In this report I will list the narratives or themes that I think will define the evolution of the US equity market in 2012.
1. Europe, Europe, Europe and more Europe. For reasons that I have written about at length, Europe is highly likely to suffer a major financial crisis and recession in 2012. Europe has chosen an economic policy - namely, fiscal austerity -- that simply cannot work under current conditions. Under current circumstances, spending cuts and tax increases will only lead to severe economic contractions that in turn will produce greater fiscal deficits.
The only viable way to finance these deficits is via additional German guarantees or ECB monetization, and Germany will likely resist both of these alternatives. Even if the Germans eventually relent, it will only be after real economies in Europe have been severely damaged and financial markets have suffered huge losses.
Investors should note that approximately 14% of sales and 17% of S&P earnings come from Europe. This is very significant. However it reflects only the direct contribution.
For example, imagine an Asian producer that sells to Europe; this producer, in turn has S&P 500 suppliers in Asia. As European sales dry up, sales of the S&P 500 subsidiary dry up. Similarly, if revenues from exports to Europe decline via reduced employment and incomes to Asian workers, S&P 500 sales to Asian consumers will decline.
2. China's hard landing. China's economy is extremely reliant on exports - directly and indirectly. China's largest export market is Europe. During the US recession of 2008-2009, China was only able to avert an outright recession through massive deficit spending and huge monetary stimulus via an almost indiscriminate expansion of credit, primarily directed at the real estate sector.
The organic impact of a recession in Europe on China's economy will be similar to the one that the US recession had on China in 2008-2009. And just as occurred in 2008-2009, the Chinese government will attempt to respond aggressively to counteract the shock to demand.
The problem is that this time around, Chinese policy makers will have one of their hands tied behind their back. On the one hand, China has the wherewithal to engage in massive fiscal stimulus to counteract the demand shock. On the other hand, China will be unable to provide effective monetary stimulus via credit expansion to the same effect that it did in 2008-2010. Most of the monetary stimulus from 2008-2010 was executed via credit expansion to the real estate and construction sectors along with the industries surrounding them. The problem is that in 2012 this sector is already choking on excess capacity and is unlikely expand activity in response to credit availability.
Quite to the contrary, the real estate and construction sector and the industries that service them are currently on a path toward contraction in 2012. Given that this sector represents between 20%-25% of the entire Chinese economy and the export sector and supporting industries represent an even larger share, it is unlikely that China will be able to avert a "hard landing" in 2012.
A hard landing in China would affect the world in two ways. First, the Chinese economic juggernaut largely drives growth in the rest of Asia. A hard landing in China, means a hard landing for the rest of Asia. Second, a hard landing in China will produce a horrific collapse in commodity prices around the world. Investors should note that at least 30% of S&P earnings (e.g. energy, basic materials) are tied to global commodities and/or global cyclicals. - examples would be Exxon (NYSE:XOM), Freeport-McMoran (NYSE:FCX) and E.I. Dupont Nemours (NYSE:DD). In the context of a collapse of commodity prices such as occurred in 2008-2009, the earnings for many companies in these sectors will not only fall; they will go negative.
3. Emerging markets. A hard landing in China and recession in Europe will produce major recessions in the export dependent Asian countries. Latin America will also experience slowdowns and recessions due to the negative impact of lowered commodities prices and reduced access to credit.
Regarding this latter point, it is important to note that emerging markets, and Latin America in particular, are highly dependent on developed-world financing, particularly from Europe. European banks are undergoing a process of massive deleveraging in their home countries. Home country governments in Europe will "strongly encourage" their banks to do this deleveraging abroad thereby ensuring that credit to emerging market nations will become highly constrained.
4. Direct effect on US economy limited; indirect impacts large. Many people make the mistake of focusing on direct links between the US macro economy and the rest of the world. For example, bears assume that since "we live in a global economy" the US must necessarily be directly impacted by events in Europe and Asia. This is a mistake since the US is a relatively self-contained economy. On the other hand, bulls make the mistake of assuming that just because US exports are a relatively small share of GDP, that the impact of crises in other nations on the US must be minor. Both of these perspectives miss the mark because they focus on the wrong variables.
