I see four black swans inbound on my radar. When they land, they will have a major impact on your investment performance this year and next. Get it right, and you should end up among the top of your investing peers. Misread the cues and you will go down in flames. It’s that simple.
Let me make your choices simple for you by providing a program for the upcoming festivities. I list each black swan individually:
1) The Presidential Election. Most of Wall Street is hoping for a Romney win, but bracing themselves for an Obama one. No matter who wins, I expect a post-election surge in stock prices as a great mantel of uncertainty has been lifted from the markets. And as we all know, markets hate uncertainty.
While the Obama lead is narrowing in the national polls, it is increasing in the battleground states. Obama is so far ahead in Pennsylvania (21) Ohio (18), Wisconsin (10), Iowa (6), and Nevada (5), they are no longer considered battlegrounds. Only Virginia (13), North Carolina (15), Florida (29), and Colorado (9) remain. Even if Romney wins all four of these, which are now showing a tie in the polls, he still loses the election by 24 electoral votes. It will do him no good to win Utah (6) by 78% instead of 73%, and that is what the national polls are reflecting.
That is where the people at Intrade are putting their money, where Obama is ahead 66% to 34% (click here). This is all great news for the stock market. According to the no less an authority – the Wall Street Journal – since 1929, Democratic presidents have seen a 10.8% stock market gain during their administrations, compared to a miserly 2.7% for Republicans. As president Bill Clinton once told me, “If you want to live like a Republican, you have to vote Democratic.”
2) The Fiscal Cliff. The media is ramping up their warnings of the dire impact of the “fiscal cliff” further scaring investors out of risk positions in everything from stocks to gold. The only real tangible impact of this “wolf crying” was to give a much-welcomed lower low in risk assets in October.
I think the Republican leadership has already read the writing on the wall that they will be punished at the polls for two years of stonewalling (as they were in 1998). The end result will be a substantially smaller majority in the House of Representatives, and the loss of one or two seats in the Senate when they had a 3:1 advantage on the calendar. That leaves the GOP with no other strategy going forward than bipartisanship, or they risk going out of business by 2016.
This augurs well for a resuscitation of the $4 trillion “grand bargain” of tax increases and spending cuts that Obama struck with House majority leader John Boehner in the summer of 2011, but was later torpedoed by the Tea Party wing Republican Party.
It may be necessary for outgoing Tea Party members to actually vacate their seats first on January 3 for a deal to be made. In that case, expect a quickie 2-3 month extension prior to the December recess before a pact is inked. This would be hugely positive for stocks for the short term.
3) The Next European Quantitative Easing. While ECB president Mario Draghi has talked a good game over the past four months, promising to rescue the Euro no matter what it took, in actual fact he has done nothing. To keep sovereign debt in southern Europe from collapsing in value, Draghi is going to have to take a page out of Ben Bernanke’s playbook, particularly the one that has “open-ended” printed on it. That means another round of monetary easing is due on the form of an additional “Long Term Refinancing Operation” or LTRO. The last one was for €500 billion, or $650 billion. Make that a double?
4) The New Year Reallocation Push. The financial system is awash in money, and individual equity weightings are at multi-decade lows. Bond allocations are at all-time highs. There is over $10 trillion in cash sitting in cash, short-term deposits, and overnight Treasury bills. Corporations have another $2 trillion in cash.
In these circumstances, it will be natural for many investors to increase equity weightings and the expense of bond weightings. Money managers who did well in 2012 (yes there are a few of us) will also get their new cash allocations at the beginning of January.
Add these annual flows to the positive developments outlined above, and you have the ingredients for a serious rise in stock prices. I think we could get as high as 1,600 for the S&P 500 in the first quarter of 2013.
The Great Obama Crash of 2013
While I believe that this quartet of black swans could catapult the major stock market indexes up 10% from here, keep in mind that this will be the last 10% of a 140% move off of the March, 2009 low. Don’t forget to sit down when the music stops playing! The next ramp in share prices could be setting up us for the Greatest “Sell in May and go away” of all time. While president Obama may be puffing his chest out over one of the greatest stock market performances on record, he may well go down in history for “The Great Obama Crash of 2013.”
