Opportunities, Risks and the Fiscal Cliff

//Opportunities, Risks and the Fiscal Cliff

Opportunities, Risks and the Fiscal Cliff

This has been a great year for risk assets such as stocks and mediocre for low risk assets such as treasury bonds and cash.  The S&P 500 is up 16% through the third quarter while the Barclays aggregate bond index is up only 4%.  Since the bull market in stocks started in in March 2009, the S&P 500 is up over 112%.  Despite the market approaching previous highs set in 2007, most investors favor bonds over stocks.  Investors have added $1.2 trillion to bond funds and bond ETF?s since 2007 versus $200 billion into stock funds, despite the strong market performance.  The current yield on 10-year treasuries is a mere 1.65% through the third quarter and -0.27% real yield after inflation.  In addition, approximately $10 trillion sits in cash throughout the U.S. economy earning almost nothing.  So why aren?t investors adding to stocks over low risk assets like bonds and cash?

Economic uncertainty remains the primary driver behind investors? low aptitude for risk.  The economy is growing at a pace of about 1.3% as of the second quarter, which is well below the historical average of 2.5%.  In addition, the European debt crisis, high unemployment, the fiscal cliff, the presidential election, future tax rates, and other variables continue to create uncertainty.  What investors are ignoring, however, is the fact that even ?low-risk? assets present risk.

The 10-year Treasury bond, for example, has climbed under a 30 year bull market.  Yields peaked in 1981 at 15.81%!  Since then, bond prices have increased and yields have declined steadily to less than 2%, where they sit today.  While increases in interest rates don?t seem likely in the near future, they are inevitable long-term.  For every 1% increase in 10-year interest rates, investors can expect the value of their 10-year Treasury bond investments to decline by 9.1%.  We believe proper diversification in fixed income and short maturities will reduce but not eliminate this risk.

Cash and CDs are asset classes of choice among the risk averse.  For every $100,000 invested in a 6-month CD, an investor is earning $440 for the year.  After inflation, cash loses purchasing power of nearly 2% per year.  Despite this lackluster return on investment, $10 trillion is sitting in cash money funds, including CDs, surpasses the total mortgage debt in the entire United States.

The Federal Reserve has been keeping both short and long-term interest rates at low levels in hopes of getting banks to lend and investors to start taking more risk.  This has yet to happen, and all the money sitting in cash and bond funds will be added fuel for future stock price appreciation.

Despite the bull market in stocks over the last 5 years, stocks remain at very attractive valuations.  The consensus earning estimate for the S&P 500 over the next 12 months is $111 per share, which represents a forward price to earnings ratio of 12.9 times.  This is a 20% discount to the historical average multiple of 16.2 times earnings.  In other words, stocks would have to increase by 20% to reach the average multiple on earnings.  While, we don?t expect the multiples to go back to the historical average short term, the current valuation discounts lend themselves to long-term stock price appreciation.  Historically, stocks trading at current valuations have never been negative 5 years later.  In fact, the average return after 5 years has been 13% annually.

The pending fiscal cliff remains the biggest short-term risk to economic growth and stock market returns.  If nothing is done by congress over the next two months, $400 billion in tax increases will go in effect with the expiration of the Bush tax cuts, payroll tax cuts, unemployment benefits and the 3.8% increase due to the Patient Protection and Affordable Care Act, commonly called Obamacare.  In addition, approximately $200 billion of spending cuts go into effect, mostly in the area of defense, which would hit our local economy particularly hard in San Diego.

All of the tax increases and spending cuts would target the current deficit, which is on track to hit $1.2 trillion in 2012 or 7.3% of gross domestic product.  The fiscal cliff would drive deficits down to 2% of GDP in 2 years.  While that would be great for deficit reduction, it would likely drive our economy back into another recession by reducing $600 billion of economic demand immediately.  Our national debt remains a concern long term, but it would be more advantageous short term to lower deficits gradually.  Both political parties recognize this dilemma, and a more gradual solution will likely prevail.  However, time is running out, and we will likely see Congress and the newly elected President scrambling down to the last minute.

At Callan Capital, we believe investors will be rewarded for taking more risk over the long term.  However, we still hold bonds and cash to help reduce potential declines short term.  In addition, we have been defensive in our bond holdings by being diversified, avoiding treasuries and keeping maturities short.

By |2017-06-02T17:58:54+00:00November 21st, 2012|Quarterly Newsletter|

About the Author:

3 Critical Considerations to Ask in a Liquidity Event

A Liquidity Event Guide that covers pre, during, and post transaction.