Now that the election is over all attention is on Washington. The President is trying to take firm positions on what he is looking for from Congress in a “patch work” bill to stave off the fiscal cliff. However, with all the drama surrounding the scandal with General Petraeus and the questions surrounding the 9/11 Benghazi Embassy attack, the President may be losing some leverage in the process of trying to ask for too much.
With the market sell off since the Presidential election, investors are getting nervous that Washington will create another crisis in these negotiations causing a major market correction. However, we don’t anticipate a major market correction will occur as Washington already seems to be cooperating more than they did with the debt ceiling negotiations. The President wants to extend most of the Bush tax cuts except for the top income earners (which he currently defines as $250,000 and above). The Republicans want to raise the threshold on what defines a high income earner to over $500,000 and they want real concessions on Social Security and Medicare changes. In my opinion, they will likely meet somewhere “left of middle” and get a “kick the can down the road” bill passed before Christmas and then propose that they will come back in 2013 with a “grand bargain”. The hard part is deciphering through all their banter in the process.
Once again the market has tunnel vision on an extraneous risk, which is unlikely to transpire. Keep in mind, the ultimate concern is that they screw it up in Washington and we fall back into a recession. However, no U.S. recession in the past 100 years has occurred without the Federal Reserve constricting the money supply by either higher interest rates or other means. The Federal Reserve has specifically stated that tightening money and raising interest rates is certainly not an element of today’s economy and won’t likely be anytime soon, even though rates are already near zero. Addressing our fiscal issues is critical mainly because businesses and investors want to know what tax rates will be. If Congress gets a bill passed it should give a short term boost to confidence. In the meantime, there is evidence that businesses have already been anticipating a potential slowdown due to nonproductive talks in Washington and have curtailed spending on plant and equipment upgrades. This would mean some of the pain has been front-loaded, and if a palatable budget compromise is forged, it will uncork pent-up demand early next year. J.P. Morgan Chase & Co. (JPM) Chief Executive Jamie Dimon hinted at this prospect last week when he suggested “the economy can boom if the fiscal issues are sufficiently addressed.”
The Fed has completely altered the relationship between stocks and bonds by nurturing an environment of deeper negative real interest rates. The interest rate used to discount the future earnings stream keeps getting more and more negative, and that in turn raises the price investors will pay for future earnings. The fact that the S&P dividend yield is triple the yield in the middle of the Treasury curve also makes equities more attractive. Five-year Treasury yields are down to 60 bps, at a time when the dividend yield in the stock market is closer to 2.3%, for a 170 bps gap which we haven’t seen since 1958.
Therefore the historic price to earnings multiple of approximately 16 times earnings is likely to be conservative considering current “low” interest rates. The reason for this is in the discounting of anticipated future cash flows, the current lower interest rates justify higher price-to- earnings ratios. So equity prices could rise even with mediocre earnings growth. If the “world is ending” fears start to lift again, investors in low yielding cash, CD’s and Treasury Bonds will eventually have to rotate into higher yielding investments including dividend paying stocks which will push valuations up.
The next few weeks are likely to remain overcast with the negative perception of political bickering in Washington. However, at this time we do not feel it is prudent to try to predict short term market fluctuations and investors should keep their discipline in their asset allocations. We will continue to monitor the short term volatility and look to add positions at very attractive prices.