Fixed Income 2013

Forecasting Wall Street With a Finger in the Wind

Jeff Sommer
Timothy A. Clary | AFP | Getty Images

The consensus outlook on Wall Street is gloomy for the immediate future, with glimmers of optimism for the longer term. This forecast might have been borrowed from Al Sleet, the "Hippy dippy weatherman" created by George Carlin.

Mr. Sleet could not actually predict the weather, but this did not deter him. Despite his manifest shortcomings, he learned how to issue gripping and reliable forecasts, which usually went like this. "Tonight's forecast - dark." Then he would pause, and continue, "later tonight, continued darkness." Like all good pundits, he also took the long view, adding a hopeful coda: "Turning to partly light in the morning."

That's about where the Wall Street consensus stands right now: the short-term outlook is dark, but it will start to clear when the immediate troubles are over.

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With a weak economy, flagging corporate earnings and the prospect of a budget impasse in Washington, many investment houses are issuing warnings of impending market turmoil.

There are "clear and present downside risks to the market in the near term," Goldman Sachs said in a recent report. At Barclays, Barry Knapp, the United States equity strategist, said that such risks were "under-appreciated by investors." And Michael Hartnett, chief global equity strategist at Bank of America Merrill Lynch, warned that investors were "bipolar" at the moment - lurching between exuberant "risk-on" and depressive "risk-off" moods.

The Treasury market, which has largely held onto the gains of an extraordinarily long bull market in bonds, could benefit if stock investors panic. High demand from safety-seeking investors, combined with the Federal Reserve's aggressive interventions in the bond market, has kept Treasury yields very low, by historical standards, with 10-year notes hovering close to 1.6 percent.

Prices, which move in the opposite direction of yields, have been pinned at very high levels. But the fixed-income rally has been doom-ridden, and isn't likely to be sustained if the economic horizon brightens.

A major economic upturn is not part of mainstream, short-term forecasts. That helps explain why Goldman has been forecasting a year-end close of 1,250 for the Standard & Poor's 500-stock index, a substantial 13 percent decline from the index's Monday level of 1,418. And the investment bank expects Treasuries to maintain their rich prices in the near future.

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Of course, these are merely probabilities.

It's not really clear where the economy - or stocks, bonds, gold or other asset classes - are heading in the near future. Plenty of analysts say that the major short-term trends are not positive, and that most discernible factors seem likely to weaken the American economy further.

First, the global economy as a whole has been slowing. And the domestic economy is bracing for a painful short-term shock, the dreaded combination of tax increases and spending cuts - also known as the fiscal cliff - that is scheduled to start on Jan. 1.

This would be a self-inflicted blow, which President Obama and Congress can prevent. While they are expected to reach a negotiated agreement, their bargaining could continue until the last minute, creating tumult in the market. However the politics play out, it appears likely that at least some taxes will rise in 2013, that some spending will be cut, and that the net economic impact over the short-term will be negative.

That uncertainty alone is likely to weigh on the market.

Based on historical precedent, Goldman says that the stock market may endure negative returns in December simply because of the possibility of an increase in the capital gains tax rate in January. The rate is scheduled to rise to 23.8 percent in 2013, including the 3.8 percent tax associated with the Affordable Care Act, from 15 percent now. And the firm is estimating that when the Washington negotiations are over, "spending cuts and expiring policies will create a $233 billion fiscal headwind in 2013."

Mr. Knapp of Barclays puts it this way: "It seems unlikely the tax cliff negotiations will produce a comprehensive solution that will significantly reduce the macroeconomic risks related to fiscal and monetary policy for 2013, at least not without the markets falling sharply and forcing compromise. In other words, these risks should linger into 2013."

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Goldman says that fiscal tightening is likely to hurt consumer discretionary stocks, particularly autos, consumer electronics, home furnishings and home improvement companies. Consumer-oriented companies like drugstores, food and tobacco companies could better weather the turbulent conditions.

Over all, Goldman favors energy and information technology companies. And while it is decidedly gloomy short term, the investment bank is quite bullish through 2013, with an S.& P. 500 target of 1,575 at the end of the year.

After so much darkness, where might this light be coming from?

First, American companies continue to gush profits, even if their growth rates are slowing. Consensus earnings-growth expectations for the S.& P. 500 for the fourth quarter dropped to 4.7 percent on Dec. 3, from 9.8 percent on Oct. 8. Still, Goldman estimates that earnings per share in the S.& P. 500 will amount to $100 in 2012, rising to $107 to $114 a share in 2013. This, combined with a moderately successful resolution of the nation's short-term fiscal problems, could propel the market upward.

Underlying the strength of the stock market are two related factors. One is the low cost of corporate borrowing, which is helping to keep profit margins high. The other is the near-zero yield on money market funds, which, if only by contrast, makes stocks relatively attractive.

Behind these ultra-low interest rates is the accommodative policy of the Federal Reserve. The central bank was likely to reiterate on Wednesday that it will continue this policy well into 2015, or even after the economy begins to strengthen, whenever that may be. Low mortgage rates appear to be reviving the long-moribund housing market, an important pillar of the domestic economy.

The policy of the Fed, and similarly expansionary monetary policies by other central banks, is bound to keep the price of gold high, in the view of many analysts. Goldman favors Freeport-McMoRan, for example, the global mining company, which has interests in copper and gold.

But unexpected shocks could alarm stock investors. Should Washington fail to reach an agreement in the fiscal negotiations, the markets could plummet. "I think we'd see a return to extreme volatility," said John Linehan, director of United States equities for T. Rowe Price, the mutual fund firm. And a heightened crisis in the European Union - or in the Middle East or any other important region - could derail the American profit machine.

For some certainty in the market, the best option is to follow the final and still operative forecast of Mr. Sleet. "The weather will continue to change on and off for a long, long time," he said, before departing the prediction business at the top of his game.

Enjoy the sunshine when it arrives, he suggested, but be prepared for periodic bouts of darkness. Investors could find worse advice.