It has been my view throughout the past two weeks that:1. there would be a last-minute compromise over the debt ceiling; 2. the market weakness (last week) over the mystery of uncertainty in Washington, D.C., should be purchased; and 3. the history and euphoria (this week) of an agreement should be sold. While the animal spirits have anticipated a resolution and have lifted the S&P 500 by 70 handles, or by 4.5%, since last Wednesday, it remains my view that stocks have topped for the year and that stocks should now be sold. Yesterday stocks soared. This morning, two other asset classes soared -- namely gold (up $35 an ounce) and bonds (the ProShares UltraShort 20+ Year Treasury ( TBT) dropped by $2 a share as the 10-year yield fell by 5 basis points, to 2.62%) -- signaling slowing economic growth and the prospects for a weakening in corporate sales/profits. Meanwhile, today the U.S. dollar is taking its worse licking in a month and is moving back toward the February 2013 lows. Below are some of the reasons behind my negative market outlook.
Hope and Can-Kicking Rule the DayMarket participants might have been somewhat naive in yesterday's celebration, as it is clear that last night's agreement again failed to incorporate any tax or entitlement reform as part of the package to a debt-ceiling extension and a clean continuing resolution. More importantly, it is not likely that the extra time bought will be used productively to achieve a grand bargain in 2014. With our snollygoster government officials simply kicking the can down the road and failing to address our growing debt problem, a normalization in interest rates coupled with U.S. demographics (the aging of our population will lift entitlement spending dramatically) will likely bring the problem back into investors' focus sooner than later.
Wash, Rinse, Repeat in Early 2014Indeed, it is unlikely that there will ever be a grand bargain with the animosity between the two parties. (Note: On CNBC's "Squawk Box" this morning, Grover Norquist basically ruled out a Grand Bargain in his fixed view on " not a penny of new revenues." The Democrats appear just as intransigent in view.) More political partisanship lies ahead - indeed, the schism between the Republicans and Democrats will likely deepen as we move ever closer to the important elections in November 2014, especially with the House of Representatives up for grabs.
At What Cost?The cost of the Washington fiasco is likely higher than many think. Our leaders and fiscal policy are growth-deflating. Using the debt ceiling as a negotiating tactic has run the risk of a more permanent and long-lasting damage to our country's reputation and hastens the day when the U.S. dollar is no longer the world's reserve currency. (Note this morning's U.S. dollar weakness after Chinese agency Dagong downgraded the U.S. credit rating.) If that damage occurs, the financing of our debt will grow more expensive, confidence will drop, and economic growth will be diminished.
Visibility Is DiminishedWith more confusion ahead in a fiscal sense, the path of economic/profit growth is unclear as business and consumer confidence has been dented. Markets dislike uncertainty. To me, it is a leap of faith to expect the 0.6% shaved off from GDP (due to the government shutdown) to be made up in the period ahead.
The End of a Strong Profit CycleLast night, we saw two high-profile and likely not isolated profit disappointments -- eBay ( EBAY) saw "a dramatic deceleration in U.S. e-commerce growth" and IBM ( IBM) was also weak -- and more might lie ahead. Most notably, top-line misses have become commonplace -- even Goldman Sachs ( GS) missed by $700 million this morning. Profit margins (which are 70% above the five-decade mean) are vulnerable to mean-reversion, and monetary policy has lost its effectiveness. I remain skeptical of the consensus view that the domestic economy will move into escape velocity and toward a self-sustaining cycle this year or next.
Quantitative Easing Has Lost Its EffectivenessThe role of stimulating growth has been squarely on the shoulders of monetary policy since 2009 as our leaders in Washington, D.C. have abrogated their fiscal responsibility. With the Fed's tools now clearly more blunt in their effectiveness, organic growth must take over. With retail (shopping center data has weakened) and housing activity already clearly eroding prior to the mess over the past few weeks, I don't see a catalyst to that organic growth. Moreover, the longer the Fed continues its current policy the more difficult it will be to extricate itself and the more likely that the market tightens (with higher bond yields ahead even if the economy remains lackluster).
Economic and Earnings Downgrades AheadEven before the Washington fiasco, earnings guidance has deteriorated (and is now back to early-2009 levels). The outlook has eroded further since the government shutdown started.
The Bullish Market DefenseThe principal defense of the markets appears to be that the Fed is going to be easy as far as the eye can see and that interest rates will remain subdued. This, to the bulls, is support for ever-higher valuations (which have already risen from under 14x at the beginning of the year to over 16x today). Expanding valuations could be the outcome if growth had reached escape velocity and was self-sustaining -- it has not.
The Bottom LineWith all the aforementioned cyclical headwinds and the growth-deflating confusion from Washington coupled with structural challenges to growth (particularly in the U.S. jobs market), I find it hard not to see a valuation contraction. If 2014 S&P profits rise by only 3% (my estimate) and with dividend yields at 2%, a one multiple reduction (which could prove optimistic) in P/E multiples (to 15x) means that the S&P 500 will drop next year. My out-of-consensus view that bond yields will drop, that economic activity and profits will disappoint and that stock valuations may contract remains in place. The division between Wall Street (stock prices and valuations marked up) and Main Street (the economy marked down) has grown deeper. Buy the mystery of the fear over the debt deliberations (last week), and sell the history of their resolve (this week). Or, as legendary trader/investor Joe Gruss once said, "Yell and roar and sell some more."
This column originally appeared on Real Money Pro at 10:29 a.m. EDT on Oct. 17.