As you know if you read my blog often, I am very cautious on the financial markets today. I believe bonds are in a bubble and that stocks, which are at multi-year highs, are overvalued and due for a correction. My concerns are further enhanced by the pending debate in Congress over the spending cuts, which they will attempt to address in February. Keep in mind that the entire month of January has now passed with no progress or even any discussions on this issue, at least that have been reported. On the bond side, the ten-year treasury yield crept above 2% this week, showing that despite the ongoing, aggressive bond buying program by the Fed as part of the QE (quantitative easing) program, bondholders are selling enough to push rates higher. The Fed has already indicated that QE and other stimulus will come to an end sometime this year. Bond investors, recognizing the downside risks in bonds, are already beginning to sell. Additional pressure on bonds is coming from those who need current income. These are investors who typically own bonds, but who are being forced to consider stock investments to attempt to replace lost income, as rates have come down to historic lows. These investors are not comfortable with the risk in stocks (if they were they would have already been invested there and not in bonds) and will be quick to get out of stocks, should the market begin to roll over and correct.
When we review the big picture for the U.S. financial markets, a probably scenario develops in which, in the short-term, the stock market corrects significantly. A sell-off in stocks of at least 15% to 20% would bring valuations back down to more acceptable levels, given slowing growth in the economic (evidenced by today’s -0.1% fourth quarter GDP report), the threat to the economy by pending government spending cuts as a result of the remaining Fiscal Cliff issues, and the coming debt ceiling debates. Slowing growth and less government spending will pressure GDP further, setting us up for the possibility of negative GDP in the first quarter of 2013. If fourth quarter 2012 GDP is not revised up, and first quarter 2013 GDP is also negative, we would officially be back in recession (a double-dip recession, which would be hugely negative). The flu that is going around (don’t laugh) is actually a big threat as well. Some estimates show that a bad flu, which this one definitely is, could take 1% or more out of GDP this year, cutting total expected growth by half or more. Add all this up and the short-term prospects for stocks are not good, which is why I am sitting in cash.
Longer-term though, after a sizable correction, there are reasons to be more optimistic about the economy, and about stocks. I believe that the economy is improving, although at a very slow pace. If trends continue, we should see economic growth of between 1% and 2% this year, and should have the possibility of slightly higher growth in 2014. The reality is that the U.S. is probably never going to grow at more than about 3%, unless we are rebounding from a massive recession, similar to 2008/9. In a normal economic recovery, the U.S., with such a large economy, will not achieve the growth rates of developing economies like China, Brazil, and India. Growth of 2% to 3% is good enough to drive strong stock market performance, as long as investors are not paying too much for the stocks they buy (like they are today).
Bonds, which again are in a bubble in my opinion, should continue to decline in price/increase in yield. This means that over time money will come out of bonds and will be looking for a new home. Stocks will likely receive a large percentage of that cash. This will provide a good foundation of steady inflows into stocks, at least over the coming year or two, until rates get back up to more normal levels. Rising rates will hurt real estate values, which again makes stocks look more attractive in comparison. Rising rates will also curtail commodity price increases, again making stocks look more attractive on a relative basis.
With all this stated, my belief is that stocks will be the best vehicle for potential profits over the next few years, but only after a correction that brings prices back down to more acceptable valuations. Investors, if they agree with this analysis, should raise cash now, and should have a viable strategy in place, ready for implementation, so that they can take advantage of a correction.