Bank of America surprised market watchers today with announcing that it will suspend its recent dividend and stock buyback program that was part of its latest capital plan approved by the Federal Reserve. The company attributed the need for such a measure to inadequate accounting for regulatory capital related to “certain structured notes assumed in the Merrill Lynch & Co., Inc. acquisition in 2009.”

It is noteworthy to mention that the US banking regulatory landscape has changed dramatically since the financial crisis in 2008 with many rules and regulations implemented since then requiring higher capital ratios and imposing limitations and restrictions on many risk-taking activities.

Before the Bank of America surprise, investors were treated to a similar surprise from Citigroup whose capital plan was rejected by the Federal Reserve for the following reasons:

“While Citigroup has made considerable progress in improving its general risk-management and control practices over the past several years, its 2014 capital plan reflected a number of deficiencies in its capital planning practices, including in some areas that had been previously identified by supervisors as requiring attention, but for which there was not sufficient improvement. Practices with specific deficiencies included Citigroup’s ability to project revenue and losses under a stressful scenario for material parts of the firm’s global operations and its ability to develop scenarios for its internal stress testing that adequately reflect and stress its full range of business activities and exposures.”

Analyzing the above, one concludes that the problems with Citigroup and Bank of America are not ones related to the core strengths or competitiveness of their banking products or activities but primarily relate to internal risk management and control issues. In other words, these are human resources issues and not necessarily capital related issues. Furthermore, these are issues that are not sudden in nature; they have been there festering for a while and have not inevitably been remedied since the financial crisis. The question that begs itself is why?

While only senior management at Citi and BofA can fully answer the above question, the answer is not hard to find if you look at the frequent announcements coming out of the banking sector for the past few years. Both banks have new leadership at the helm and both banks have announced massive layoffs in recent years. Bank of America’s “Project New BAC” Called for 30,000 layoffs between the third quarter of 2011 through 2014. Citigroup’s new CEO Michael Corbat announced plans to cut 11,000 jobs shortly after he took the helm in late 2012 on top of massive ones that took place since 2008. One can’t argue that layoffs aren’t necessary in the normal course of business particularly after a severe financial crisis, but one wonders if some job cuts were wise in certain departments given much expanded regulatory oversight. Or put another way, one wonders why certain departments, namely risk management and accounting, for example, weren’t beefed enough to meet the increasing risk management and accounting reporting challenges.

To summarize, the issues with Citigroup and Bank of America relate to human resources more than minimum capital requirements and one wonders that of the thousands of job cuts announced, these banks, and others, may have cut too deeply in some departments and ended up losing a dollar to save a dime.

This week’s Federal Reserve FOMC meeting was the first headed by new Chair Janet Yellen. Among the other novelties of this meeting was the removal of the Fed’s quantitative guidance on the level of unemployment that the Fed deems noteworthy as an indication of future inflation. The FOMC statement and the subsequent remarks made by Yellen at her press conference gave way to great confusion and misinterpretation among traders and led to a seesaw session on Wall Street with a 100+ point swing on the Dow Jones Industrial average.

Though some of Yellen’s comments are open to different interpretations, the Fed’s actions are crystal clear: The Fed announced a $10 Billion further reduction in its asset purchase program or QE. While many believe the Fed is reducing its asset purchases due to an improving economy and a gradually decreasing unemployment rate – with maximum employment being one of the Fed’s objectives given its dual mandate – however, many forget the Fed’s second mandate which is price stability. Clearly, the Fed is not happy with inflation expectations and thinks they are too low. However, as Bernanke alluded to before, the FOMC has come to the conclusion that, given its costs and benefits, QE is not the best tool to pump inflation and that forward guidance should be relied on more instead. Hence, it was not surprising the amount of time Janet Yellen spent explaining all the nuances of the change from quantitative to qualitative guidance.

Nevertheless, the reality is that the Fed is reducing stimulus while Yellen’s own assessment of the economic recovery is that it has been “disappointing”. If the Fed’s intent behind its multiple rounds of quantitative easing was to reduce interest rates and effectively push other asset prices higher (read stocks) then that was magnificently achieved in 2013 with the S&P 500 rising by more than 30%. However, that did not do much in raising inflation and that is the real reason in my opinion QE is being wound down in favor of forward qualitative guidance.

