It has been a rough couple of weeks for equity investors since the election. We’ve been treated to a virtually uninterrupted decline in price. The consensus wisdom is that now that the election is out of the way, investors are intently focusing on the fiscal cliff. The popular press is full of these stories. Personally I do not believe the fiscal cliff is the primary or one and only driver of equity market action in recent weeks. Why? First, financial markets rarely discount twice what they already know. The fiscal cliff “issues” have been more than well known for a year and a half. And post the super committee failed meetings of December 2011, investors have even known with certainty the date (YE 2012) at which the cliff would arrive. So all of a sudden fiscal cliff issues are a surprise? Not likely. My personal feeling is that what we are seeing has much more to do with investors and the markets contemplating the character of corporate earnings looking into 4Q and the first half of 2013. So probably the most important issue for equity investors in the month(s) ahead is to watch how the markets react once the fiscal cliff issues are kicked down the road yet again, even with partial near term reconciliation.
Maybe to a fault, I’ve been anticipating a nearer than not resolution to the cliff. And of course that “resolution” will most likely take the form of kicking the majority of cliff decision making down the road into 2013. Why am I anticipating quick action? I believe that the one thing that absolutely gets the attention of politicians is a market decline. Remember TARP in 2009? It happened just like that post a swift and meaningful very short term decline in equities. After initial political faction fiscal cliff discussion last Friday, even the likes of Nancy Pelosi publicly acknowledged the need for action to “calm short term market nerves”. Believe me, politicians get it. Do they really want to be blamed for a disappointing Christmas and immediate 2013 recession due to lack of cooperation? With the mid-term 2014 elections just not that far away, I think not. Moreover, Mr. Obama will now very much be concerned with “legacy” in his final four years. Ideology or ego, just what’s it gonna be?
I do not mean to turn this into a political discussion, but rather one of simply “listening” to what the markets are “telling us” as of late. As I see it, there just happens to be a bit of incongruence in market action recently in terms of fiscal cliff anticipation. It’s this incongruence that’s telling me to be very watchful of market character once the cliff issues become a story for another day. Let’s look at a few “market messages” of the moment that if nothing else raise a few questions.
We know that the two key cliff issues are government spending and taxation. From a longer term standpoint, I’ll suggest that government spending issues are the more important of the two, although change in taxation can absolutely cause change in behavior. Reason being government spending involves “multipliers”. Government spending cuts are essentially stimulus in reverse and by definition the positive multiplier effect of government spending acts as a contraction multiplier. Additionally, over the last four years, government spending and US exports have been the two strongest legs of the domestic economic stool. We know we are losing export steam. As per the fiscal cliff mandates, US government defense spending is certainly in the middle of the fiscal cliff cross hairs. And if that’s so, then why has the defense sector outperformed the broad S&P since a month and one half prior to the election? It was only late last week that weakness relative to the SPX really began to show up.
If investors/the markets are correct in price discounting, they are telling us Federal government spending cuts are perhaps a low probability outcome in the current fiscal cliff debate.
Yet simultaneously, defensive sector (utility and telecom) dividend oriented stocks have been dropping like rocks in recent weeks. 10-15% price declines, essentially wiping out at least a few years of dividend income, have been commonplace in these groups. Admittedly, the last discussion I penned in these pages concerned valuation metrics in the telecom and utility space. I pointed to two longer term holdings I had sold based strictly on historic valuations parameters, but those sales had nothing to do with dividend taxation as part of the cliff issues to come. Very much unlike the defense sector relative equity outperformance, the electric utilities have been underperforming the SPX since late summer of this year, most pronounced directly after the election.
Same deal goes for the telecom stocks since late September – straight down relative to the broad market S&P, the relative performance decline being a bit more pronounced since the election.
So based on the equity sector relationships reviewed so far, it appears that the market is discounting no Federal spending cuts, but the market is discounting the fact that dividend tax hikes are coming.
Does this sound reasonable when looking at the deeply divided political party landscape of the moment? Revenue enhancement with no accompanied spending cuts? It does not seem reasonable at all as we know compromise is the only logical fiscal cliff outcome very near term. Compromise with a big dollop of postponement.
The final market relationship that has me scratching my head a bit is REITs relative to the SPX. Have a look.
Relative underperformance of the REITs set against the SPX really began in early July of this year, even earlier than the utility and telecom relative sector weakness. Yes, we know the REITs are big dividend payers. BUT, REIT dividends are non-qualified! They never received the qualified dividend tax breaks in the first place. So although they are a yield oriented sector, they have no dog in the fiscal cliff hunt vis-à-vis personal taxation. This is a good part of the incongruity that has me scratching my head a bit. The theme of the three charts above is that yield is selling off regardless of fiscal cliff tax impact. And this fits with a market currently discounting and all of a sudden concerned with the fiscal cliff as per the message of the REITs? Maybe so, but I’m a bit fuzzy on the logic.
Sorry to have dragged you through all of this, but looking at all of these relationships set against the context of only fiscal cliff issues raises more questions than it answers. The market is telling us a one sided outcome is probable – no spending cuts, but tax hikes remain intact. Given the divisive nature of party politics of the moment, a one sided outcome seems a low probability bet, not a high one. All of this together at least suggest to me that the near term fiscal cliff issues are not the sole driver of overall market weakness of the moment. 3Q earnings looked at in their entirety were an eye opener. The impact of European and Asian weakness on corporate earnings seem far from having played out in terms of total cycle. So although cliff issues will perceptually impact investment decision making until nearer term resolution, my suggestion is that the markets must be monitored closely once the near term perceptual cliff issues have been resolved, kicked far enough down the road to no longer be an immediate concern, or a little bit of both.
For now, I’m assuming that politicians enact some type of even temporary fiscal cliff “fix”, and soon. Again, the terror point for politicians is a meaningful decline in the equity market. Very short term as of the end of last week, markets are oversold. It’s how markets act when oversold (or overbought, for that matter), that can be the most meaningful tell concerning intermediate market movement to come.
At the prior lows we saw divergences between prices, and technical indicators such as relative strength, money flow, and stochastics. Will it be so again? One never knows, but watching for positive divergences such as these could be very important in the weeks ahead. Bull markets often stay in overbought territory for a lot longer than one may expect. Bear markets simply act in reverse. The technical character of the financial markets post even a temporary cliff fix will answer the question as to whether the recent market angst was about the cliff itself, or something yet to come like further weakness in corporate earnings not yet reflected in analysts estimates. Stay tuned, the answer to this line of questioning lies dead ahead.
About Brian Pretti CFA
Brian Pretti CFA Archive
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