Market Commentary
by Byron Wien
 
02/04/2013

Serious Hurdles Ahead

The Ten Surprises of 2013 got off to a rocky start in the first half of January.  The United States equity markets surged in the first week after Congress was able to pass legislation avoiding an increase in taxes on more than 90% of employed Americans.  When you take a hard look at the deal, it was very disappointing.  The original proposals by both President Obama and House of Representatives Speaker Boehner asked for $2.4 trillion in different proportions of revenue increases and spending cuts over ten years.  The final deal amounted to $600 billion, mostly from raising taxes on high income earners; spending cuts were minimal.  What’s more, the 2% payroll tax holiday expired; I had thought it would be phased out gradually.  This will reduce paychecks for all those employed and is bound to have an impact on consumers.  In my view the Republicans were out-traded.  They were fearful that they would be blamed by everyone if all the Bush cuts expired, so they agreed to a deal that was far from the one they originally offered.

As for the Surprises that looked bad out of the starting gate, the Republicans seem like they are going to let the Democrats take the lead on immigration reform.  This would be a serious missed opportunity because many Hispanics align with Republicans on a number of social issues.  Also, the price of oil rose in early January in spite of higher North American production and declining imports; bank stocks rallied; and gold declined.  All of these were contrary to what the Surprises implied.  In contrast, the Japanese and Chinese markets did well, as two of the other Surprises suggested.  It is not unusual for the Surprises to get off to an uneven start.  They are contrary to the prevailing view of investors and often the trend established in the previous year continues for some time.  After talking about the Surprises for several weeks now I find that my conviction about them has not waned.  Considerable research went into the development of each of them and I’m anxious to see how they work out.

The first Surprise is that Iran announces that it finally has developed enough enriched nuclear material to produce a weapon and the International Atomic Energy Agency confirms the claim.  For several years I have been attending meetings held by several foreign policy think tanks and reading articles in various journals about the Iran nuclear threat.  Almost all of them, together with statements by various elected and appointed officials, conclude that Iran’s nuclear development effort must be stopped.  It may already be too late.  A so-called “red line” when the program would have advanced too far or been hidden effectively was supposedly passed last September and nothing was done.  I believe Israel fears that the retaliation that would follow an Israeli attack on Iran’s nuclear facilities would be devastating in spite of the sophistication of the Israeli missile shield.  The damage from cruder missiles launched by Hamas in Gaza reinforced that view.  I also don’t think the United States has an appetite for a third military adventure in the Middle East.  There is also the question of how effective an attack by anyone would be.  It might delay the program but not stop it at this point.  I think world policy will shift from prevention to containment and I hope it will be effective.  Other countries unfriendly to the United States like North Korea and Pakistan have nuclear weapons and have not used them.  Mutually assured destruction is a powerful deterrent. 

In the second Surprise I projected a decline in year-over-year earnings for the Standard & Poor’s 500 in 2013.  Most strategists and analysts are estimating 2012 operating earnings at about $100 and 2013 at $110.  I think $95 for 2013 is more realistic.  Third quarter earnings in 2012 were down 1.5% for the index and fourth quarter earnings are likely to be weak as well.  While there are some positives that should help earnings in 2013, like the recovery in housing and lower gasoline prices, increased taxes are likely to have some adverse impact.  Most observers, including myself, believe that the economy is going to have real growth of only 2% in 2013.  If that is the case, revenue increases for most corporations will be modest.  Some costs will be higher, and profit margins, which are at an all-time high both as a percentage of sales and as a percentage of Gross Domestic Product, are likely to be squeezed.  I think earnings will have a difficult time improving under those circumstances. 

The stock market does not always react to disappointing earnings, but I think it will this year.  Investors are complacent or optimistic, and that often creates the background for a market decline when the news turns negative.  We also have the prospect of a battle in Congress over the debt ceiling which is likely to diminish investor confidence.  Finally, the deferred sequestration of funds for both defense and healthcare is scheduled for implementation soon and this will take some government purchasing power out of the economy.  It will be hard to delay the sequestration further.  All these conditions make me believe we will see the S&P 500 at 1300 some time in the first half of this year, more than 13% below the present level.  I don’t think we will be in a bear market because valuations are not extreme.  By the end of the year the index should regain its lost ground and end about where it started in January.

In the third Surprise I thought that financial stocks, which did so well in 2013, would reverse that trend.  I continue to believe there is too much capacity in the banking and investment banking/brokerage industry.  There are too many institutions in this field and they employ too many highly paid people.  Regulation is increasing and the business is both highly competitive and litigation-prone.  For most of the companies, return on equity is in single digits.  Compensation will continue to move lower and there are additional layoffs ahead.  Trading volume is in a secular decline and investment banking fees will be under pressure.  Profits should reflect these adverse conditions and the stocks should respond accordingly.

