Shaping a portfolio for 2013 (ll): the US

I’ve been having a horrible time organizing this post.  I keep going off on tangents.  So I’ve decided to stick to making assertions.

Here goes:


 The long-term growth rate for real (i.e., adjusted for inflation) GDP in the US is around 2%.  We’ve been growing at that rate for the past few years.

I don’t see any reason why 2013 should be any higher.  Arguably, the withdrawal of government stimulus could shade that figure downward a bit.

If we assume inflation at 2%, this means nominal GDP growth of 4% for 2013.  That probably translates into 7%-8% profit growth for the domestic operations of US-listed companies.

changing growth patterns

The pattern of this recovery has been far different from the norm for the US during my working career.  Industry, tourists and the affluent–not the usual suspects (housing, autos and widespread consumer spending)–were the hot spots during the earlier years.

In mid 2011, focus shifted.   Recovery broadened to include more ordinary Americans.   Early 2012 gave the first signs that the domestic housing market was bottoming, suggesting an uptick in activity was in the offing.   At around the same time, slowdown in China called into question the durability of the luxury goods/tourism boom.

2013?  I think housing and consumer durables (like cars) will be the stars.  Reacceleration of the Chinese economy after the recent change in Communist Party leadership will also boost businesses that cater to Pacific Basin demand.

pent-up demand, anyone?  …anywhere?

 The recovery is pretty long in the tooth, both in business cycle and stock market terms.

Typically, when the economy is under stress, individuals stop buying and companies defer investment.  This creates “pent-up” demand that begins to be satisfied as soon as economic circumstances look brighter.  Spending surges for a while and then tails off to trend.

More than four years in, there’s not much that hasn’t had a chance to experience this cyclical surge.  Exceptions:  Housing is one area.  Autos are another.  We’ll be getting fresh data in a couple of weeks, but a year ago the average car on the road in the US was 11 years old.

As they see that pent-up demand is increasingly satisfied in the economy, stock market investors always increasingly shift their focus away from economically sensitive names and more toward niche companies with a history of strong profit growth in both good times and bad.  In other words, they shift from value to growth.  I think this will be another important feature of 2013.

Washington, a force for PE multiple expansion?

Over twenty years ago, a former colleague helped me to the conclusion that neither major political party in the US had an economic agenda appropriate for the modern world.  I think this is truer now.

Back then, the possibility that Washington craziness was clipping 1% a year off real GDP didn’t seem that important (I’ve just made up the 1% number, but I don’t think having an exact figure is critical). Inflation was higher; real growth was better, too.  So if the political status quo meant nominal GDP growth came out at 6% instead of the 7% it might have been were economically sensible policies in effect, did it really matter that much?

Today, in contrast, those extra 1%s would come in mighty handy.  Growth is slower.  International competition is fiercer.  And we’re in the earliest stages of national belt-tightening needed to pay the gigantic bills Washington has run up.  But everyone knows that Washington is dysfunctional and is steering us along the initial leg of the same trip Japan has taken from world dominance to irrelevance.

An investment point?  I think that the worst that we can reasonably expect from the White House and Congress is already pretty much factored into today’s S&P price earnings multiple.

Yes, this may unfortunately be the most probable case…

…but if I’m right, it would be hard for Washington to create a negative surprise.  Even a mild positive one could create multiple expansion.   Not anything to act on today, but something to keep in mind.

US economy vs. US stock market

It’s important to keep in mind that the course that US GDP takes and the one the US stock market takes are two separate things.  For one thing, half the profits of the S&P 500 come from non-US operations (split roughly equally between the EU and emerging markets).  For another, some important sectors of the economy, like autos, construction or real estate, have little representation in the index.

For 2013, a key question will be how to arrange the mix of domestics and foreign-earners in the portfolio.

Shaping a portfolio for 2013(l): general

I’m going to be writing about my equity strategy for 2013 over the next week or so.  I’ll be doing so from the perspective of a US-based investor, although the conclusions should apply–with some adjustment–for investors based elsewhere.

I’m going to use the same format as a year ago.  Today, some general observations.  Then, my take on the US, the EU and China (the last as a proxy for emerging markets in general).  After that, my thoughts on how the S&P 500 will perform this year.  Finally, what I think an actively managed equity portfolio should look like.

If I were still a working professional I would have done this all a month ago. I assume all my former peers began to adjust their portfolios in November or December, as well. But as an individual, I can turn on a dime.  So I really don’t need to be as early as I used to.  More importantly, though, two new issues have come up in recent weeks that call into question what I probably would have written a month ago.  More about this below.

thematic questions

I see three big themes for world equity markets in 2013.  They are:

out of intensive care?

