The S&P 500 was up 16% for 2012 and experienced its lowest volatility since 2007. During 2012, we saw only 3 days when the market was either up or down by more than 2% as compared to 2011 when we experienced 35 such days. Looking at the S&P 500, you wouldn’t expect that we are about to face the Fiscal Cliff, which refers to the economic effects that could result from tax increases, spending cuts, and a corresponding reduction in the U.S. budget deficit beginning in 2013 if existing laws remain unchanged.
We anticipate that the market will be more volatile in the future and therefore have been looking for ways of buffering that volatility. Unfortunately, finding alternatives has become much more challenging as the market has become highly correlated. During the last decade, we have gone through two (2002 and 2008) of the three worst bear markets in the last 80 years and there is nothing fun about them. It is the equivalent of death by a thousand paper cuts. Those who weathered the storm have been rewarded, so it does remind us that, over the long term, it is best to stay the course and not try to time the market by jumping in and out. A strategy we are considering gives good downside protection but will not shoot out the lights when the market rallies. To put it in baseball terms, we hope to generate a lot of singles without incurring the risk of striking out.
Tax zombies here, there, everywhere
According to the Tax Policy Center, a nonpartisan research group, going off the cliff would affect 88 percent of U.S. taxpayers, with their taxes rising by an average of $3,500 a year. Below are more specific tax increases based on income if Congress and the White House do not act:
- Annual income of $50,000 to $75,000: $2,399 average tax increase
- Annual income of $100,000 to $200,000: $6,662 average tax increase
- Annual income of $200,000 to $500,000: $14,643 average tax increase
- Annual income of $500,000 to $1 million: $38,969 average tax increase
- Annual income of more than $1 million: $254,637 average tax increase
For those making more than $250,000, contributing factors to the increase in taxes would be an increase of 4% in tax rates in the top bracket, 5% increase in capital gains and 3.8% surtax on investment income.
What’s the Drag?
What these tax increases will mean for the economy is a highly controversial topic. The National Bureau of Economic Analysis says an exogenous tax increase of 1% of GDP lowers real GDP by roughly 2% to 3%, which would put us on the cusp of a recession. Others say it could be as much as 4%, which would clearly put us into a recession whose duration would be uncertain.
Corporate America is begging for predictability in Washington’s tax policies. They have more than $1 trillion on their balance sheets. It doesn’t make good business to have that trillion earning less than 1%, but the other alternative is to invest it in something that could create long-term growth but, for the uncertainty of Washington’s actions, might end up being a write-off.
Fiscal Cliff solved, now onto spending cuts
We survived the fiscal cliff with the passage of the American Taxpayer Relief Act (ATRA), the main goal of which was to raise taxes but did little to address spending cuts. This is the first increase in income taxes in almost 20 years. It will increase the tax rates on married taxpayers earning over $450,000 ($400,000 for single) by allowing the Bush tax cuts to expire but will affect all working taxpayers with the expiration of the 2% payroll tax cut.
The second chapter of the fiscal cliff, the debate on spending cuts, was deferred for two months which will coincide with the vote to increase the debt ceiling. As mentioned above, the ARTA went a long way in addressing the revenue side of our deficits but little to impact spending; for every $1 cut in spending, taxes increased $41. Spending cuts are the real long term solution for eliminating our recurring deficits. Since the year 2000, on a cumulative basis, annual deficits total more than $7.1 trillion. This is confirmed by our net increase in debt of more than $10.7 trillion for the same period. When taxpayers and businesses cut spending it means they will spend less this year than they did last year. When Washington talks about cutting spending, that translates to a reduction in the rate of growth of spending. They need to adopt what everyone else in America has to secure a healthy future.
You will find in our portfolios that we are replacing some of our active managers with very low cost index funds because we are finding the performance of individual stocks held in our active managers’ portfolios is becoming highly correlated with the appropriate indexes and, as a result, it is more difficult for active managers to outperform indexes after factoring in their fees. We will continue to work with active managers who offer strategies for specified needs in our portfolios — for example, a manager who has a demonstrated strategy that provides downside protection that can’t be duplicated by an index fund.
U.S. markets will find growth difficult, though it isn’t unreasonable to expect stocks and bonds to be positive in the single digits going forward. If the dollar weakens, it should help our exports. Though the euro zone is struggling, there are pockets of value that make the area worth investing in. The emerging markets are the growth engine and account for 50%+ of global GDP, even factoring in a slowing China (although it looks like it is beginning to recover).
When investing we look at the alternatives available at the time. Currently, we have money market at 0%, investment grade bonds at 1 to 3%, lower credit quality bonds at 4 to 5%, international bonds at 3 to 5%, and stocks with a dividend yield of approximately 2% and an unknown return. The risk with having too much in money market and bonds is inflation – while you won’t notice the effects of inflation over one to two years, it will be problematic over the long term because you will lose purchasing power. As such, most investors need to own at least some stocks in order to achieve a return that will exceed the rate of inflation over the long term. Alternatives such as real estate appear to be fully valued at this point, and commodities, which historically have not been correlated with stocks, can be very volatile. So, alternative asset classes do not come without risks. We continually evaluate various options to find strategies that can help our client portfolios meet their investment goals.
How about some good news?
With natural gas prices as much as 80% below the levels in Europe and Asia, America is gaining a competitive advantage in manufacturing for the first time in decades. BlackRock CEO Larry Fink recently told the story of a CEO who moved a factory from Germany to America just because of lower energy costs. Expect more of that in the coming years.
What’s more, U.S. wages have been growing more slowly than productivity for decades, while areas like China have been experiencing the opposite. Factor in shipping costs, and Boston Consulting Group thinks parts of America will become the cheapest manufacturing sites in the industrial world within five years.
For the quarter ending December 31, 2012, returns for the S&P 500, NASDAQ, Russell 2000, MCSI EAFE, MSCI ACWI, and Barclays U.S. Aggregate Bond indexes were 16.00%, 17.45%, 16.35%, 16.13%, 13.43%, and 4.21%, respectively.