Heads Or Tails - The 2013 Coin Toss
In money management long term success lies not in garnering short term returns but avoiding the pitfalls that lead to large losses of invested capital. While it is not popular in the media to point out the headwinds that face investors in the months ahead - it is also naive to only focus on the positives. While it is true that markets rise more often than not, unfortunately, it is when markets don't that investors are critically set back from their long term goals. It is not just the loss of capital that is devastating to the compounding effect of returns but, more importantly, it is the loss of "time" which is truly limited and never recoverable.
Therefore, as we look forward into 2013, I want to review three reasons to be bullish about investing in the months to come but also review three risks that could derail the markets along the way.
Bull Point 1: Interest Rates To Remain Low, Yield Chase Remains
The Federal Reserve has committed to keeping interest rates suppressed until at least 2015 if not longer. This low interest rate environment will continue to weigh on the ever increasing number of individuals heading into retirement who feel an urgency to generate an income stream to supplement retirement benefits. Therefore, the chase for income, or yield, is set to continue in the coming year as the low interest rate environment continues to push more individuals out of cash and into more risky investments. While "yield chases" have always ended badly in the current macro environment such an outcome is a low probability event in 2013.
Bull Point 2: Technical Trend Remains Bullish
The "trend is your friend - until it isn't" is an age old traders axiom. Yet it is a sage piece of advice. There was a time in history when investors actually invested in stocks for the "long term," however, with the advent of the internet, online investment access and high speed trading, those days are gone. The rise of ETF's and "program trading" has led to a market where the bulk of the daily price action in stocks is driven by the direction of the overall market.
In such an environment investors are generally better served understanding, and investing, with the trend, or direction, of the overall market rather than "hoping" their investments will work out. Currently, as the chart below shows, the markets are still in a well-defined bullish trend. While the historical peaks of the market are still providing some potential resistance to the current advance - the trend is remains positive suggesting that exposure to risk should maintained.
Bull Point 3: $85 Billion Per Month
Of course, one of the most bullish catalysts in 2013 is the Federal Reserve and the two simultaneous large scale asset purchase programs (Quantitative Easing or QE) totaling $85 billion a month. The liquidity that is pushed into the financial system by these programs has boosted asset prices historically. While each program has had a diminishing rate of return the programs do provide support for the bullish investment theme.
The chart below shows the current Federal Reserve stimulus induced market rally as compared to the "Mortgage ATM" liquidity boosted rally from 2004-2008. If this market continues to play out the same pattern the markets could yet see a fairly bullish advance in the months to come as QE3/4 push assets prices higher.
Bear Point 1: Debt Ceiling Debate
With the "fiscal cliff" resolution behind the next big hurdle for the market will be the debt ceiling debate. In 2011 the debate over the debt ceiling led to a credit downgrade by Standard & Poors and a 10% stock market loss in a three week span.
The obvious risk is that once again the debate reaches a fevered pitch and rattles the markets. One caveat, however, is that market participants are more aware about the fact that the U.S. will not actually default on its debt so any negative impact to the financial markets will likely not be as severe as seen previously. Furthermore, as opposed to the summer of 2011 when QE 2 had already ended, the markets are currently supported by QE3 and 4.
However, with increased taxes already set to provide roughly a 1.5% drag on economic growth any resolution of the debt ceiling debate which leads to larger than expected spending cuts could negatively impact the markets to some degree in the coming year.
Bear Point 2: Earnings
It is currently estimated that corporate earnings, as we addressed in our 2013 outlook, could reach an all-time higher of $105.88 a share this year. This would represent an increase of $8.10 a share over current levels.
Currently, 2013 reported earnings are currently set at $100.71 for the S&P 500 by Standard & Poors. This would represent a rise of 14% in the coming year from the current levels of $87.1. The risk to that bullish outlook comes from a couple of areas: 1) the Eurozone recession is set to continue through the rest of this year putting a drag on exports which currently makes up roughly 40% of domestic corporate profits and more than 13% of GDP, and; 2) Corporate earnings have already begun to show early signs of weakness amid slower economic growth. The impact of higher taxes and potential spending cuts will further impact earnings in 2013.
The ability for corporations to continue keeping profit margins intact by cutting costs has likely come to an end. The recent price increases in the markets have led to an expansion of multiples as earnings have declined. Historically, price expansions, without an underlying increase in earnings, are not sustainable. Therefore, any further deterioration in corporate earnings in the coming year will likely lead to a recoupling of prices to earnings.
Bear Point 3: Slow Growth Economy
As stated above the impact from rising taxes, potential cuts in spending, and slower economic growth from the Eurozone is likely to further weigh on the domestic economy. With the economy already growing at a sub-par rate there isn't much wiggle room between growth and contraction.
One thing that has been overlooked on many fronts is that Obama had control of the House, and the Senate, when he first entered office in 2009. This control lead to the passing of ObamaCare, successive bailout programs for housing, automobiles, and the financial industry which flooded the economy, and financial markets, with dollars - a lot of dollars. Those injections, combined with a massively bombed out economy from the financial crisis, led to a sharp rebound in economic growth which was almost entirely centered around inventory restocking and a resumption of exported goods and services.
However, in 2010, Obama lost control of the House to the Republicans which has led to two subsequent years of political gridlock. That gridlock has resulted in very little progress in providing the fiscal policies necessary to support economic growth.
This lack of progress has clouded the planning ability for small businesses and reduced the need for continued buildup of inventories as the exportation of goods and services has slowed. The chart below shows exports, and imports, post the recessionary bottom as stimulus programs impacted the economy and the subsequent fade as economic strength has waned.
The problem of a sub-par growth economy is that lack of "escape velocity" required to start organic growth. Current employment gains, and growth in GDP, have been little more than what would be expected from normal population growth and inflation. However, the problem is that such an environment does not foster higher levels of wage growth, higher levels of corporate profitability or economic prosperity.
Risk Management Makes The Difference
While the list could obviously be much longer the point is that for every bullish point that can be made there is an offsetting risk. The reality is that no one knows for sure where the markets will end this year. While it is true that "bull markets are more fun than bear markets" the damage to investment portfolios by not managing the risks can be catestrophic. A measured approach to optimism, where the relevant risks are given due weight, will always lead to longer term portfolio success.
This is why we manage portfolios from a risk managed approach – greater returns are generated from the management of “risks” rather than the attempt to create returns. Our philosophy was well defined by Robert Rubin, former Secretary of the Treasury, when he said;
“As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.
Most people are in denial about uncertainty. They assume they're lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it's a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”
It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin's approach, and ours, go beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of acknowledged uncertainty is it keeps you honest.
“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”
The mistake that most investors make is assuming that portfolios are treated like a light switch. However, good portfolio management, as stated, requires a strategy that manages portfolio risk like a rheostat. When the overall market trends are positive the allocation of risk is dialed up. Conversely, when data trends become negative - risk is reduced. The management of risk is what has always separated successful investors from the rest.
Chasing markets higher is fun - until it isn't.
The reality is that we can't control outcomes; the most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.