Yet again our stock markets are completely beholden to the decisions of a few men. The ‘fiscal cliff’ negotiations are the only game in town.
Last night the S+P 500 sold off through some important levels and looked pretty sick indeed, until US President Barack Obama and House of Representatives speaker John Boehner announced that they both felt confident that a deal would be reached sooner rather than later.
Suddenly, stocks spun on a dime and shot higher.
They rallied nearly 2% from the lows that they were trading at just before the announcement.
It almost feels like they time the announcements based on where stocks are trading. It wouldn’t surprise me if they really did…
‘Excuse me Mr President, but the stock market is currently down over one per cent. Could you make an announcement that the talks are going well? We’d really like stocks to finish in the green today.’
Perhaps my cynicism is going a little too far, but I feel confident that keeping the stock market afloat is top of mind for both the government and the Federal Reserve.
Fed chairman Ben Bernanke has quite frankly stated that the wealth effect from a rising stock market is something he’s trying to achieve through his relentless money printing.
For a bear like me this can make trading the stock market incredibly frustrating. I’m quite literally ‘fighting the Fed’. This is something most stock market pundits will say is suicide.
But as far as I am concerned the higher they coax the stock market the further it has to fall when reality strikes…
I read an interesting article by John Hussman on Mish’s global economic analysis blog (My favourite site for economic analysis) that stated:
‘Our estimates of prospective stock market return/risk, on a blended horizon from 2-weeks to 18-months, remains among the most negative that we’ve observed in a century of market data.‘On the valuation front, Wall Street has been lulled into complacency by record profit margins born of extreme fiscal deficits and depressed savings rates. Profits as a share of GDP are presently about 70% above their historical norm, and profit margins have historically been highly sensitive to cyclical fluctuations. So the seemingly benign ratio of “price to forward operating earnings” is benign only because those forward operating earnings are far out of line with what could reasonably expected on a sustained long-term basis.
‘On the basis of smooth fundamentals such as revenues, book values, dividends and cyclically-adjusted earnings, the S&P 500 is somewhere between 40-70% above pre-bubble valuation norms, depending on the measure. That’s about the same point they reached at the beginning of the 1965-1982 secular bear period, as well as the 1987 peak.’
‘We remain convinced that stocks are richly valued here. A fairly run-of-the-mill normalization of valuations in the course of the present market cycle would imply bear market losses of about one-third of the market’s value, without even establishing significant undervaluation. Then again, there’s no assurance that valuations will normalize, or that stocks will experience a bear market here. Maybe Wall Street is correct that profit margins will remain forever elevated and The New Global Economy™ will never again witness “normal” valuations on these measures at all. There’s no shortage of analysts who effectively embrace that view by focusing only on forward-operating earnings.’
Hussman is obviously talking about the very big picture there, and it would be foolish to actually trade the stock market today based on that view alone. The difficulty, as always, is in the timing.
Our resident small-cap fanatic, Kris Sayce, says no. He’s been in the stock market for the past few months telling his readers to punt on small-cap stocks, as many of them hit new low points. His view is that because of the big gains on offer, you only have to allocate a small part of your savings in order to get a big return.
And if things don’t work out, well, you’ve only lost a small amount of cash.
But I look at the stock market differently. My role isn’t to help traders with a small part of their wealth. I’m helping them manage their entire trading portfolio, which is usually many times larger than a small-cap portfolio.
And one thing I’m looking at currently which I find interesting is the deterioration in new capital goods orders (technically defined as the year over year change in Non-defence capital goods excluding aircraft):
The reason I find the recent fall so interesting is that this chart looks eerily similar to the long term chart of the S+P 500:
The only real difference between the two is that new orders have already rolled over and are falling, whereas the stock market is still near the highs. If I was a betting man I would have to say that the stock market is close to following the new orders chart lower.
Also it’s interesting to note that new orders haven’t had such a steep decline in the last 30 years without a concurrent recession, as noted in ZeroHedge.
