The Earnings Cliff Is Upon Us
The fiscal drag may be understated both on domestic economic growth and profit expectations. Though the drag from the fiscal cliff agreement appears to many to be a manageable $250 billion-$280 billion (or less than -0.80% taken off U.S. GDP), the actual multiplier of this drag is greater than most are projecting (over -1.5%).
Consensus domestic economic growth expectations may be overstated. Moreover, there should be additional drags from spending cuts in the upcoming debates. Consensus real GDP growth in the U.S. is about +2.5% -- I expect no better than +1.5%.
In terms of S&P profits, the "V" in profits and profit margins since 2008 is likely over. Already margins in fourth quarter 2012 are expected to drop from 9.5% to 9.1% sequentially. Consensus 2013 S&P profits are about $107 a share, top-down estimates are about $108 a share, and bottom-up estimates are north of $112 a share. I live at $95-$97 a share, which, if accurate, will be a big disappointment (and will almost negate the possibility of multiple expansion, which has become the meme of strategists).The early fourth-quarter earnings report card is unimpressive. For example, Wells Fargo (WFC) had a slight penny beat, but its effective tax rate fell from 34% to 27% and mortgage originations slipped by $15 billion, to $125 billion sequentially.
The Interest Rate Cliff May Lie AheadBonds, which have been in a 30-year bull market, are likely to be poor investments in the years ahead -- perhaps much worse than most believe. The consensus appears to be that the 10-year will rise no higher in yield than 2.25%-2.50% in 2013-- based in part on continued deleveraging, slow growth and a friendly Fed (which will effectively repress long rates). It is important to recognize, however, that there is a limit to how much interest rates can rise before other asset prices are negatively impacted, as long-term interest rates are the discount rate upon which future profits are valued.
A Reallocation out of Bonds Into Stocks Is Not a CertaintyThere are numerous reasons why a broad reallocation is a premature thesis. Mutual funds are generally nearly always fully invested (with little cash in reserve), and large pension plans are slow-moving and usually respond only after a clear trend change has been in place for a while. Individual investors have been victimized by the screwflation of the middle class -- with middle class wages being outpaced by the costs of the necessities of life, this demographic has a lower propensity to invest in equities than at other times in history.
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