My 2013 outlook is coming a bit late this year and so readers should assume that it covers the period from February 1 through December 31, 2013.
Let us review where we have stood previously. I was tactically (medium-term) and strategically (long-term) bearish at the beginning of 2012. As detailed in my latest article, the scenarios for Europe that I expected did not transpire, and by late August of 2012, I called off my bear market prediction and suggested a more constructive tactical stance. In my most recent article I explained where I think my tactical S&P 500 forecast through August 2012 went wrong.
For reasons I have detailed elsewhere, I have not changed my view that real (inflation-adjusted) equity market returns in the next 10-20 years will, on the whole, be significantly below historical norms. However, this essay will concentrate on the medium term prospects for US equities and will outline some asset allocation ideas.
Summary Analytical Framework
My analytical framework for market strategy takes into account four main sets of factors: 1) Valuation; 2) Change in fundamentals; 3) Technical analysis; 4) Psychology. In this section, I will briefly outline my analysis of each of these factors. In a subsequent section, I will expand specifically upon the fundamental factors.
1. Valuation: Neutral. The aggregate valuation of S&P 500 index of stocks is well within normal historical ranges (+1,-1 STV), on most measures. The trailing PE of the S&P 500 is currently 17.3 compared to the historical average of about 15.4 since 1871. The 12-month forward PE of the S&P 500 is currently 14.0 versus a historical average of 12.8 since 1976 (the latest date forward earnings estimates are available). Stocks look expensive based on Robert Shiller's PE10 methodology (current 22.4 versus average of 17.3 since 1871) but I believe Shiller's PE10 methodology is fundamentally unsound and is currently underestimating normalized earnings. My own estimate of normalized earnings places the market's current PE well within normal historical levels. Stocks look very cheap according to the so-called "Fed Model" and other models that compare equity earnings yields to current bond yields, but this methodology is also unsound. If you normalize bond yields, stock values are well within normal parameters compared to bonds.
In sum, valuations are currently neither particularly cheap nor expensive. Therefore, valuations should not be a major driver of stock market returns.
2. Change in fundamentals: Positive. When overall fundamental momentum is changing in a positive direction, particularly relative to expectations, stocks tend to do well. From a long-term point of view, none of the secular structural problems that have roiled markets in Europe, China or the US have been resolved. However, cyclical macroeconomic growth fundamentals are rebounding notably around the globe and my outlook is for this trend to continue, at least for the next 6-9 months. I will discuss this more thoroughly in a separate section.
3. Technical analysis: Positive. There can be little doubt that the price action is positive. Upward thrusts are sharp and prolonged, while pullbacks are short and shallow. This basic price action plus many indicators, including moving average crosses, up/down volume indicators and others, evince strong demand/supply dynamics at work. Having said that, given recent strong advances, some measures of momentum are showing signs of exhaustion on a short-term basis (e.g. Tm Demark system). Furthermore, significant resistance points lay immediately ahead. Therefore, I would say that technically the overall technical position of the market seems strong, but could run into some headwinds on a short-term basis.
4. Psychology: Mixed. The price action, various sentiment surveys and the VIX tend to indicate substantial bullish sentiment and complacency, which is normally a bearish sign. However, this bullishness may only be skin deep as the bullish sentiment seems to be mainly concentrated amongst investment professionals and active investors, while the sentiment of the general public towards stocks and the macro economy at large is still quite depressed. Thus, the medium-term sentiment situation may yet be supportive. However, in the shorter term, excessive bullishness by currently active investors could signal a risk of a correction.
In sum, the overall mix of factors that comprise my approach to strategy call for a cautiously opportunistic approach on a 6-9 month basis.
The Fundamental Outlook
It is important to remember that about 50% of S&P 500 earnings derive directly from outside the US, and that if internationally priced goods (inputs and outputs) are factored in, well over 60% of S&P earnings derive from non-US sources.
US: Fundamentally, the US is in a good position to experience accelerated growth in 2013. There is significant pent-up consumer demand, consumer balance sheets have stabilized, and corporate balance sheets and cash levels are extraordinarily favorable. Political risks surrounding the debt ceiling have subsided. Significant headwinds remain, including the increase in the payroll tax and possible fiscal tightening (both tax and spending). But all and all, in the absence of significant external shocks, the US seems poised to accelerate GDP growth to the 3.0% level and possibly beyond.
Europe: None of Europe's fundamental problems have been fixed. The major problem in Europe is a dysfunctional currency arrangement amongst highly disparate countries. Having said that, the most immediate dangers in Europe have been taken off the table now that the ECB has explicitly assumed the role of fiscal deficit financier of last resort. As long as this remains the case, default risk in Europe for the foreseeable future is minimal. At the same time, while European economies, and particularly the PIIGS, are undergoing significant recessions, this seems to be occurring in a manner that the economic, financial, political and social systems are able to withstand. Therefore, a convalescent but relatively stable Europe does not appear to pose the sort of immediate threat to global stability that it did in 2013.
Japan: Japan is in full stimulus mode - fiscal and monetary. Whether this will work in the long term is debatable. But Japanese stimulus measures should provide a net positive to global growth in 2013.
China: China's economy is still fundamentally dependent on the export sector. As GDP accelerates in the US, Japan and stabilizes in Europe, Chinese GDP can be expected to rebound. While China's economy suffers from massive imbalances in various key sectors, these imbalances can persist for quite a bit longer as long as the economy is growing vigorously led by strong exports as well as the policy-driven stimulation of internal demand.
Emerging markets: Latin American economies are generally tied to commodities prices while the largely export-dependent industrial Asian economies are largely tied to the economic cycle in the developed world and China. In this sense, to the extent that the US, Japanese and Chinese economies are in acceleration mode, cyclical emerging market economies should generally boom.