One of the Surprises I got right in 2012 was the decline in the price of oil.  West Texas Intermediate crude dropped from $100 at the beginning of the year to $79 in June.  It was the first time in my career that I had forecast a decline in the price of oil after a decade of projecting successively higher levels.  I think this trend will continue.  At the beginning of 2012 the Bakken formation in North Dakota was producing 500,000 barrels a day from hydraulic fracking; by December it was producing 728,000.  Oil production in North America is increasing exponentially and imports from the Middle East are down.  This has enormous economic and geopolitical implications.  In the fourth Surprise I see the Democrats recognizing the importance of energy independence and getting behind a program to allow more hydraulic fracking in less populated areas like Wyoming, Montana and the Dakotas.  They also should permit more drilling on federal land.  A program of this kind would lead to lower gasoline prices and produce more jobs.  This, together with more homebuilding and infrastructure revitalization, could help to reduce unemployment, a key objective of the Administration.  There will be objections, to be sure, from environmentalists, but the positives of this program will be seen to outweigh the drawbacks.  Alternative energy sources have only reduced our fossil fuel consumption in a minor way and if we can produce more oil in North America and import less, the country would benefit significantly in many ways.  The price of oil could drop to $70 a barrel. 

Mitt Romney lost the election in November by only a small margin.  African Americans, young people, Hispanics and independents provided important support for Barack Obama.  Of the Hispanics who voted, 71% cast their ballots for the president.  This group represents almost 17% of the population and their proportion is growing.  Many Hispanics are pro-life or otherwise support conservative social positions.  The most important issue for them is, however, immigration and the Democrats reached out on this issue with the Dream Act, which provided a path to citizenship for some illegal immigrants.  In the fifth Surprise I suggest that the Republicans could seize the immigration initiative from the Democrats by introducing legislation that would allow illegal immigrants to apply for citizenship if they had been in the United States for a decade; had a high school diploma or its equivalent, or had served in the military; had no criminal record; and could pass an English proficiency test.  A plan like this would convert many Hispanic voters to the Republican side and could have a major impact on the outcome of the 2016 presidential election.

In the third quarter of 2012 the Chinese economy had hit a soft patch.  Many indicators were weak and there was speculation that the leadership change about to take place in the Communist Party would result in policies that were not conducive to growth.  I expected the leadership change to be positive.  I thought real growth would be comfortably in the 7% range and that policies would be implemented to address corruption and lay the groundwork for broadened social support, including retirement and healthcare programs.  In the sixth Surprise I said I expected the Shanghai Composite to rise 20% in 2013; in contrast to some of the other emerging markets, the Chinese market has been strong in January.

For a long time I have been keeping an eye on agricultural commodity prices.  As the developing world improves its standard of living, its demand for a better diet with more protein increases.  This should mean increasing consumption of meat and poultry and the feedstock corn.  In the seventh Surprise I projected a dollar increase each in the prices of a bushel of corn and wheat and a 20% increase in the price of livestock.  I also said that commodities would become more respectable as an asset class and be included in more institutional portfolios.  Over the past year another reason has emerged for thinking commodities would do well.  Whether you believe the world is getting warmer or not, the number of droughts producing crop failures in various regions is increasing.  Thus you have a circumstance where demand from the emerging markets is increasing and supply from the producing areas seems to be decreasing.  I do not think this is a temporary phenomenon.  The price of agricultural commodities should be on an upward path.

While gold is a commodity of sorts, I view it as a universally recognized store of value and therefore an insurance policy against a calamity in financial assets.  In addition, central banks around the world, particularly in the developed world, have been expanding their money supply rapidly and in effect debasing their currencies.  Gold has been consolidating for two years since it peaked at $1900.  With continued monetary expansion everywhere and the kind of uncertainty and turbulence I expect during this year, I think it is time for gold to make another move higher, perhaps back to $1900.  Most commentary on the metal is negative, with many believing the price is headed a lot lower, so this eighth Surprise has not gotten off to a good start.

There is probably no major market in the world that is more underweighted in institutional portfolios than Japan, the planet’s third largest economy.  The country has been in a deflationary recession for the better part of two decades; it is a high-cost producer in a low-cost region; its population is old and getting older; and its market has had many false starts in the past.  The positives are that it has elected a new leader, Shinzo Abe, who has a plan to stimulate the economy using both fiscal and monetary policy (in spite of the high level of national debt); investor sentiment toward this market has been negative; and most institutional portfolios are underweighted.  If the simulative policies work, the economy could strengthen and earnings for many of the country’s world-class companies could increase impressively.  In my ninth Surprise I have the Nikkei 225 rising to 12,000 in 2013.  A rally started in the Japanese market in November and it is continuing this year.

Finally one of the big Surprises of 2012 was that the European Union would hold together with the euro remaining the principal currency of the continent.  Even Greece avoided being thrown out.  Today it looks like Europe has muddled through its sovereign debt crisis primarily because of the easy monetary policy of the European Central Bank.  The structural changes which are essential for the long-term survival of the Union have been slow in coming.  There is likely to be some form of a banking union and a fiscal convergence plan is being discussed, so some progress has been made.  Europe remains in a mild recession, a condition which is likely to prevail throughout 2013.  I think there will be European earnings disappointments like those I expect in the United States.  In my tenth Surprise I anticipate a 10% correction at some point in most European markets this year.

The definition of a Surprise is an event which the average investor believes only has a 33% chance of happening, but where I think the probability is greater than 50%.  The effort is designed to stretch my own thinking and that of others.  The score is secondary.  Now, let’s see how the year turns out.

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