When looking at the above my conviction increases that we may be getting close to a fairly sizeable fall in the stock market.
We may have seen a big spike in the stock market last night on hopes that the fiscal cliff issue will be resolved, but the fact is the Democrats and Republicans are still miles apart. If you’re interested in knowing where they actually stand then this quote from ZeroHedge gives you a good insight into where things are really at:
‘Any deal on the cliff requires an acceptance of the relative role of revenues and outlays in closing the budget gap. The official positions of the major players are miles apart. President Obama has proposed a roughly $4 trillion 10-year deficit reduction plan that is $1.5 trillion (or 40%) tax increases, mainly from allowing the Bush tax cuts to expire for upper income households. His plan has been roundly rejected by Republicans. They argue that most of the spending cuts are not real: his $4 trillion includes almost a trillion in savings that were already agreed to in the first part of the debt-ceiling agreement and almost another trillion in savings from the winding down of the war in Afghanistan. Stripping those items out, the tax increases become three-fourths of a $2 trillion deficit reduction plan.
‘By contrast, the two main House Republicans, speaker Boehner and Budget Committee chairman Paul Ryan, have suggested that spending cuts should account for all or the vast majority of the cuts. In his negotiations with the President in 2011, Speaker Boehner was apparently close to agreeing in principle on $0.8 trillion in tax increases, or 20% of a $4 trillion dollar plan. However, that deal quickly fell apart once it began to be fleshed out and vetted with the rank and file members in Congress. Moreover, the plan’s reliance on “dynamic scoring”- raising revenues by stimulating growth-has already been strongly rejected by Democrats. Paul Ryan has offered budgets in each of the last two years that include dramatic cuts in spending – including effectively eliminating all of non-defense discretionary spending – but no increase in taxes.
‘To reach a deal, the two parties must not only bridge a huge gap in terms of the tax share-somewhere between 0% and 75% – they must also agree on the same accounting system.
A big precedent
‘The outcome in this initial round of negotiations could set the tone for future deals:
- What is the percentage split between revenues and outlays?
- What kinds of revenue increases are acceptable?
- Will the deficit reduction be “dynamically scored”?
- Will the austerity be relatively big or small?
‘Members of both parties feel that their leaders have given too much ground in the past. Democrats were upset when President Obama agreed to extend all the Bush tax cuts. Republicans are upset about extending the payroll tax cut and extended unemployment benefits. For different reasons, neither party was happy with the outcome of the debt-ceiling debate: for some fiscal conservatives, any debt-ceiling increase was wrong and neither party liked the sequester.
‘For Democrats, there will never be an easier time to raise upper-income tax rates, since they are set to go up automatically at year-end. This is why many liberal leaning politicians and analysts are arguing that it is better to let all the tax cuts expire-go over the cliff-and then offer to restore tax cuts for just low- and middle-income families. At the same time, if they raise revenues by closing loopholes, it will be harder to do comprehensive tax reform later. On Medicare, there are limits to how much payments to providers can be cut without seriously impairing service. Moreover, as we have seen with the “doc fix”, if the cuts are too big, they simply become part of the annual mini-cliff.’
It’s quite clear from the above that headlines announcing that a fiscal cliff deal is imminent are premature. It’s my strong view that the current rally will not last much longer and the potential downside once the downtrend reasserts itself will be very large.
My current target for the S+P 500 if things unravel is all the way down at 1266…a drop of more than 10% from the current level.
Murray Dawes
Slipstream Trader
From the Port Phillip Publishing Library
Special Report:
Retire Rich, Happy and Free From Money Worries
Daily Reckoning:
Nothing More than Feelings… For the Aussie Dollar
Money Morning:
Why I’m Bullish on These Beaten-Down Stocks
Pursuit of Happiness:
Make Sure You Have a ‘Preparedness Kit’
Australian Small-Cap Investigator:
Why Speculating On Small-Cap Stocks is Your Best Bet in a Rigged Market