Inflation risk: In the above scenario, commodity prices could escalate stoking general price increases around the world and igniting now-dormant inflation expectations. In the US, the risk of domestically sourced inflation is relatively low due to labor market and capacity utilization slack. However, the risk of foreign sourced inflation is very real. Commodity price inflation is very likely if economies in China and emerging markets accelerate significantly. At the same time, inflation in China and emerging markets has proven itself to be very responsive to global demand and this inflation can be exported to the US through various channels. Above all, inflation is largely a psychologically driven phenomenon driven by expectations and heightened inflation around the globe could ignite dormant inflation expectations in the US.
As things stand right now in the US, both overall and core CPI are quite high given how sluggish GDP growth is. Therefore, a combination of accelerating growth in the US, imported inflation and heightened inflation expectations may well provoke a significant increase in inflation in the US. In my view, the Fed's newly announced core inflation threshold of 3.0% could come into play during the second half of 2013.
Why is an inflation of acceleration a risk to stock prices? Moderate inflation per se, does not pose a threat to equity fundamentals. However, it poses a threat to the Fed's QE program. Anticipation of the end of QE and/or the unwinding of that policy could well have a negative impact on equity markets. Just as anticipation of QE has driven several major rallies in stocks since 2009, it is not unreasonable to think that anticipation of the end of QE could negatively impact stock values. Furthermore, sharply rising gasoline prices have historically tended to signal cycle turns in the economy and stock market. While I would expect this to be a concern for the second half of 2013, markets could begin to discount such a scenario at any time.
Please note that inflation risks are magnified by the fact that few currently give them any credence. Financial markets have become complacent about inflation.
Event risks: Iran, North Korea and any number of other isolated events could change the course of the global economy. While I do not foresee any of these risks manifesting in the foreseeable future, all such potential threats must be monitored.
In sum, demand side fundamentals around the globe seem poised to start firing on various cylinders, dragging even an ailing Europe along with it. It is important in this respect to recall that monetary easing has been flooding markets for a while in virtually every major region of the world. Therefore, any pick up in consumer and business demand will be met by abundant credit and liquidity, enabling strong demand side growth fundamentals. Indeed, notwithstanding the recent negative fourth quarter GDP print in the US, and other disappointing GDP results around the world, most key indicators thus far in late 2012 and early 2013 suggest an acceleration of economic activity. This is clearly a positive environment for equities. However, inflation risks lurk around the corner from accelerating global growth, and this could derail the progress of equity prices at some point during 2013.
This essay is not the appropriate format to lay out a full portfolio. Therefore, I will concentrate on broad asset allocation suggestions.
Bonds: All but the shortest term and highest quality bond positions should be liquidated. Bond returns in 2013 will probably be bad, and could be very bad. Yields and spreads are extremely low at a time when the economic cycle and inflation dynamic may be set to turn. A short TLT and/or JNK position can be considered.
Equities: For tactical medium-term investors, an overweight equity allocation can be considered. This can be implemented via SPY. Under the fundamental scenario described above, the outperforming sectors could be small-caps (IWM), growth stocks (VUG) or (VBK), financials (IYF), and emerging markets (EEM). I would expect value and dividend oriented stocks to lag in terms of relative performance. Strategic investors who are not comfortable with tactical timing should remain defensive in their equity allocations, if any.
Commodities: Commodity stocks (DBC) and commodity producing stocks (IGE) should do well. I particularly like the oil service sector which investors can gain exposure to through IEZ. Gold and gold stocks might seem to be an attractive option in a scenario of accelerating inflation. However, gold prices are very expensive relative to virtually all other investable assets and I therefore consider any allocations to gold (GLD) or gold stocks (GDX) to be highly speculative trades as opposed to being prudent investments.
Cash: Long-term strategic investors who do not wish to invest tactically should maintain large overweight positions in cash and very short-term bonds. More tactical investors should probably maintain an overweight allocation to cash raised via the liquidation of all bond holdings while cautiously building a more or less neutral allocation to equities.
Timing: The above suggestions are for a 1-9 month timeframe only. Inflation dynamics must be monitored in the interim as any confirmation of significant acceleration of commodity prices and/or inflationary pressures in emerging markets, investors should quickly trigger reconsideration of equity allocations as speculation will mount about unwinding of expansionary central bank policies around the world.
My tactical bearishness from July of 2011 through August of 2012 was premised on the development of a steep crisis in Spain and Europe. While none of the secular fundamentals in Europe have improved significantly, the crisis there seems to have stabilized on a cyclical basis. As a result, without the weight of the world's largest economy and financial system bearing down on it, the rest of the global economy will be free to experience a rebound, capitalizing on ultra-low interest rates and unprecedented liquidity.
Having said that, I continue to believe US equity returns in the next 10-20 years will significantly trail historical averages. Constraints on consumer and government spending (due to consumer and government debt overhang), demographic headwinds and heightened macroeconomic volatility will tend to depress real returns on equity investments over this timeframe. A long and hard road will likely be interspersed by an increase frequency and intensity of bear markets.
Nothing in this scenario is incompatible with intermittent bull markets - even very sharp ones. The US is currently experiencing one of these bull markets and it could well be extended if macroeconomic improvements around the world as outlined in this essay materialize.
It will not be easy to ride these intermittent bull markets. Therefore only investors comfortable with tactical short and medium-term trading and investing should attempt to do so. Investors with a more long-term and/or passive bent should remain heavily allocated towards cash and ultra short-term bonds in order to capitalize on better opportunities that will surely come. As of this writing, the S&P 500 is currently at 1498. I believe that there will be opportunities in the future to purchase stocks at levels substantially below today's prices, though not necessarily in the first few months of 2013.