Why You Should Prepare For An Equity Sell Off in 2013

Forget the Fiscal Cliff; there are bigger worries for investors

Having examined the current markets, and what has led us to today’s stock market levels, it’s clear to me that 2013 could be a pivotal year for investors. It’s going to be a year in which markets could prove volatile at best to coming down with a bang at worst.

Before I discuss this further, I want to make one thing plain: I don’t think that the ‘Fiscal Cliff’ will be the catalyst for a stock market slide, because I don’t think we’ll get into the situation where it can be. History has shown that US lawmakers pull back from the precipice – remember the debt ceiling crisis of 2011? In fact, the market fell away because of the gathering expectation that the debt ceiling would not be readjusted and the country would come to a standstill. When such an outcome was averted, markets began to rally again.

And it is this market psychology that leads me to believe the stock markets could be in for a tricky year in 2013. Markets are forward looking: they react to expectations and it is when those expectations turn out differently that markets move in the opposite direction. If anything, I think the expected problems of the Fiscal Cliff are, to a great extent, already written in to current market levels. So it could be that the market should rally in the New Year.

But I do see many other reasons to guard against a market fall in 2013.

A look at recent history

It’s the recent history of the market, and the reasons for the bull run of the last 4 years that give me pause for such concern. Looking at the reasons for the bull market over the last few years will give us an idea of the reasons for caution now.

Stocks just haven’t seemed to want to fall since the low of the stock market crash in 2009. With the financial crisis in full swing, investors believed the world was coming to an end. The S&P 500 fell away to a level of around 700, less than half its high in the fall of 2007.

Since 2009, however, stocks have been climbing a wall of worry. As each new and seemingly larger problem has reared its ugly head, it has been shot down and investors have bought more shares.

Europe’s debt problems have surfaced, caused concern, and then seemingly disappeared. And the markets’ have risen in response.

China’s slowing economic growth has come out as expected, or only a little worse, and the markets have reacted positively.

Jobless figures in the United States have remained stubbornly high, despite economic growth that has defied the fortunes of the rest of the world. With every shock to expectations the market has somehow moved higher, as expectation for continuing low interest rates have held stock valuations.

Corporate Profits have kept rising

Looking back to the low point of 2009, it is now easy to say how undervalued stocks were. Corporate profits had not pulled back as far as was expected and have risen strongly since. A large part of this rise has been promoted by huge cost cutting measures conducted across the board – a major reason that jobless numbers have remained high throughout the recovery.

But corporate profits have begun to reverse. As the weakness of the global economy has finally begun to hit home, and further costs cutting measures are becoming more difficult to put into place, earnings and earnings growth has begun to reverse. The Price/Earnings ratio of the S&P 500 now stands at 16.5, above the long term average of 14.5. During the 2007 to 2009 market downturn, this indicator fell as low as 10.2. It won’t take a lot for corporate profits to come under further pressure, and this will lead to an erosion of valuation. We probably won’t get down to a P/E ratio of 10 again, but share prices will likely reflect weaker earnings expectations as reality sets in.

Cheap Credit and Fiscal Stimulus

The Fed has kept rates low and pumped money into the economy at the same time through a huge quantitative easing program. This hasn’t added billion the economy, but trillions. It has to be questioned how much further the Fed can go, or will want to go now that the election season is out of the way. The huge energy given to the money supply will eventually lead to increased inflation and this will necessitate higher interest rates. And that will squeeze spending power. It’s not a question of if this happens, but when.

I know that I’ve said the Fiscal Cliff will be a non-event, but the fact remains the US is running a huge budget deficit of more than a trillion dollars each year. There are two potential negative outcomes to the US economy that I see here. The first is that taxes have to be raised and/ or spending cut. This may be as a result of an agreement on fiscal policies between Congress and the Presidential office: the Fiscal Cliff will be averted for the time being, but problems stored for 12 months or so.

The second and more worrying concern is that foreign appetite for US bonds wanes. Is this possible? European buying of bonds is likely to be more inwardly concentrated as it battles its own financial free fall, and China has made noises previously about cutting back its buying of US government debt. Will 20013 be the year this happens? The possibility should not be ruled out as its economy begins to slide to the lowest growth rates seen for more than a decade.

The Eurozone

Each month the Eurozone seems to move through yet another debt crisis. Ireland, Greece, Portugal, and Cyprus have all had bailouts. Greece’s continues to pose problems as austerity measures demanded by the ECB, Europe’s leaders, and the IMF kick its economy further into recession. Each tranche of extra cash for Greece has to be agreed between Europe’s members.

Now Spain looks likely to need a full bailout – its banks have already received around €95 billion. Spain is in the second year of a hard biting recession that has seen its unemployment rise to over 25%. A bailout will mean further austerity measures put in place. Could Spain end with a multi-year recession that stretches beyond Greece’s six years to date?

Meanwhile, the Eurozone as a whole has just been declared in a double dip recession, with even Germany teetering.

If Spain succumbs to the need for a bailout, will Italy be next. If the level of debt the country has is anything to go by, it looks likely.

Europe has deep set worries about its debt levels and its economy. With indebted nations unable to spend their way out of recession, the outlook for American exports does not look good, and this will apply further downward pressure on corporate profits.

The Election Year Rally

Election years tend to follow a general market patter. The year starts well in stocks, before it then sees a pullback before recovering strongly through the summer and into Super Tuesday. This year has followed that pattern. But nearly half of all the years following an election year have seen the S&P 500 fall back. With the S&P up by over 100% since the low of 2009, history is on the side of 2013 being a year for a fall in equity valuations.

In Conclusion

Working through the list of reasons that the market has been so bullish over the last four years, it’s easy to see that the market has bounced from what was a clearly oversold position back in 2009.

This bounce has been helped by improving corporate earnings that have benefitted from cost cutting measures and a monetary and fiscal stimulus that is unprecedented in United States’ history. At some point the private sector’s capacity to continue cost cutting and the Fed’s ability to carry on pumping money into the system will both come to their natural ends. When this happens, economic growth could turn around and head sharply lower and corporate earnings head south, too.

In summary, it is corporate earnings that will dictate market direction. Europe’s impending implosion, though delayed, may serve as the real catalyst that causes those earnings to fall harder and faster than most fear. The problem is that the US is running out of wiggle room to hold up its economy at home should its export markets deteriorate further.

The market has lost the stimulus of Presidential election year, and its foreign markets are disappearing, with Europe’s woes increasing on an almost daily basis. Corporate cost cutting measures are nearing maturity (if not already there). Inflation is being stored for a future explosion. The Fed is desperately trying to prop up the money base.

In short, all these problems that have been climbed over the last few years have built the foundation which the market’s current value has been built. Investors should prepare themselves for those foundations to turn to sand.