What matters to investors from the above discussion is the impact that Fed policy, and actions, will have on various asset classes. Everything else being equal, the best interpretation can be achieved if we can gauge investors’ risk appetite. So the best question we can ask is what will the new Fed policy do to investors’ risk appetite? Instead of trying to opine qualitatively on this issue, we should look at what the markets have been performing since the beginning of 2014:

Gold is up nearly 10%, Stocks are unchanged, while 10 Year Treasury bonds are yields have dropped by 7% since the beginning of the year currently yielding around 2.75% after starting the year near a 3% yield. Clearly, investors have adjusted their risk appetite after the Fed announced its QE taper in December 2013.

Gold Versus Change in 10 Year Treasury Yields Versus S&P 500 Jan 2 – March 20Chart Courtesy Yahoo Finance

One would think that Treasury yields would go up once the Fed reduced its bond buying program but the opposite has happened. Surely, it is the lack of inflation expectations but also it’s a reflection of a decrease in risk appetite. Similarly, Gold is not up because of inflation fears but because it is perceived as a safe haven in time of turmoil.  One can argue that current geopolitical risks can be temporary, but nevertheless those risks do impact risk appetite. Lastly, the fact the S&P 500 is practically unchanged is further evidence that investors are not as enthused about stocks as they were in 2013. Back in August of 2013, I was anticipating the Fed to announce a reduction in QE in September and a drop in risk appetite by year’s end. The Fed ended up announcing the taper in December and we are now seeing this anticipated drop in risk taking.

Where to invest in 2014?

If the above scenario holds true, it would be prudent for investors to reign in their risk taking in 2014. Given the reality that short term interest rates are rising, risk appetite is declining and economic growth is sluggish, it would be wise to overweight defensive assets at the expense of more economically sensitive ones. Of the 10 S&P 500 sub-sectors, our favorite sectors to overweight include Utilities stocks for their defensive qualities. Financials as a group will benefit from rising short term interest rates and will likely reward investors with higher dividends and buybacks in 2014. Healthcare and Consumer Staples stocks are equal weight sectors in our opinion while Technology, Industrials, and Consumer Discretionary stocks are our least favorite. Gold continues to be a good hedge with a 10% portfolio weighting whereas allocations to Treasuries (10 Year+) should be higher than 25% while keeping a decent percentage in cash for opportunistic purchases – which we think there will be plenty.

Herbalife (NYSE:HLF) disclosed today that The Federal Trade Commission is opening a civil probe into the business activities of the MLM supplements maker. After being briefly halted, shares of Herbalife dropped 17% before rebounding and closing down more than 7% for the day.

While I have no position in the shares of Herbalife, it has been interesting to watch this Wall Street Soap Opera unfold over the last 14 months ever since Bill Ackman from Hedge Fund Pershing Square unveiled his short position back in December 2012.

It will very likely take some time (more than 6 months) before we know what the outcome of the FTC investigation but while no one knows for sure what the outcome will be; it is a safe bet that it will be one of the following 3:

Herbalife will be exonerated and, effectively, given a clean bill of health by the FTC

Herbalife will be found in violation of some FTC rules and will be fined several million dollars but will continue as a going concern.

Herbalife will be found to have material violations and will be forced to materially change the way it conducts its business and forced to pay a very sizable and material fine (hundreds of millions of dollars).

Those bullish on Herbalife will be expecting the first outcome or full exoneration while those who agree with Bill Ackman will be expecting the third outcome or material violations in the way the company conducts its business.

Given the fact that Herbalife has been in business for a long period of time in a fairly heavily regulated industry and has been scrutinized by regulators in the past, it is hard to believe that it can be significantly running afoul of the law for so long. It is of course not impossible but I see it as improbable.

Likewise, expecting the FTC to give a clean bill of health to Herbalife is also unlikely as it never is a good thing to be investigated by the government. Is it likely that Herbalife has cut some corners when it comes to adopting best practices in its industry and that any compliance slack will be identified by this FTC investigation? I say the odds are significantly greater than zero. But, will those violations be material from a financial or business standpoint? I believe that any violations, if any, will likely not be material.

So what happens to the stock in the meantime?

Herbalife shares hit a 2014 high of $83.51 on January 8th and have been trading lower ever since closing at $65.39 on the day preceding the FTC announcement. One can make the argument that investors have been anticipating some bad news but nevertheless, a 22% decline off the January highs is noteworthy. The company is expected to announce quarterly earnings in late April and until then the stock is likely to move based on the actions, rather than the words, of the main antagonists in this saga. Carl Icahn who currently owns 16% of the company sits on the Board and is likely restricted from trading in the company’s shares until after the next earnings report – that is if he has any interest in increasing his already sizable stake. So essentially, the stock will likely continue to be volatile without any major catalysts on the upside or downside until the company announces earnings. Professional options traders selling volatility are likely the ones to be making any money trading Herbalife in the near future.

