markets have moved back to the all time highs largely on a belief that Fed policy would work but it has not. The truth is we have survived only through fiscal stimulus equal to 9% of GDP. This can't continue despite those who seem to prefer this course.

The stock market has moved back to all time highs but the economy is just as sick as it was in 2009 with the added caveat that we now have a bloated national debt and a bloated Fed balance sheet. The solution has turned into a significant part of the problem and only adds to the overall negative outlook in coming years.

A deflationary spiral is not a good thing but it is hard to see any other outcome if one looks at the situation without bias. Additionally trying to forecast future price action based on any historical data set seems useless at this point. There is simply no prior period that correlates well with the situation we find ourselves in today.

We are a global economy today and virtually all major economies are facing the same dilemma. Fiscal irresponsibility has overleveraged and jeopardized our future. Europe is in recession, Japan has remained bogged down for years now and the U.S. - choosing the same dead end path has now expanded debt to a point in excess of GDP.

There is ample evidence on a global scale that these policies haven't worked and no reason to assume that things will change until the source of the problem in the first place is resolved. The truth is an irresponsible and government sponsored initiative to over leverage America began decades ago. In the first decade of the new century the markets have recalibrated two times before moving higher.

The problems were created by an excess of debt and it was the promise of more and easier access to debt that pulled us back from the abyss two times now. We have continued this policy of solving our debt problems with even more debt. The difference this time is that private sector banks, corporations and individuals balked and chose instead to hoard cash. It is this dynamic that will produce a steep recalibration in 2013 and the beginning of the deleveraging that must occur before we can return to the buy and hold strategy that most long for.

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. I am short a group of tech stocks and financial stocks.

Source: Using Common Sense And Logic To Forecast 2013 - Part 3