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The Sandy Spring Way

January Observations

January 10th, 2013 | By Beau Mercer

Don’t stop, thinking about tomorrow,
Don’t stop, it’ll soon be here.
It’ll be better than before,
Yesterday’s gone, yesterday’s gone .”

—Fleetwood Mac

New Year’s Eve has always been a time for looking back to the past, and more importantly, forward to the coming year. Out with the old, in with the new! Fortunately the Mayan calendar calculation that the world would come to an end on December 21 did not come to pass. The Mayans, typical politicians, had some difficulty with the arithmetic of the stars (the budget was irrelevant). 2013 is about the present and has little to do with the past. Despite nearly constant headline risk, 2012 was a good year for equity investors. S&P 500 companies managed to climb 13.4%, largely on the back of the Federal Reserve Board stimulus. Six of the 10 companies that drove 88% of the S&P’s growth were financial companies. The bond market eked out a gain of 4.22% in the very low interest rate environment. Treasury yields are currently showing signs of a positive reshaping of the yield curve but real interest rates remain negative.

2013 investing will involve both luck and valuation. A good economy does not necessarily signal a positive equity market. The economy is bigger than the politicians. Valuation begins with both the known knowns and the unknown unknowns. One known is that unemployment will continue to be worrisome until Congress recognizes the implications of their actions. Four 2013 trends. FIRST, global growth is likely to surpass US economic growth in 2013 implying that large capitalization companies with greater exposure to the global economy will outperform. The US economy has settled into a slow growth strategy which has both short and long term implications. A disinflation theme keeps thumping inflation themes and free enterprise is an afterthought. The US is awash with cash and fear. The Affordable Care Act, Dodd-Frank regulations, and significant middle class tax increases obviously will influence both personal and corporate investment decisions. Re-employment and business investment will improve but the ‘sequester’ may limit the participation of the defense establishment.

SECOND, US equities will continue to rise, but much less than 2012. The relief rally that took place after the passage of the fiscal cliff legislation will fade as the debt ceiling and fourth quarter earnings reports take center stage. Yogi Berra might observe that negotiations over the debt ceiling will be acrimonious. A constitutional law debate (Section 4 under the 14th Amendment) which essentially states that the validity of US government debt ‘shall not be questioned’ will take place resulting in the middle class paying additional taxes for social security and defense. At mid-year, investors will recognize that the fiscal drag can be managed and that corporate earnings are going to exceed expectations.

THIRD, geo-political tensions will remain elevated. The Middle East and North Korea promise market volatility. Emerging markets will lessen their trade dependencies on US and Europe. US corporations will continue moving manufacturing capacity back to the states’ (Apple has made it clear that it will build more of its products in the US). The recession, which has consumed Europe, will abate in response to the policy action by the European Central Bank.

FOURTH, the deleveraged consumer and the cash rich corporation will pay additional taxes. Both the payroll withholding tax and self employment tax rates return to their previous levels. Long term capital gains rates will increase and itemized deductions will be phased out. The government needs revenue and despite the electoral promises the middle class is the source. The amount of increased taxes will surprise and influence consumer decisions in 2013 to the possible detriment of GDP growth.

“Politicians are people who, when they see the light at the end of a tunnel, go out and buy another tunnel.” —John Quinton, American actor and writer.

—Fred