In terms of direct effects, it is true that the impact of crises in Europe and China through loss of US exports is relatively modest. Indeed, it could be argued that crises in Europe and China could have net direct benefits for the US economy. For example, China's woes will produce a commodity price collapse that will have a far more beneficial impact on the commodity-importing US economy than the detriment from lowered exports to China. Furthermore, global crises ensure ample capital flows to the US and ultra-low interest rates.
The problem is that there are large but difficult-to-measure indirect linkages. For example, global economic turmoil can negatively impact both investor sentiment and consumer sentiment. Since consumption and investment make up the lion's share of US GDP, even marginal shifts in the propensity to consume and/or invest can have a major impact on overall GDP growth.
Other indirect impacts on the US economy can be classified as "financial contagion." For example, falling stock prices originally triggered by foreign events can depress consumption and investment via "wealth effects" as consumers and investors feel poorer and also become more risk averse in their behavior. Another example would be the effect of international crises on bank lending. To the extent that US banks are forced to take hits to their balance sheets from foreign exposures, they may restrict credit to US consumers and businesses - both due to the need to deleverage their balance sheets as well as rising aversion to portfolio risk.
In any event, the bear case for US equities and index ETFs such as SPDR S&P 500 (NYSEARCA:SPY) and Powershares QQQ Trust (NASDAQ:QQQ) is not primarily based on the direct and/or impacts of global crises on the US macro economy. It is based on the impact on the earnings of S&P 500 companies, which is quite a different matter.
5. S&P earnings hit hard. The impacts of a global crisis on S&P earnings will be large. First, foreign sales comprise over 35% of S&P 500 revenue and in the neighborhood of 50% of S&P 500 earnings. Second, a global crisis would primarily affect cyclical and financial sectors that are subject to huge swings in earnings. For example, tumbling commodities prices can cause the earnings of energy and basic materials companies such as Chevron (NYSE:CVX), Alcoa (NYSE:AA) to swing from large profits to deep losses. Furthermore, US financials earnings such as Citi (NYSE:C) and Morgan Stanley (NYSE:MS) could swing to negative if they are forced to take hits on their international exposures in Europe, Asia and Latin America.
Indeed, if Europe experiences a major contraction and China experiences a hard landing, investors will be extremely fortunate if the S&P 500 can muster $60 in EPS between 2Q 2012 and 2Q 2013. Considering that consensus is currently forecasting EPS of roughly $110 for that period, it is quite likely that if the consensus were eventually to downgrade its expectations towards $60 that stock prices would adjust significantly downward.
6. Risk premiums rise; PE ratios fall. Obviously, a global economic crisis would cause risk aversion to rise. P/E ratios will fall and spreads to Treasuries of all risk assets such as corporate bonds and equities will tend to rise.
7. Strong dollar. A global crisis will be associated with a strong US dollar. A strong USD will negatively impact revenues and profit margins of US companies.
8. Treasury bubble. It is likely that a major bear market triggered by a global economic and financial crisis will be associated with an ever greater bubble in US Treasury bonds as global investors seek the relative perceived security of the USD and US sovereign paper.
9. 950-1,020 Target. My S&P 500 (SPX) target is premised on a confluence of two factors. First, there are strong technical supports at both of these levels. Secondly, my estimate of normalized earnings for the S&P 500 is in the range of $85. With the S&P at 1,000 the PE of the S&P 500 would be 11.7. This is at the lower end of the "normal" historical range for the S&P 500 (Pending:GSPC).
In my view, assuming that the crisis that I am forecasting for Europe comes to pass, the enormous uncertainties surrounding the future of the US and global economies and financial systems will warrant a PE multiple towards the bottom of the historical range.