The Post-Election Correction

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On November 6, President Obama was re-elected for 4 more years. On November 7, the S&P 500 fell -2.3% and has continued to fall since; it is now down -4.6% since Election Day. Overseas markets have fared somewhat better, as the MSCI All-Country World ex-US index is down only -3.3% over the same period. What gives?

You’ve probably heard about the various worries in the news: the impending “fiscal cliff,” continued concerns about Greece and Spain, recession in the Eurozone, the once-in-a-decade transfer of power in China and now, a possible war in the Mideast between Israel and Hamas. There are certainly enough negatives to keep our spirits down.

But except for the Mideast conflict, all of the above have been known about for many months. Could it be that a majority of investors were hoping that one political party would control both houses of Congress and the Presidency, permitting a quick solution to the fiscal cliff? This is highly unlikely.  The polls, the various betting websites and bookies from Vegas to London all had odds significantly favoring the outcome we actually experienced: Obama remains president, the Democrats continue to control the Senate, and the Republicans own the House.

Perhaps the only surprise was the Democrats’ margin of victory, which was wider than most expected. This worries conservatives, as the Dems may think they have a mandate for all their policies, including raising taxes on the wealthy, making compromise less likely. And yet the Republicans are holding fast to their pledge not to raise taxes on the rich. A continued impasse over the fiscal cliff seems likely.

Don’t Worry, Be Happy

Don’t let this worry you too much. First, the stock market’s fall is being largely driven by individuals taking capital gains this year, as they expect the rate to rise from 15% to 20% in 2013. Stocks that have been particularly strong over the past 12 months are falling hard post-election. Apple Computer, for example, is down almost -9.1% since last Tuesday, double the fall of the S&P 500. Brokers are calling their clients urging them to sell in order to take advantage of this year’s lower capital gains tax rate, and clients are apparently obliging.

Second, at today’s press conference after the “fix the fiscal cliff” kickoff meeting, it became clear that both sides are ready to compromise in order to reach an agreement. It’s still possible that only a temporary fix will be put in place and need to be revisited in 2013, but that’s OK as well because the same key players (Obama, Boehner, Reid, Pelosi and McConnell) will be at the negotiating table next year. The stock market’s reaction to lawmakers’ optimistic tone was swift and sharp, with the S&P 500 rising +1% in a matter of minutes. The quick market turnaround also suggests that it won’t take much to push stocks back up.

Third, as I’ve said before, the fiscal “cliff” is really more of a gentle slope. Even without a deal before January 1, the government has a lot of flexibility to delay spending cuts. At the same time, a significant part of the additional taxes owed—should the Bush tax cuts expire—will be borne by individuals who pay quarterly estimated taxes, and these aren’t due until April 15. The effect on the much larger number of individuals having taxes withheld from paychecks will be more muted.

Fourth, stocks have already discounted a lot of bad news, including a recession next year. In the 1990-1991 recession (which is a more “typical” recession than either of the last two), corporate earnings fell -19% from their peak before recovering. If we assume a similar decline in corporate earnings next year (which I am not predicting), then at today’s close the S&P 500 is selling at 16.9 times those recession-level earnings. This is, perhaps coincidentally, exactly the same as the average price-earnings ratio since 1960. Thus, one could logically say that a recession is already priced into the market. If corporate earnings actually grow next year—or just don’t decline—then stocks are at least 20% undervalued today.

Fifth, investor sentiment is in the toilet, with most measures nearly as low as in May of this year when the S&P was about 6% below its level today. And investors have become bearish very quickly: the AAII bull-bear spread went from -1.4% last week to -20.0% this week. (It bottomed in May at -22.4%.) At the same time that investors are down on stocks, they aren’t too optimistic about the economy, either. As I meet with professional investors, nearly every one I speak to thinks the US will go into recession next year (which by itself might explain the market’s funk). I think they’re quite wrong. And even if they are correct, the market has already priced this in (see above).

Stand Out from the Crowd

These professionals also seem to be putting their clients’ money where their mouth is. Individual investors have continued to shun cheap stocks and buy expensive bonds. Since the stock market peaked on November 1, 2007, investors have pulled over $475 billion out of equity mutual funds, while stuffing $1.02 trillion into bond funds. And this trend shows no signs of abating. Last month, investors pulled $15.2 billion out of equity mutual funds, after removing $24.4 billion in September (despite a strong stock market that month). Over the past year, money flowed out of stock funds during 11 of 12 months, while bond funds have seen inflows in every one of those months.

When individual investors dump stocks for many months in a row, that’s good news for the minority who stay invested. As you probably know from reading my newsletters, individual investors have lousy timing. In the early 1980s, when stocks began soaring upward, equity mutual funds didn’t start attracting money again until 1986, and this was merely a trickle. Investors only started pouring money into mutual funds in earnest after 1994, more than 12 years into one of the greatest bull markets in history. They continued to increase their investments until—you guessed it—2000, at which point the market began a long decline and investors started pulling money out again.

Individual investors’ impeccably bad timing continues. In the face of a market that has doubled since March 2009, investors continue to pull record amounts of money from stock funds and stuff it in bonds at record low yields. (Why are people buying 10-year Treasury bonds at a fixed 1.6% yield when stocks like Proctor and Gamble are paying a 3.4% dividend that, at least currently, is more lightly taxed and tends to increase every year?) If history is any guide, investors will start piling back into equities only after the bull market is several years—even a decade—old and interest rates have risen substantially, crushing the value of those bond funds. Please don’t follow the crowd: your wallet will thank you.

