Outlook For Equities: Time To Take The Foot Off The Accelerator

Includes: BND, IWM, SPY, TLT
by: Morningstar

By Michael Rawson, CFA

The Congressional Budget Office recently laid out two economic forecasts based on two different fiscal policy paths. Neither forecast looks appealing.

In the first one, the Bush tax cuts expire while government spending is cut by about $100 billion according to current law. This is effectively the removal of fiscal stimulus and raises the likelihood of recession in 2013. This path requires no Congressional action. In other words, unless Congress acts, we are headed off a fiscal cliff. We can see the effects of a fiscal cliff in Europe, where they call it austerity. Eurozone gross domestic product contracted in the second quarter and the continent has likely entered another recession.

The second path requires the extension of tax cuts and postponement of spending cuts. This would cause another $1 trillion deficit and even under this scenario, the economy would expand in 2013 at a meager 1.7%.

There are two approaches to stimulating economic growth: through either the supply side or the demand side. Cutting taxes is a supply side measure, because at a lower tax rate, we keep more of our earnings, giving us an incentive to work harder, thus increasing the supply of labor. Under the Obama plan, taxes on the highest wage earnings will rise and approach 50% of earnings all in. The idea of losing half of your paycheck to taxes might lead some to spend more time on leisure activities and less on work.

A boost in government spending is a demand-side measure, as government spending has a multiplier effect that trickles through the economy. Economists have long believed that supply-side measures were the only ways to permanently boost the economy. To them, supply-side measures work in the long run while demand-side measures would work only in the short run. To this, John Maynard Keynes, a champion of demand-side measures, replied that, "In the long run, we are all dead." However, it is hard to imagine that even Keynes would have advocated the kind of structural deficits we are now running.

Such confusion on the fiscal side puts more pressure on the Federal Reserve to act on the monetary side. Indeed, Fed minutes released this week seemed to indicate that more bond buying is on the horizon: "Additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery."

To be sure, Morningstar is not predicting a recession, but rather sluggish growth. As our economist Bob Johnson has pointed out, leading indicators are still positive.

The Outlook for Stocks
There seems to be a growing aversion to taking on equity risk, as highlighted by the strong flows into bond funds and out of stock funds over the past four years. Given this bifurcation in asset flows as well as the market's reasonable valuation at 14 times price/forward earnings, the contrarian in me wants to bet on equities. However, if we do hit another economic rough patch, which looks increasingly likely, earnings will come under pressure and stocks may, in fact, turn out to be overvalued.

A higher P/E can be supported by stronger growth, however both economic growth and earnings growth have slowed. Rather than look at one year of earnings, a better measure of stock valuation is the Shiller P/E, also known as the cyclically adjusted P/E because it smoothes the effects of the business cycle. By that measure, stocks are priced well above their long-term average.

For a more rigorous analysis, investors can also evaluate the market through a fundamental "bottom-up" approach. To this end, Morningstar has more than 100 equity and credit analysts who build discounted cash flow models for each stock they cover. Based on these projections, they assign fair value estimates which can be aggregated up to the index or fund level. Currently, they cover 469 stocks in the S&P 500, or 99% of the assets. They see the fair value of the S&P 500 at about 1,500, for a price/fair value of 0.93. While the market is currently trading below fair value, there is very little margin of safety.

Many investors are anticipating a far more challenging market. For instance, Goldman Sachs strategist David Kostin sees a global economic slowdown, margin pressures impacting earnings, and policy uncertainty over the fiscal cliff limiting investment and capital expenditures. This leads him to forecast the S&P 500 to fall to 1,250.

Taking Action
Tactical investors and speculators who believe that we are headed for a recession and that stocks look overvalued can take one of three possible approaches. The first would be to trim long exposure. This would mean cutting any overweightings to equities, such as SPDR S&P 500 (NYSEARCA:SPY). Higher-beta funds such as the small-cap iShares Russell 2000 Index (NYSEARCA:IWM) may be particularly vulnerable and are also potential candidates for profit-taking.

Another approach for aggressive traders would be to short stocks. This article by my colleague Tim Strauts is a good primer. Finally, remember that if stocks do sell off, the safety trade will be back on and Treasuries will rally. The safe-haven trade, along with a potential extension of "Operation Twist" could make Vanguard Total Bond Market (NYSEARCA:BND) or iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT) interesting tactical plays.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.