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 Ahead
Bonds, 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 Certainty
There 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.