It’s been a couple of weeks since I last posted, as I’ve focused on family and friends during the holidays. Meanwhile, we’ve seen a “fiscal-cliff” market rally. The details on the deal are explained here:
Here’s the quick summary:
- Permanent extension of Bush-era tax rates for incomes under $400,000
- Permanent annexing of Alternative Minimum Tax to inflation
- Expiration of payroll tax cut (payroll taxes on income less than $100,000 go back up by 2%)
- Capital gains and dividends get a top rate of 23.8% – up from 15%, but less than the top for ordinary income (http://www.huffingtonpost.com/2012/12/18/fiscal-cliff-agreement_n_2325351.html)
- Budget cuts are postponed until March 1. They will be revisited before then.
So we have an agreement, the market rallied, and all is good, right? Unfortunately no. These 3 charts are from John Mauldin’s Dec 31 Thoughts from the Frontline (http://www.mauldineconomics.com/):
This chart was included to show the link between long-term bull and bear cycles with market P/E ratios. This may look like 2 charts of the same thing, but it isn’t exactly, because it shows how important multiples growth is over earnings growth.
Here are the 2 other charts:
With these charts, Mauldin’s newsletter explains inflation or deflation as driving P/E’s lower while price stability drives them higher.
Currently, the P/E ratio of the S&P 500 is 17.28 (http://online.wsj.com/mdc/public/page/2_3021-peyield.html)
According to these charts, this is just the above the mid range at 15 if you expect earnings growth to continue at 3%, but at the peak of the high range if you expect earnings growth to be 2% going forward. These ranges were made with the assumption that investors would price in the same risk premium for holding stocks no matter what growth is estimated going forward – and of course the assumption that the overall market earnings will grow at the same rate as GDP.
The danger here is that if P/E ratios are at the high end and about to decrease, we will either see a short period of sharp market declines (like the early 1930’s) or an extended flat market (in real terms, not nominal) like during the 1970’s.
Personally, I think that the 1970’s version is more likely given the determination of the Fed to prevent deflation, but with more of a post-1989 Japan twist to it as inflation and growth remain low for a time. With this view in mind, I consider dividends and/or interest to be the primary drivers of gains going forward. The exception of course is with Gold, which I believe will continue to rally as emerging market central banks continue to diversify into it rather than continuing their previous policies of loading up on US Treasuries (balanced with some European and Japanese government debt exposure). Silver is likely to follow gold higher, but I don’t expect it to lead, and I expect that to be driven by primarily by investor expectations for it to follow gold rather than directly by central bank purchases. Silver is simply a smaller and riskier market, but I recently put some money into SLV and I also have exposure with companies like SLW which has both Gold and Silver exposure (I also hold RGLD, SAND, GFI and GLD).
From the purely fixed income side I’m still holding vehichles like JPM-I and NLY-C (exchange traded preferred shares), and CEG-A and PHR (exchange traded debt).
I also still like the high payers with commodity exposure like SDR (Royalty Trust), TNH, BWP, SDRL, KMP, ETP (MLP’s), and I still hold EXC as a utility which will hopefully still have a decent yield if it follows through with a dividend cut.
Grant Williams also had an interesting newsletter, delving much more in the area’s of government fiscal issues in Japan, Europe and the US. Needless to say, they are still major areas of concern. Good luck on your hunt for gains, and remember not to rely too heavily on stock appreciation in the coming years.