And now for something completely different…

Hey American consumer, you can afford to live a little now

 If you ask Bill Gross or CNN, we remain in the depths of the darkest recession since the 1930s and will for several more years. We disagree: while we’re still a long way from boom times, we are in an economic expansion we think has many more years to run. Corporate earnings—the main driver of equity prices—remain strong despite slow sales growth, and the employment picture in the US continues to improve, although at a slower rate than many had hoped. And while corporate spending has rebounded smartly from its precipitous 2008 decline (albeit at a much slower pace recently), the American consumer has been holding back. We think that’s about to change.

The shell-shocked consumer

The average American saw his or her investments plummet four years ago. Millions lost their jobs, and those that remain employed likely haven’t seen their compensation rise much since 2009. What do people do when money gets tight? You can’t stop paying your mortgage, car insurance premiums or utility bills (if you want to remain housed, insured and warm). Instead, you cut discretionary spending: buying fewer luxury items, taking cheaper vacations, eating at home instead of in restaurants, putting off home remodeling, keeping that rickety old car instead of buying a new one. You get the picture—we cut things we can live without, things we enjoy but don’t need. Americans started cutting discretionary spending four years ago, and they did it forcefully and quickly.

The stock market illustrates this vividly: From the November 2007 market top to the March 2009 bottom, only the Financial and Materials sectors performed worse than Consumer Discretionary stocks. With the financial industry supposedly on the verge of collapse, it makes sense for financial stocks to have fallen -75%. On the other hand, seeing the shares of consumer discretionary firms fall -55% over the same period is almost more surprising. Nike, McDonald’s and Home Depot didn’t need bailouts, and their balance sheets weren’t fatally leveraged like AIG and many mortgage lenders. These stocks tanked because the American consumer cut his/her spending so much and so quickly, wreaking havoc on these companies’ bottom lines.

Why we should see a rise in discretionary spending

One of the reasons I believe we will see a significant rise in discretionary spending in the US is that we are collectively spending so little on it now relative to our discretionary income. In the second quarter of 2012, American consumers spent only 28.2% of their after-tax income on necessary items: housing, food, energy and financial obligations (rent or mortgage payments, credit card debt, auto leases, homeowners’ insurance, property taxes, gasoline, etc.). This is the lowest such level in at least 40 years. As you can see in the graph below, this figure hovered in the 30-32% range for much of the 2000s and was as high as 36% in 1980. For simplicity, let’s call the percentage of after-tax income spent on housing, food, energy and financial obligations “X.”


Mark Twain said “there are three kinds of lies: lies, damned lies and statistics,” so let’s make sure we’re not being tricked. We calculate X as a simple fraction: (dollars spent on food, energy and financial obligations / dollars earned after-taxes). If incomes increased on average while dollars spent on the three categories remained the same, the fact that X is so low would be misleading. However, personal after-tax income today is barely higher than it was in 2008, so that the denominator has not been growing lately.

This means that the numerator (dollars spent on the three non-discretionary categories) must have dramatically decreased over the past 4 years, with most of that coming from lower debt payments owing to falling interest rates and consumer deleveraging (paying off debt). It also means the statistic is probably not a lie (or a damned lie), and correctly indicates that Americans have a much larger percentage of their income available to spend on things they want.

What do I do with this information as an investor?

Does more free cash flow automatically lead to more discretionary purchases? Obviously not; people can save this money instead of spending it, and they have been doing exactly that for the past 4 years. But prior to the Great Recession, the average American accumulated plenty of mortgage and credit card debt by buying things they couldn’t really afford. Now that people can afford to buy things again, why wouldn’t they eventually buy more of what they want (rather than need), since they were willing to do it even when they couldn’t afford it? And let’s not forget that over the past four years, people have held off on home remodeling and car buying, taken more frugal vacations, eaten out less and reined in their online shopping habits. There’s a lot of pent up demand out there that will eventually need to be satisfied.

As an investor, I over-weight a sector that I believe will do particularly over the next year or two. Recently, I have started increasing the weighting of consumer discretionary stocks in client portfolios. I can do this in one or more of three ways:

(1)   Buy more consumer discretionary stocks, such as Home Depot (NYSE: HD), (NASDAQ: AMZN), Chipotle Mexican Grill (NYSE: CMG) and Toyota Motor (NYSE: TM). Note: These are just examples. I am not recommending you purchase these, or any, specific stocks.

(2)   Buy stocks that are not classified as “consumer discretionary” but that benefit from increased consumer spending. Examples include American Express (NYSE: AXP), VISA (NYSE: V), and Apple Computer (NYSE: AAPL).

(3)   Buy a mutual fund or ETF that offers exposure to the consumer discretionary sector.

I cannot tell you which approaches make the most sense for you; it depends on your risk tolerance and the current makeup of your investment portfolio (and of course, whether your portfolio is being managed by KCS or another firm).

Nothing in the above article is to be construed as an investment recommendation. I do not recommend that you buy or sell securities before consulting your financial advisor.