November 8, 2012
The election is done. Now comes the hard part: governing. Little wonder, therefore, that the mood within the financial markets suddenly shifted from nervously uncertain to downright bearish. Those on Wall Street who were hoping for a Romney rally instead got a Washington wipeout as major stock market indexes suffered a 2 percent tailspin. The dive was the worst of the year and dropped the Dow Jones industrial average below 13,000 for the first time in three months.
For the rest of 2012, macro issues – and particularly the fiscal cliff and our odds of toppling into a Greek-style morass – will dominate not only the headlines but also how financial markets behave, trumping company-specific news. Unless a pharmaceutical company triumphantly announces a cure for cancer, or the discovery of a fountain of youth, we’re in for a prolonged period in which mid-cap companies can announce new contracts, large-cap companies can put forth bullish forecasts – and all will be ignored as investors rivet their gaze on Washington.
Here are some thoughts on what lies ahead for markets, based on a handful of early post-election commentaries, or those published in the days leading up to the election focused on the market environment in coming months:
“The hard-fought election will likely be followed by more fighting in Congress, resulting in higher volatility and a potential pullback for the stock markets … Markets may provide attractive buying opportunities” in the final weeks of the year. – Jeff Kleintop LPL Financial
We’re already seeing the first part of Kleintop’s prediction come true, as the specter of a divided Congress – a Democratic-dominated Senate and a Republican House of Representatives – makes investors worry that avoiding the fiscal cliff will be all that more difficult. The sentiment is understandable given the gridlock and increasingly vituperative political rhetoric of the last two years.
But Kleintop’s second point – that there is the prospect of bargains being created by the dramatic selloff – is equally valid. Look for them in so-called “Republican” industries, such as some of the energy companies entering a new era of large-scale domestic shale oil and gas discoveries.
There also are likely to be bargains among the companies that continue to spend on research and innovation. Studies of what drives corporate spending and hiring decisions have shown that only rarely do tax policies on their own shape that spending. True, if a punitive tax is directed at a particular industry – coal mining, say – or regulations viewed as burdensome are directed at, say, the pharmaceutical industry, that may well constrain spending. But if companies believe that failing to spend will cause them to miss a chance to generate profits, they’ll spend. People don’t stop coming up with smart business ideas based on who occupies the White House or Congress.
“Monetary policy will have to remain very loose and, along with a renewed escalation of the crisis in the euro-zone, this should anchor 10-year Treasury yields at around 1.5%.” – Julian Jessop, Capital Economics
In light of the uncertainty surrounding the fiscal cliff, one of the biggest sources of investor anxiety remains what will happen to corporate dividends. That has kept the pressure on stocks with high dividend yields in recent weeks, and may continue to do so, given the market belief that President Obama will lobby for a return to treating dividend income as ordinary income for those earning $200,000 or more a year. But against the backdrop of loose monetary policy and rock bottom Treasury yields, dividend stocks are likely to remain attractive investments. A stock that offers a 3.5 percent yield, even if that yield is taxed at the top marginal rate, will still look more appealing than a 10-year Treasury bond paying 1.5 percent, except for the most risk-averse investors. Municipal bonds – which have attracted steady inflows from investors for most of 2012 – are also likely to emerge as attractive.
“To a significant extent, foreigners finance the deficit by buying U.S. bonds. Should the bond market impose reform on policy makers in the U.S. by selling off bonds, the implications for the U.S. dollar might be far more sever than they have been for the euro.” – Axel Merk, Merk Investments
Merk’s point is an interesting one – and indeed, we’re already seeing the dollar take a beating in the immediate aftermath of Obama’s victory. If, as Merk argues, the hefty current account deficit in the United States is a source of risk, investors can address that by diversifying their portfolios more broadly outside the dollar. It’s worth remembering that if the dollar falls, returns generated from non-dollar investments automatically do better.
True, it is getting harder to find a corner of the world that isn’t suffering to some extent from the global economic slowdown, and no one in their right mind is going to put 5 percent to 10 percent of their portfolios in those pockets that are going gangbusters – Indonesia and South Africa spring to mind. But for those anxious about the dollar’s fate in the short and medium term, it makes sense to check out the growing array of funds that specialize is higher-yielding bonds from governments that have only recently made the leap into investment grade territory.
“The American Society of Civil Engineers gave the nation’s infrastructure an overall rating of D.… The investment need is particularly great in the transportation sector and water systems.… At near-zero interest rates and a high unemployment rate, a massive infrastructure program would therefore make a lot of sense – from all angles.” – Harm Bandholz, UniCredit Research
President Obama now doesn’t need to worry about re-election, but undoubtedly he’ll be concerned about his legacy. A major part of that is the jobs outlook. Investment in infrastructure is a necessary and logical move – and in contrast to monetary stimulus, it would lead directly to job creation. As a medium-term issue, it’s worth keeping an eye open for comments from the President that indicate this is becoming a priority, and then seeking out some of the heavy industrial stocks most likely to benefit, ranging from engineering companies to makers of heavy equipment like Caterpillar Inc. (CAT).
“Our base case remains a high possibility of a market-unfriendly resolution to the fiscal cliff resulting in dampened risk appetite.” –Bank of America Global Economics teamIn the eyes of these Bank of America economists, this prospect argues in favor of a higher dollar. But it’s also a recipe for investors taking shelter in safe assets, including gold. Indeed, it’s hard to envisage a scenario under which gold falls suddenly out of favor, however irrational owning it at relatively high prices has become in recent months. Hoping to profit from the movement in gold prices is little more than speculation, and there may be better assets to own if you are investing for the long-term gains. But in the nervous, uneasy and risk-averse climate that is likely to prevail over the next few months, safe assets are likely to appreciate.
“Of the past 15 elections, the 4th quarter of the election year was up 13 times . . One-third of the time the 4th quarter of an election year was up (more than) 8%. That would translate to a one-third chance of a 9% gain from current levels… The only two negative [market returns] were in the recessions of 2000 and 2008, so unless you believe we are in a recession with money availability shut down, it stands to history the SPX should see a meaningful advance through year end.” – Tony Dwyer, Canaccord Genuity market strategist
It’s nice to know that optimism isn’t dead.