At this point, it looks like both sides of the fight have expended most of their bullets. Carl Icahn and the company have been pitching a flawless game up until this point while Ackman’s relentless lobbying has finally gotten him to first base today with this FTC probe. The game is far from over and the score is heavily in favor of the HLF longs up to this point.

Much has been written about the upcoming reduction of the Federal Reserve’s bond buying program known as Quantitative Easing. There has been a lot of debate on not only when Ben Bernanke will start this much anticipated tapering but also about what impact this will have on the bond and stock markets.

Many commentators believe that as treasury bonds keep falling in price, due to ever increasing interest rates, investors will somehow rush into stocks to escape the drop in the value of their bond holdings. Well, we think quite the opposite is about to happen. The next rotation will be from stocks into bonds and not the other way around. Others interpret rising interest rates as a sign of impending economic growth that will benefit stocks. We are in unprecedented era – interest rates are rising due to prospects of an imminent decrease of stimulus and not because of an abundance of economic growth. Yes, when rates rise in response to good economic growth stocks will do well but if rates rise due to the removal of performance enhancers (QE) then stocks will likely under-perform going forward given current economic and corporate earnings growth prospects.

Based on statements from the Federal Reserve and Ben Bernanke’s latest testimony in front of Congress, I am in the camp of those who believe that the Fed will start reducing its bond buying program in September. In my estimate, it is clear that the Fed is not waiting for robust, or even good, economic reports in Employment or inflation to start its tapering as many believe, but it’s just the lack of terrible economic reports. As it has been often repeated by Fed Chairman Ben Bernanke, one of the main goals of Quantitative Easing was to boost asset prices. With stocks as measured by the S&P 500 rising 16% in 2012 and more than 19% at the end of July 2013 one can’t argue that QE has not achieved its intended goal of boosting asset prices.

7, 10, and 20 year Treasury Bond ETFs have steadily dropped in value since May while Stocks have flat-lined. This phenomenon will reverse soon.

What does this mean?

For Bonds, it is not surprising that as we saw investors front-run the Fed into buying Treasuries before the latest iteration of QE was announced we now are seeing investors exit en masse as the Fed is preparing to reduce its purchases. The 100 basis point increase in 10-year Treasury rates so far this year has not come on the back of robust economic reports as trailing 12-month average monthly non-farm employment growth has been sub 200,000 (189,000 and likely declining) and GDP growth sub 2%. We believe the increase in rates has been purely based on the anticipated reduced demand (purchases) by the Fed and a great deal of this anticipated tapering is probably already priced in the bond market. Risk averse treasury bond investors will reduce maturities, alter makeup of their bond holdings, or go into cash – and not into riskier equities particularly if the increase in yields is triggered by the lack of expected future demand by the Fed rather than healthy economic growth that often leads to monetary tightening and higher interest rates to curb inflation.

For stocks, the impact of the Fed’s tapering can be evaluated based on your answer to the following simple question:

Given that corporate operating earnings for the S&P 500 were up less than 1% in 2012 (yes you read that right) and are up less than 5% for the first half of 2013 according to Standard & Poor’s one can logically conclude that perhaps stocks are a bit ahead of themselves at this point. However, given that stocks are already up so much, the need for further QE is negated based on asset prices alone. Furthermore, if the outlook for GDP and earnings growth in 2014 is cloudy right now then it would make sense to hold back further bond purchases for later when asset prices (read stocks) take a tumble when – or if – this weaker outlook actually materializes. There is no need to keep pumping an already inflated stock market; but it would be better to save some ammunition for later when investor’s 401ks really need it – now they don’t.  History will likely judge quantitative easing as probably the most effective tool ever used to boost asset prices in the US. Keeping this tool effective requires that you stop using it when asset prices are already goosed up. With the S&P 500 up as much as 19% one can argue that the Fed can raise a mission accomplished banner for 2013 and save further QE ammo for later.

