Fueled by a heavily committed central bank, an improving housing market, and a dearth of investment alternatives, the S&P 500 is yet again flirting with all-time highs. The near straight-line increase over the past several weeks, which has driven the index up 13% since mid-November, has further emboldened investors in search of acceptable returns. Adding fuel to fire has been a long-awaited wave of corporate merger announcements. Happy days seem to be here again. Yet we still get the nagging feeling that something is amiss. We’ve long ascribed to the old axiom that “markets climb a wall of worry”, yet the wall ahead seems especially steep given the massive gains we’ve enjoyed since the market lows of March, 2009. We still believe strongly that investors will be well-served by owning stocks for the long haul, and a continued defensive posture makes most sense for the months ahead.
Several issues are bugging me. The most obvious is the impending sequestration, which calls for $1.2 trillion in mandatory federal government spending cuts over a ten-year period. The consensus opinion now seems to be that we will indeed go over the sequestration “cliff” on March 1st, but that the effects will quickly be reversed (to some extent) before the continuing resolution deadline (March 27) and everything will be hunky-dory. March 27 is the date on which funding for a number of government programs will expire. In the event that Congress is unable to come to an agreement to continue funding these programs, the government will essentially shut down. Now maybe I’m being naive, but is there any reason for me to be optimistic at this point about an agreement at the circus called Capitol Hill?
The second issue of concern is a more recent phenomenon. Last week, the press was reporting on some internal Wal-Mart emails that suggested first quarter sales are off to a horrible start. This news led to a sell-off in shares of Wal-Mart and other retailers that target the low- to moderate-income consumer. The sales weakness is being attributed to three factors. First, there has been a delay in the payment of Federal income tax refunds due to the changes in the tax code. According to UBS, “federal income tax refunds are received by around 78% of all taxpayers and approximately 82% of taxpayers reporting under $50,000 per year in adjusted gross income (AGI)”. The refund delay has led to lower spending than would have been the case if refunds had gone out on time. However, the two-week delay in the filing season is a transitory issue, and the effects of the delay will quickly reverse.
Second, the increase in the payroll tax for all taxpayers (from 4.2% back to the old rate of 6.2%) is having a disproportionate effect on the low- to moderate-income consumer. The increase in rates translates to $700 per average worker per year, according to the Tax Policy Center. For most families, $700 is a significant amount of money to suddenly lose, and the aggregate tax increase represents money that won’t get spent in the economy this year.
Third, gas prices have been increasing in recent weeks, which acts as a tax on the consumer. The average price for a gallon of gas was up to $3.64 on February 15 compared to $3.29 a month prior, according to AAA.com. Again borrowing from UBS, each $0.10 increase in gas prices costs the US consumer $10 billion per year. Clearly higher gas prices are having an impact, but that impact is likely limited so far. A final factor that may be affecting the consumer’s willingness to spend is the continued uncertainty with regard to sequestration, the debt ceiling, and their effect on the labor market.
Our last, and perhaps most pressing, concern is the near- to intermediate-term development of monetary policy. Speculation has increased in recent weeks about an impending end to Fed quantitative easing later in 2013. The minutes of recent Fed meetings have told us that an increasing number of Fed members may have reservations about the “pedal-to-the-metal” easing policy. Other prominent voices, such as the Wall Street Journal’s Jon Hilsenrath, have said that individual Fed officials are starting to worry about froth in particular asset markets, like the high-yield bond market. An article in today’s Wall Street Journal by another author discussed the increasing risk that rising competition is having on commercial bank loans (”Business Loans Flood the Market”, by Shayndi Raice). Are we so far removed from the recent real estate and tech bubbles that the Fed will ignore these rising risks?
Indeed, the recent rise in bond yields seems to support the notion that the Fed may be nearing an end to QE. But while higher interest rates may be increasing the attractiveness of stocks (versus bonds) in the near term, an end to QE and resulting higher rates may ultimately turn out to be a negative for stocks. After all, low interest rates have forced many an investor into stocks over the past few years. Higher interest rates may ultimately lure investors back to bonds, while raising the cost of borrowing across the corporate universe could inhibit profit growth and stock buybacks (which have increased demand for stocks). Rising rates could also affect the resurgence in M&A activity we have seen in recent months.
Our overriding message over the past couple of years has been that stocks, and in particular high-quality blue chips, are a very attractive investment alternative given the paltry returns available from alternative asset classes. Our thesis remains in tact. However, we are more strongly committed than ever to our support of high-quality and defensive companies. We say this every week, but we’ll say it again: we see no reason to swing for the fences in this environment.