But can they cause financial market pullbacks? The most notable stock market pullbacks of the past two years coincided with spikes in solar activity. In particular, recent stock market pullbacks have coincided with solar flares: August 2011, November 2011, May 2012, and October 2012. However, it was not the consequent electromagnetic storms that disrupted the stock market. Instead, it was flare-ups of a different sort: the debt ceiling debacle (August 2011), the European financial crisis (November 2011 and May 2012), and the U.S. election and fiscal cliff concerns (October/November 2012).
The potential flare-ups we are monitoring at GGA this year are:
- European crisis: The scandal in Spain plaguing Prime Minister Mariano Rajoy, the deadlocked election outcome in Italy that puts economic reforms at risk, and the unwillingness of Germany to approve any more aid ahead of the fall elections in that country all raise risks. It was events in Europe that pulled stocks down 10% or more as measured by the S&P 500 in the spring of each of the past few years, and we are watching things closely for a repeat.
- Spending sequester: The Congressional Budget Office estimates that the fiscal drag from the sequester in 2013 would be about $85 billion, or about 0.5% of gross domestic product (GDP). This adds to the roughly 1.5% drag on the economy from the fiscal cliff tax increases that went into place January 1, 2013. That is a materially negative impact for an economy that registered a contraction in the fourth quarter and is on track for only sluggish growth in the current one.
- Government shutdown: The continuing resolution funding the government expires on March 27, 2013 and could prompt a government shutdown (though certain essential components like the armed forces will continue to operate). While tax collections will be reaching their seasonal peak as the April 15 deadline approaches, tax refunds processed by the IRS may take much longer than usual. In 2012, the average tax refund check was nearly $3,000, and refunds totaled hundreds of billions (according to the IRS), which triggered a wave of consumer spending. These processing delays could cause consumer spending to drop and negatively impact stocks in the consumer discretionary sector.
- Quantitative easing: The Fed is likely to begin to slow or stop the current bond-buying program, known as quantitative easing (QE), later in 2013 or very early in 2014. These steps toward a return to a more normal monetary environment are likely to lead to higher interest rates and tighter credit conditions for borrowers that can weigh on the stock market. Changes to Fed programs—or even deliberations months ahead of the potential end of a program or start of a new one—have punctuated the volatile moves in the market over the past five years.
Exacerbating these potential flare-ups, currently high energy prices can make the economy and markets more vulnerable to a negative event that drives stocks lower. Every 10 cents gasoline prices rise takes more than $10 billion out of U.S. consumers’ pockets over the course of a year.
However, it is important to note that the potential negative impact of these risks is limited by the fact that they have been known for some time. Though they may contribute to market volatility this year, the forewarning of them makes a bear market unlikely. Bull markets do not tend to end with the S&P 500 stocks valued as low as they are today, which is the lowest price-to-earnings ratio at a bull market peak since World War II. Therefore, based upon these factors, while ups and downs may continue, we believe the bull market is unlikely to be over.
In an up-and-down market environment, investors may seek to benefit from volatility in several ways, including:
- Buying the dips: Buying makes sense in fundamentally improving areas such as housing and manufacturing.
- Seeking yield: Focusing on the yield of an investment rather than solely on price appreciation may potentially enhance total returns.
- Going active: According to our research, using active management rather than passive indexing strategies may enhance returns as active managers tend to outperform their indexes when volatility rises.
Despite these flare-ups, I believe the sun will still be shining by year end, and stocks and bonds may deliver modest gains for investors in 2013. As always feel free to call or email if you have any questions or comments.