Where to invest for the rest of 2013

As mentioned earlier, with the S&P 500 index up 19% at its highest point so far in 2013, the risks going forward are likely to the downside. As interest rates increase, we are likely to see more income focused equity investors attracted to bonds rather than the other way around. Taking profits and reducing equity exposure is probably the conservative way to go. For existing equity exposure, overweight positions in healthcare and consumer staples stocks are probably the safest places to be in. As for bonds, if you have not reduced maturities and bond duration in your portfolio then you have already suffered most of the losses that you are likely to suffer in 2013. I expect 10-year Treasury bond yields to stabilize around the 3% to 3.20% area and actually start declining again as inflows from equities rush into the safety of treasury bonds if stocks start selling off. The areas where it is probably prudent to increase allocations to is the US dollar at this time. As interest rates increase and as inflation remains under control, the US dollar will likely appreciate against other major currencies. In addition, any added volatility in the markets will be dollar positive as well. In tandem with increased US dollar exposure, and as a natural hedge, an increased allocation to European equities based on valuation is also warranted at these levels.

Bernanke’s Legacy

Bernanke’s legacy will be that he not only was the Fed Chairman who restored investor’s 401Ks – or 201Ks as they were referred to in 2009 – back to their original 401K values in only 4 years – quite a feat after arguably the worst financial crisis since the great depression – but he left his position while leaving the same effective tools he utilized to be used just as effectively by his successor.

The next Blackberry (NASDAQ:BBRY) breakthrough may not be hardware but software. A prescient question was recently posted on a popular Blackberry fan website: If you can get a BlackBerry that can run Android apps just as smoothly why get an Android phone? This renewed speculation about what Blackberry has up its sleeve came about after its shares surged by more than 7% on Monday after speculation that Blackberry is about to release a new handset dubbed the Z30 that supposedly has a 5 inch screen, a faster chip, and an improved battery life. This may or may not be the reason for the stock surge. After dropping nearly 40% since reporting earnings on June 27 any jump in the shares may be attributed to short covering as more than 160 million shares, representing 1/3 of the float, are sold short.

Back in November of 2012, I wrote here about the optionality inherent in Blackberry’s shares which were, incidentally, trading at current levels – around $10. This was before the release of the company’s much anticipated Blackberry 10 operating system devices. The thesis was that the potential success of the new phones warrants more upside in the stock given the company’s solid balance sheet which should limit downside risk. The stock went on to reach a high of $18.32 in late January just before the official BB10 release date on January 30. Following my own advice I had sold my position and moved on to other stocks.

I think the shares are worth another look after having seen them drop significantly after the last quarterly earnings report. There are 3 main reasons that give the shares renewed optionality at these price levels.

1) We are yet to see full quarter unit sales figures for the company’s flagship device, the Q10, which has the standard Blackberry keyboard. The Q10 was released internationally in late April and in the US in June. Because the company reports on a fiscal quarter and not a calendar one, its last quarter included results from March , April and May which means that US Q10 sales were not included in its disappointing fiscal Q1 earnings report. Because of its limited product portfolio, Blackberry’s results can be volatile and a single product can materially change results. This volatility is one key to optionality embedded in the shares. BB10 device roll out is still in its early stages and it is too early to call it a failure.

2) The company’s CEO Thorsten Heins hinted at the company’s annual meeting that he is open to all strategic alternatives. More importantly, one notable action that the company took making its popular Blackberry messenger BBM App available on other platforms such as Android and Apple’s iOS making way for BBM to be a standalone mobile social network. Samsung is the first hardware maker to incorporate BBM on its devices. I believe this is an important step and a marked change in strategic thinking at the company. What I think we are seeing is a step in formalizing and highlighting the 3 key divisions that the company operates in: Hardware, enterprise software & network services, and mobile social networking. Those three divisions are certainly very intertwined right now but I am speculating that the company is taking tangible steps to delineate them putting it in a better position to divest one or more at some point. With more than $5 in cash per share as of the last quarter,  and with shares trading between $9 and $10 currently you are basically paying less than $5 for all of those divisions – IP included.

3) Just as I started this article, software is probably a major key factor in the company’s turnaround. Given the company’s recent subscriber trends – company lost 4 million subscribers last quarter – a major imperative is to stop the decline in subscriber growth and hold on to its more than 70 million subs as of last quarter. Software in my opinion will be a key factor in this. BB10 and its enterprise counterpart BES 10 are made to be adaptable to Android and iOS. Since Android is open source it is more likely that you will start seeing more and more Android applications running on your Blackberry. This has not happened yet but all indications point in this direction. One of the main knocks on Blackberry was the lack of availability of the quantity and quality of Apps available on Android and Apple’s iOS. If you have a device that can run most Android apps, at least, then that is one reason for current subscribers to stick with their current Blackberry device – it will certainly reduce churn.

