2012 Second Half Outlook: Interesting Times To Be Continued

As we pass the halfway point of 2012, it is worthwhile to assess the outlook for the remainder of the year.  Put simply, these remain extraordinary times offering attractive opportunities but not without profound risks.

The economy is a primary driver of markets.  And the economic outlook has been increasingly deteriorating both in the U.S. and abroad for months.  While such weakness would imply a steadily declining stock market in normal times, these are far from normal times.  Although we certainly saw overall weakness for stocks during the second quarter, they have shown periods of resilience along the way, particularly during the month of June (stocks are down -2% so far in July).  What is most notable is that any recent pockets of strength have occurred directly in opposition to many other market indicators that would otherwise suggest stocks should be moving steadily lower, particularly from currently elevated price levels at over 1300 on the S&P 500.

This leads to a reasonable question.  Why were stocks able to rally in June despite a weakening global economy and the persistent risk of a major crisis from Europe?  It mostly comes down to the forces of monetary stimulus, as the market has otherwise generally disconnected from fundamentals.  Basically, stocks will rise or fall on any given day based largely on whether the market believes the U.S. Federal Reserve or some other global central bank stands ready to print more money or not.  And the same generally holds true for the bond and commodities market.  A market based on speculation surrounding the policy decisions made by a few select individuals around the world is certainly not a healthy foundation for markets.  But until these global central banks are ready to stand aside and allow the markets to cleanse themselves and find their equilibrium prices, such are the additional risks to navigate in the current environment.

So given their importance, what can we expect from the U.S. Federal Reserve and other global central banks?  The Fed announced at the end of June that they would extend the program they began last October known as Operation Twist through the end of 2012.  What is notable about this plan is that it likely provides enough stimulus to keep the stock market from crashing lower, but not enough stimulus to cause it to float higher the way it had under past programs such as QE1 and QE2.  This helps explain why stocks have been chopping back and forth for the last few months in posting a -6% decline from its early April highs.  Looking ahead, unless the U.S. economy completely falls apart or crisis breaks out in Europe, both of which would imply a sharply lower stock market from current levels, we are unlikely to see a more stimulative QE3 program from the Fed before the end of 2012.  All of this implies that the stock market may continue to grind back and forth in a gradually downward sloping trend for the next several months if the status quo holds.  Of course, a catalyst event such as a new stimulus program (upside) or an outbreak of crisis in Europe (downside) at any time along the way remains a notable risk that could dramatically change this outlook.  This requires close monitoring as we move forward.

The threat of the fiscal cliff in the U.S. also looms as an increasing risk as we move toward the end of 2012.  What is the fiscal cliff?  At the end of the year, roughly $500 billion worth of government spending programs and tax cuts are set to expire.  This amounts to 3.5% of the entire U.S. economy.  In short, the expiration of these programs would likely immediately thrust the U.S. economy into recession if it’s not already there by then.  Making matters even more complex is the fact that the Fed’s Operation Twist stimulus program is now set to expire at the exact same time.  All of this uncertainty, of course, is negative for stock prices.  Will the Federal government likely allow the U.S. economy to go completely over the fiscal cliff?  Probably not.  But here is where it gets tricky.  The U.S. presidential election is scheduled for November 6.  Every member of the House of Representatives and a number of Senators will also be up for election.  And virtually no politician will have any interest in even engaging the conversation about how to deal with the fiscal cliff until after the election, as the topic is too risky for most from a political perspective.  As a result, we are not likely to see any action in Washington to begin dealing with the fiscal cliff until at least mid-November, which leaves policy makers less than seven weeks that includes two major holidays before the end of the year to try and resolve this issue.  So as we draw closer to the edge of the fiscal cliff, the uncertainty will likely mount and the negative pressure on stock prices may build along with it.  This will be another important issue to monitor in the months ahead.

So barring a dramatic economic reversal or the launch of a major Fed stimulus program, most every current factor implies a challenging road ahead for stocks in the second half of 2012.  Where then are the best investment opportunities in the months ahead?  Most reside outside of the stock market.

Bonds continue to offer appeal for several reasons.  First, U.S. Treasuries are attractive primarily for the reason that they tend to go up when the stock market goes down.  For example, Long-Term U.S. Treasuries are up +15% since the stock market peaked back in early April.  Thus, Treasuries continue to provide a good way to hedge against a stock market decline.  Other bond categories also remain attractive in this type of environment including Build America Bonds and National Municipal Bonds.  And Agency Mortgage Backed Securities also work well not only for the fact that they steadily rise – they have gone up by +26% almost without interruption since the beginning of the financial crisis – but they are also likely to be the focus of any potential Fed QE3 stimulus program if it were launched in the coming months.

Precious metals such as Gold and Silver also remain attractive.  Although both have struggled in recent months due to the limbo state created by the Fed’s Operation Twist program, they offer good protection against either outcome in the end.  If the economy falls into crisis (and the Fed is forced to print more money), investors will likely flock to the protection of hard assets such as Gold and Silver.  And if the economy manages to pick up renewed steam, Gold and Silver will provide protection against the inflation that is likely to accompany any sustainably robust recovery given all of the money that has already been pumped into the system to this point.

Stocks will also continue to offer opportunities on a selective basis.  Even if the stock market continues to grind lower in a choppy fashion, we’re likely to see periodic rallies as long as the Fed is providing some degree of monetary support (or the perception that they will provide more of it).  And individual stock names are likely to be thrown to the curb on any given trading day, perhaps due to a disappointing earnings report.  Watching for the major sell off of any high quality, low volatility names may present usually attractive short-term trading opportunities at any point along the way.  As we enter Q2 earnings season starting this week, I will look to keep you updated on any positions that set up well in this regard.  Lastly, if the overall stock market were to start cascading lower as it did during the summer of 2010 and 2011, this may present the opportunity to take on more broader market positions in the aftermath of the decline.

The second half of 2012 promises to provide a new set of interesting and sometimes unpredictable experiences for the global economy and markets.  And I will continue to provide you with updates as events unfold.

Published by Eric Parnell

Registered Investment Advisor

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