The budget and debt ceiling agreement reached a couple of weeks ago settled nothing; rather the agreement was to continue funding the government at its prior levels until January and included promises to negotiate the 2014 budget before December 13, 2013. The problem with this agreement remains the same… the House of Representatives wants sustainable spending cuts and no new taxes, while the Senate wants new tax increases and no spending cuts. Both sides remain adamant in their positions and the special budget committee will probably fail just like it did in 2011 when the goals were exactly the same.
If lawmakers don’t come up with a bipartisan agreement the sequester cuts are scheduled to increase again in January. This is the ace in the hole for the Republicans. They can simply do nothing and spending will decline again in January.
Meanwhile, national debt jumped +$328 billion when the government reopened after the shutdown and it now stands at more than $17 trillion. The reason for the big jump was because the Treasury replenished the funds it used from other Federal accounts (i.e. state grants, infrastructure projects, etc.) to keep government payments flowing during the shutdown. Although these funds were already allocated to other uses the Treasury dipped into those accounts using what it calls “extraordinary measures” to avoid defaulting on payments. Once the debt ceiling was lifted the law allows the Treasury to borrow money to replenish the funds used for those ”extraordinary measures.”
Currently the debt ceiling is suspended until February 7th. That means the government can borrow whatever it wants and analysts believe it will raise the debt by another $750 billion. If the budget negotiations do not go well and it appears we are heading into another battle in late January the Treasury Department could load up on additional debt ahead of the February 7th deadline. That would allow them to weather the storm on another deadlock for a couple additional months using the extra cash before resorting to the extraordinary measures yet again.
The equity markets are moving higher but not because earnings have improved. It is moving higher because sentiment is bullish, and sentiment is bullish because the markets are moving higher. This is a circular argument that could go on for some time or it could fail at any moment. The S&P is up +30% in the past 12 months and more than +25% in 2012. Over the same period S&P earnings are only up about +5% which means the gains in the market are a result of increased market valuation on those earnings. In other words the market went up four times as fast as earnings. A big part of those earnings gains have come from companies reducing costs and buying back shares of stock, which reduces the number of shares outstanding and increases EPS. Unfortunately the gains did not come from rapidly increasing revenue. Over the last several quarters revenue gains have been in the low single digits.
Job growth during the recovery since 2009 has been the slowest of any major recession since 1981. Furthermore, the economy as measured by GDP has posted its weakest rebound after any major recession. In fact the past six years has seen the slowest GDP growth since 1936. With GDP averaging about 1.5% growth this year the lack of product demand has stalled the normal business expansion cycle. However, the equity market is acting like there is a real economic rebound underway and stocks are being priced for that scenario. If this outlook changes prices are going to struggle.
Job Growth after the recessions from 81/82, 90/91, 01, and 08/09
Affordable Care Act
There could be trouble ahead. Some analysts believe we will return to recession in 2014 as a result of Obamacare. Depending on which study you believe it is estimated that 75%+ of all jobs created in 2013 have been part time to get under the 30 hour threshold for full time workers. Employers can take three 40 hour workers and cut them back to 30 hours each, then hire a new worker at 30 hours and the same amount of work is performed. Only the 120 hours are now spread between four workers instead of three and the employer does not have to provide insurance.
That translates to wages getting cut by -25% for the three workers and they have to buy their own insurance through Obamacare at rates that are higher than 2012 and 2013 levels. In other words they now have less income and more expenses. This is a recipe for reduced consumer spending in 2014 because consumers will be forced to pay higher healthcare costs or pay 1% of their gross income in taxes (penalty tax) in 2014 and 2.5% in 2015.
One of the big flaws in the plan is the need for 7 million healthy young people to sign up for insurance, pay the higher healthcare rates, and subsidize the poverty level and older people who use more healthcare. How many healthy young people under the age of 30 are going to rush right out and buy a $250 or $300 per month health insurance plan they might not even use? They will pay the penalty tax and it will force prices up for everyone else and that means less consumer spending down the road.
While the recessionary impact of the Affordable Care Act (ACA) may not be felt until well into 2014 I believe it will continue to increase in severity as the year progresses. With consumer spending already slowing due to the migration to a part time workforce it could slow even further as individuals and families are forced to pay for insurance in 2014. This is effectively a new tax on American workers. This was the argument lawyers used in the Supreme Court and the judges ruled in favor of the argument. Now we are about ready to see those taxes come home to roost.
In reality there were 20 new taxes created in the ACA and while some have already started the majority will begin on January 1, 2014. Analysts believe the taxes will average about $6,000 per person. Individuals won’t see them all directly because they are taxes on medical devices, hospitals, drugs and higher Medicare fees but you will pay them in some form. There is even a tanning tax for people that use tanning salons. The IRS received $500 million to setup enforcement of the new taxes and regulations.
Eventually Fundamentals Will Matter
Stocks may continue to rally for a few weeks but there should be a correction of at least -5% to -10% very soon. After a few downticks in the economic data throughout September and October we are seeing some improvements over the past couple of weeks. And if the data improves it will likely lead to the Fed tapering its assets purchases early next year. Reducing the amount of purchases is only the first step. Eventually they will be forced stop purchases, and then finally withdraw purchases made over the past 4 years by selling their assets back into the monetary system to reduce the money supply. The Fed will need to do this to keep inflation under control and eventually they will raise interest rates. The Fed’s balance sheet now stands at more than $4 trillion and it is growing by $85 billion per month. It has been a party and all parties eventually come to an end. That may not come until late 2014 or 2015 but the markets are a forward looking mechanism and prices will react accordingly.
The other issue facing investors in 2014 is they will eventually realize that the Affordable Care Act is going to create stress on the economy and that nothing was solved in the October agreement between lawmakers that reopened the government. They have to negotiate the budget by December 13th to prevent automatic spending cuts (sequestration) being implemented on January 1. The spending cuts are part of the 2011 law but they were suspended back in December 2012 and I seriously doubt the Republicans will allow them to be suspended again. If we happen to get past the budget battle with little damage we’ll have to deal with the debt ceiling again on February 7th.
This gives institutional funds a short window to strategize and decide how they want to position their portfolios for year end. The headlines over disagreements in the bipartisan budget committee will probably begin in early December. That could be the signal to start ratchet down the hatches for the next storm. The way the calendar is setting up we could see momentum in the markets pulled forward into November and it is setting up December and January as potentially bearish months.
The bottom line is the market is way overdue for a big correction. If the Fed tapers asset purchases and the economy slows in 2014 the correction could take prices much lower than most analysts would have you believe. There is no fear and investor complacency is rampant.
For me the risk to equity prices over the next three months is to the downside, not the upside. We want to take advantage of the opportunity by being short the S&P 500 and Nasdaq 100 when the correction comes. All of our signals are pointing a top in the S&P December contract (ESZ3) between 1773 and 1785, and in the Nasdaq 100 between 3405 to 3428. We are near these levels now and believe a top could happen at any time.
Finally, I’ll leave you with the below chart courtesy of SentimentTrader.com. It shows the inverse relationship between the % of bullish financial Newsletters and prices in the S&P 500. The percentage of bullish newsletter sentiment has exceeded its prior highs from March and May, and that of any other week since at least 1997. Over the long term when newsletters are overly bullish, i.e. above 70%, markets tend to decline in the coming weeks and months. This is no guarantee a decline will happen but it is not a bullish indicator for stocks, at least in the near term.