The "fiscal slice" -- the recent congressional agreement to avoid the fiscal cliff -- was met with initial jubilation, but investors are now wondering what will come next. There are a few things that we know and a few that we don't know, but there is a simple rationalization that will allow us to move forward regardless.
1. The current multiple of the S&P 500 is 16.25.
2. The earnings growth rate for the S&P 500 in 2012 was 4.16%.
3. GDP growth averaged about 2.57% in 2012.
4. There is a clear relationship between low GDP and low earnings.
5. GDP is expected to grow by only 1.9% after the "fiscal slice."
My assessment on earnings and market valuation is that the multiple is undeserved given current and expected earnings growth rates. However, the jubilation still exists.
We also know:
1. QE3 sounds good on paper -- $85 billion per month.
2. But the U.S. treasury also sells $74 billion more bonds every month as well.
3. The "fiscal slice" will take about $16 billion per month out of the system.
4. The real liquidity added to the system per month is roughly -$5 billion.
5. QE3 is not stimulative like QE2, but it does increase the velocity of money.
1. The Investment Rate tells us we are in the third major down period in U.S. history
2. This is like the Great Depression and stagflation; it tells us this will last until 2023.
3. The rate of change in the decline of the Investment Rate gets more negative after 2012.
4. The Investment Rate is natural and inevitable.
5. This is a demographic study that has never been wrong.
With no real stimulus the economy is actually left to grow more naturally, and therefore the Investment Rate will likely result in a slow but steady economic deterioration as this year progresses.
However, the market is always right, even when it is wrong. We cannot impose our will on it. If the market is poised to move higher than we must respect that, as we must do if it is poised to move lower. At least for now, the market appears poised to move higher. It broke above important Fibonacci-based inflection levels on Wednesday, and if it stays above these further gains in the S&P 500 (SPY +0.56%), NASDAQ (QQQ +0.51%), and Dow Jones Industrial Average (DIA +0.43%) appear likely. In addition, the Russell 2000 (IWM +0.73%) has broken above a major longer-term resistance line, which is also a bullish sign.
Although my assessment is clear and rational, please notice the conditional tone and take it to heart. From both a valuation and a macroeconomic perspective the market has no business rising from these levels. But the market is always right and we must respect what it does and where it is going.
Purposefully my asset allocation models are not dependent on market direction and can work regardless of where the market goes. For example, the Swing Trading strategy -- which only returned about 14% last year, lagging the S&P -- can work if the market rises, falls or moves sideways. I suggest investors adopt a similar model because the market is not acting rationally, but we can't fight it.