The housing market in the US peaked and began its lengthy swoon in early 2007–six years ago!

The wheels began to come off the financial system in the US a year later–five years ago.

We can now see that the domestic housing market began its recovery nine months or so ago (one sign was how analysts were hooted down by talking heads whenever they said anything positive about housing).  Last week, newly released minutes of the last Fed meeting show the monetary authority thinks the US will no longer need further extraordinary life support measures (that is, continuing QE) within at most 12 months, maybe half that.  This is partly because the Fed judges the cure to be worse than the disease.  It’s also partly because the US economy is developing a pulse of its own, although not the youthful, vigorous one we might have hoped for.

At some point, professionals will begin to bet that bonds can’t get more expensive and that yields will begin to go up.  We know the Fed thinks the “normal” level of overnight interest rates is 4%+.  So bond prices have a considerable way to fall as/when a turn occurs.

Could this be happening now?  I don’t have strong conviction, but my guess is that it is.  This is my first December change of heart.  During such periods in the past, stocks have gone sideways to up while bonds have been falling.  If we assume (as I do) that the Fed can control the speed at which rates rise, to thus ensure that economic growth won’t be completely undone by the increasing cost of money, then sideways to up should be  our baseline assumption this time as well.

structural and cyclical

The basic macro problem with the US and the EU:  they’ve both been motoring down the same road to ruin blazed by Japan twenty-some years ago.

That is, in both the US and the EU politicians have responded to declining competitiveness by heavy borrowing.  In itself, that isn’t necessarily bad.  But as far as I can see, the money went to prop up vested interests like real estate rather than to economic restructuring (education, infrastructure, industrial capital investment).  For southern Europe the metaphorical government credit card has been maxed out.  That’s merely a worry right now for the US.

Concern that the forces of the status quo are too strong for either the US or the EU to break a spiral of gradual decline has already been factored into today’s stock prices in both areas.  The main reason for the big rally in EU equities during the second half of 2012, in my opinion, is actions by EU governments that imply they’re shifting out of denial and beginning to address structural issues.

Is it possible that fiscal cliff negotiations in the US show a similar willingness to discard outmoded ideology in favor of economically sound solutions to structural problems?  Maybe.  If so, expect price earnings multiple expansion for the S&P this year.

stock market characteristics

less information

I mean less readily available company analysis done by seasoned professional securities analysts.

Virtually no one I knew as a brokerage house securities analyst during the middle of the last decade is still so employed.  Many have left the industry; others are either self-employed or members of small research cooperatives with limited clout.  I have no insight into what the buy side has done over the past few years, but the shrinkage in funds under management–leading to substantially lower operating income–can scarcely have been an incentive to hire new researchers.

Less efficient markets aren’t all bad.  They mean a greater chance for us as individuals to uncover valuable market or stock-specific information before it becomes generally known.  On the other hand, newer, less skilled players on both the brokerage and money management sides mean that the rules of the game may be changing in weird ways.  In particular, it may take much more time than we might imagine for the light bulb brightly burning in our heads (we hope!) to go on in someone else’s.

more volatility

Individual investors have been shifting increasingly away from actively managed stock mutual funds into index funds and ETFs.  Whatever the balance between short-term traders and long-term investors may be, this action is clearly shifting power toward traders.

The inefficient flow of information may also tend to increase short-term market volatility, as investors have less practical research-based reason to stand counter to the current flow of trading.

Academics use volatility as a synonym for risk.  Other than in their fantasy world, however, it isn’t.  A stock that goes up every day is more volatile than one that never moves–or one that only trades once a week.  But that doesn’t mean it’s riskier, in the way we use that word in normal speech.  There’s no denying, though, that the current stock market I see is more opaque than it was a decade or two ago.  Therefore, it’s harder to predict the timing or effect on the market of better information we may have.

my bottom line

We’re soon going to be entering year five, measured from the market bottom in late March 2009.  And we’re already well into year four of economic recovery from the macro lows later that year.  So there isn’t an awful lot of gas left in the tank to fuel surprisingly strong economic performance–or corporate earnings results, I think.

On the other hand, relatively stimulative money policy around the world suggests that global recession isn’t just around the corner, either.

Absent craziness out of Washington, to me it seems like a flattish year for the S&P, with maybe more short-term ups and downs, and with stock pickers having a chance for much better returns.