Let me list the reasons why I expect a recession in 2013:
*You can take all the short-term stimulus measures you want – both fiscal and monetary – and they don’t change the fact that we are only six years into a demographic headwind that doesn’t veer into a tailwind until 2022. The retirement of the baby boomer generation will continue to act as a drag on the economy for another decade, paring growth by 1%-2% a year.
*While the resolution of the fiscal cliff will be hailed as a great accomplishment, the bottom line is that a $4 trillion agreement will take 25% out of our GDP. Spread this out over 30 years and it cuts growth by 87 basis points a year. Over 10 years it chops growth by 2.5% a year. If you are only growing by 1.5%-2% a year, this means recession.
* Look for Europe to remain in recession, adding more dead weight to corporate earnings here. Some 25% of U.S. multinational earnings come from the continent. Look no further than General Motors (GM), which expects to take a $1.5-$1.8 billion hit on its continental operations this year (click here).
*Ditto for China, where a growth recession is delivering a serious blow to any company involved in the commodities sector, including steel, coal, iron ore, and copper. After peaking at 13%, the Middle Kingdom’s GDP growth rate is down to 7.4%, and where the bottom will be found is anyone’s guess. I’m thinking that the Chinese economy doesn’t reaccelerate until well after the once a decade leadership change is completed in March.
*While QE3 will give us a nice 4-6 month boost to asset prices, it can’t do it forever. The Fed has hinted that this program could go on indefinitely, but it won’t. There is no reason to unnecessarily boost inflation in the 2020’s with liquidity injections now that are not wanted.
*We will enter the next recession with the highest unemployment rate in history, now 7.8%. This will make it longer and deeper, potentially taking the headline jobless rate up to a mind boggling 15%.
*The year after a presidential election is always a great year to have a recession because it gives the ruling party three years to dig out before the next one.
*All of the gains in the stock market since June have been achieved through multiple expansion – from 12.7X to 14x today and 16X by March, Corporate earnings have actually been flat to falling during this time. Many companies are now hunkering down and reducing spending in expectation of a 2013 recession. This is why capital spending only reached half of the peak spending seen in the previous cycle.
If I am wrong with this analysis, the markets will bounce along sideways in an environment of falling volatility. That’s why I am positioning myself with in-the-money calls spreads in order to profit from every possible scenario.
A Crash, But Not a Big One
All of this adds up to a big “R” for 2013, and share prices will no doubt reflect this. But I’m not looking for a major collapse a la 2008-2009, which saw a 53% plunge in the (SPX). I’m thinking more like a 25% to 37% pull back from a 1,600 top to no worse than 1,000. Those predicting Armageddon-like meltdown to 600, 300, or worse will be wrong by miles.
My reasoning is very simple. To get those huge, cataclysmic sell off of 500-800 Dow points a day you need to have a massive amount of leverage in the financial system. You had that six years ago, with equity hedge funds levered by 200% and bond funds betting the ranch with 1,000% or more long positions.
Every firm on Wall Street had positions up to their eyeballs, with Morgan Stanley (MS) and Goldman Sachs (GS) running $40 in holdings for every $1 in capital, and Lehman Brother and Bear Stearns choking on $100 or more. When the margin calls went out, puking of major positions was the inevitably result, with dire effects on share prices.
Conditions couldn’t be any more different today. Hedge funds are typically running modest longs of 10%-20%. If they asked for 200% leverage, their prime brokers would probably tell them to go to hell and close their accounts. Morgan Stanley (MS) and Goldman Sachs (GS) are now running more bankerly 10X leverage. Individual stock investors have gone missing in action.
In fact, we have seen leverage squeezed out of every sector of the financial system for the past six years, from bank lending to credit cards and consumer loans. Second mortgages have virtually ceased to exist. The bottom line is that the long positions needed to trigger a giant crash just don’t exist.
Hopefully, it will be a short recession, maybe six months in duration, or only two back-to-back down quarters. After that, one of the biggest buying opportunities of the decade will set up for all asset classes. That will be the subject of a future report.
Not This Time