Comstock Partners, Inc.December 20, 2012
The Market Rally Is Based On Hope Rather Than Substance
Is the market rally since the low of November 16th signaling better times ahead? We don't think so. It seems to us that Wall Street is automatically assuming that the fiscal cliff will be settled by year-end, that the economy will subsequently recover at a stronger pace and that the market is significantly undervalued. We disagree on each count.
While we don't know the outcome, the odds that we go over the fiscal cliff are greater than the market is discounting. Although Wall Street and Washington are only 250 miles apart, they speak different languages, and market experts have never been too good at interpreting political events. The investment community's main interest is to find some solution that will help the market, while Washington's main goal is to get incumbents re-elected.
The Street doesn't understand Washington and, in turn, Washington doesn't understand the Street. It is entirely conceivable that the White House and Congress cannot find common ground in time, simply because doing so could harm somebody's chances at re-election. Getting to an agreement in time requires complex compromises leading to a delicate balance that ensures enough votes in both houses to ensure passage. We also note that something would have to be done about the debt limit that will be reached again sometime in February. If not, another crisis would be upon us early in the new year.
However, even an agreement on the fiscal cliff in time to keep from going over the edge would be a long way from ensuring smooth sailing for the economy and markets. While going over the cliff results in extreme austerity that everyone wants to avoid, a settlement would also result in austerity, although obviously not as severe. Since the goal of this exercise is to reduce the deficit, a solution would necessarily involve some combination tax increases and spending cuts, a portion of which would be applicable in 2013. This would create strong headwinds in an already fragile recovery.
Despite monthly ups and downs in the various economic releases, the economy has been softening in recent months, and will get no help from a settlement of the fiscal cliff. Real consumer disposable income has been trending down and wages are flat. This is a negative indicator for consumer spending, which has held up only because the savings rate has come down. Core new orders for durable goods has been declining for the past year, indicating a weak outlook for capital expenditures. A number of leading corporations have been reducing guidance for 2013 earnings. The Conference Board Leading Indicator Index has been flat for six months and the three-month moving average of the Chicago Fed's National Activity Index, covering a wide swath of indicators, has been down for eight straight months.
At the same time the global economy has been slowing down with some areas in recession and others showing lower growth. The IMF has recently reduced its global growth forecast for both 2012 and 2013, and, according to RBC Capital Markets Chief Economist Tom Porcelli, the PMIs of two-thirds of the globe are in negative territory.
In sum, once the fiscal cliff crisis is past, we will be facing a faltering U.S. and global economy as well as significant downward earnings revisions, a situation that investors would find exceedingly disappointing.