By
Morningstar
:
By Michael Rawson, CFA
The Congressional Budget Office recently laid out two economic
forecasts
based on two different fiscal policy paths. Neither forecast looks
appealing.
In the first one, the Bush tax cuts expire while government
spending is cut by about $100 billion according to current law.
This is effectively the removal of fiscal stimulus and raises the
likelihood of recession in 2013. This path requires no
Congressional action. In other words, unless Congress acts, we are
headed off a fiscal cliff. We can see the effects of a fiscal cliff
in Europe, where they call it austerity. Eurozone gross domestic
product contracted in the second quarter and the continent has
likely entered another recession.
The second path requires the extension of tax cuts and
postponement of spending cuts. This would cause another $1 trillion
deficit and even under this scenario, the economy would expand in
2013 at a meager 1.7%.
There are two approaches to stimulating economic growth: through
either the supply side or the demand side. Cutting taxes is a
supply side measure, because at a lower tax rate, we keep more of
our earnings, giving us an incentive to work harder, thus
increasing the supply of labor. Under the Obama plan, taxes on the
highest wage earnings will rise and approach 50% of earnings all
in. The idea of losing half of your paycheck to taxes might lead
some to spend more time on leisure activities and less on work.
A boost in government spending is a demand-side measure, as
government spending has a multiplier effect that trickles through
the economy. Economists have long believed that supply-side
measures were the only ways to permanently boost the economy. To
them, supply-side measures work in the long run while demand-side
measures would work only in the short run. To this, John Maynard
Keynes, a champion of demand-side measures, replied that, "In the
long run, we are all dead." However, it is hard to imagine that
even Keynes would have advocated the kind of structural deficits we
are now running.
Such confusion on the fiscal side puts more pressure on the
Federal Reserve to act on the monetary side. Indeed,
Fed minutes
released this week seemed to indicate that more bond buying is on
the horizon: "Additional monetary accommodation would likely be
warranted fairly soon unless incoming information pointed to a
substantial and sustainable strengthening in the pace of the
economic recovery."
To be sure, Morningstar is not predicting a recession, but
rather sluggish growth. As our economist
Bob Johnson has pointed out
, leading indicators are still positive.
The Outlook for Stocks
There seems to be a growing aversion to taking on equity risk, as
highlighted by the strong flows into bond funds and out of stock
funds over the past four years. Given this bifurcation in asset
flows as well as the market's reasonable valuation at 14 times
price/forward earnings, the contrarian in me wants to bet on
equities. However, if we do hit another economic rough patch, which
looks increasingly likely, earnings will come under pressure and
stocks may, in fact, turn out to be overvalued.
A higher P/E can be supported by stronger growth, however both
economic growth and earnings growth have slowed. Rather than look
at one year of earnings, a better measure of stock valuation is the
Shiller P/E, also known as the cyclically adjusted P/E because it
smoothes the effects of the business cycle. By that measure, stocks
are priced well above their long-term average.
For a more rigorous analysis, investors can also evaluate the
market through a fundamental "bottom-up" approach. To this end,
Morningstar has more than 100 equity and credit analysts who build
discounted cash flow models for each stock they cover. Based on
these projections, they assign fair value estimates which can be
aggregated up to the index or fund level. Currently, they cover 469
stocks in the S&P 500, or 99% of the assets. They see the fair
value of the S&P 500 at about 1,500, for a price/fair value of
0.93. While the market is currently trading below fair value, there
is very little margin of safety.
Many investors are anticipating a far more challenging market.
For instance, Goldman Sachs strategist David Kostin sees a global
economic slowdown, margin pressures impacting earnings, and policy
uncertainty over the fiscal cliff limiting investment and capital
expenditures. This leads him to forecast the S&P 500 to fall to
1,250.
Taking Action
Tactical investors and speculators who believe that we are headed
for a recession and that stocks look overvalued can take one of
three possible approaches. The first would be to trim long
exposure. This would mean cutting any overweightings to equities,
such as SPDR S&P 500(
SPY
) . Higher-beta funds such as the small-cap iShares Russell 2000
Index(
IWM
) may be particularly vulnerable and are also potential candidates
for profit-taking.
Another approach for aggressive traders would be to short
stocks.
This article
by my colleague Tim Strauts is a good primer. Finally, remember
that if stocks do sell off, the safety trade will be back on and
Treasuries will rally. The safe-haven trade, along with a potential
extension of "Operation Twist" could make Vanguard Total Bond
Market(
BND
) or iShares Barclays 20+ Year Treasury Bond(
TLT
) interesting tactical plays.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
Genesco's Strong Same Store Sales Growth Should
Lead To All Time Highs For 2012
on seekingalpha.com