For all of the above reason I am comfortable with the risks and rewards and willing to invest in Blackberry shares at current levels. I am fairly confident that as the fiscal second quarter earnings date approaches, currently scheduled for release on September 27, many short sellers and many investors will pile into the shares ahead of what will likely be another market moving earnings report.

Chart Courtesy Sameer Singh / CC BY 3.0

Yahoo’s shareholders and many pundits were happy with Yahoo until Monday when the company announced that it is buying back 40 million of its shares from one of its largest shareholders and current board member, Dan Loeb of hedge fund Third Point LLC at last Friday’s closing price of $29.11. In addition, Loeb announced that he and two of his associates will step down from the company’s board. Since then Henry Blodget of Business Insider absurdly suggested insider trading, while Steven Davidoff of DealBook questioned the timing of the deal and its impact on other shareholders.

I will not address the insider trading charge since it was brilliantly refuted in this Bloomberg piece by Jonathan Weil. However, I will address the other charges, mainly that the timing is suspect given that Loeb got a sweetheart deal by selling at Friday’s closing price and not paying a discount as is ‘supposedly’ customary in all large share sale transactions. The main gripe here is borne out of the fact that the stock dropped by 4% on Monday when the transaction was announced. I do not know Dan Loeb nor do I have any position in Yahoo right now.

What most investors fail to realize is that the stock dropped not because Yahoo was the buyer but because Loeb announced the sale of two thirds of his stake irrespective of who the buyer was. Loeb, as the main catalyst for change at Yahoo, and later as board member and an insider, was followed into the stock by many investors and other hedge funds after he first purchased his stake claiming that the shares were deeply undervalued at the time. So when he announces an exit by dumping a majority of his holdings, rest assured that all the other investors who followed him will take notice and many will do the same as this will be taken as a signal that Yahoo’s shares are at, or near, fair value. Moreover, there is a precedent of this. Earlier this year, on Friday February 1 after the markets closed, Loeb announced that he has sold 11million of his roughly 74 million shares at the time or 15% in the open market. Not surprisingly, Yahoo’s stock dropped by 2% in heavy volume on Monday. So a 4% drop when that same big, and well informed, investor announces that he sold 65% of his shares is not surprising and has nothing to do with who the buyer is. This is what can be called a “signaling discount”. Arguing that Yahoo should have negotiated a discount to the Friday closing price would have only made the drop on Monday even worse as it would signal to the market that the company believed its shares were overvalued at Friday’s close. A 4% drop because of Loeb’s signaling that shares are nearing fair value would have been exacerbated by an acknowledgement from the company that this was not only true but that Friday’s close actually exceeds fair value. A large share sale between two private parties is a lot different than a buyback by the issuer.

Another criticism is that Yahoo’s buyback program was used to buy Dan Loeb’s shares while other shareholders “went to the back of the line”as Robert Cyran from Breakingviews put it. The problem with this reasoning is that it fails to acknowledge that when a company buys back its shares, all shareholders benefit irrespective of whom those shares were bought from since it decreases the supply of shares, or float, and boosts earnings per share. In hindsight and as of now, it looks like Loeb may have indeed made a good trade but that does not mean that other shareholders lost because Yahoo bought his shares. Had he not sold his shares to Yahoo he would have been selling them on the open market at a slower pace and putting downward pressure on the shares (let’s call that a liquidity discount) in the process to the detriment of all other shareholders. Furthermore, as I explained above, this liquidity discount is in addition to the signaling discount that will occur when Loeb publicly announces that he sold his shares. What Yahoo did is remove this liquidity discount from its shares to the benefit of all shareholders including Loeb.

The third most frequent condemnation of Loeb is that there was some dereliction of duty when he announced that he will be stepping down from Yahoo’s board before the company’s turnaround was complete and that he has “issued an enormously damaging vote of no confidence in the company”. This view is utopian to say the least and fails to take into consideration the initial motive for Loeb’s involvement with Yahoo in the first place. Loeb, just like any other hedge fund manager, got involved with Yahoo to realize value for his fund investors first and foremost. When he was elected to Yahoo’s board he had a fiduciary duty towards all Yahoo shareholders. When his respective fiduciary duties to his fund investors and Yahoo shareholders conflict, make no mistake about it, Loeb’s allegiance and commitment is to his fund investors first and foremost. It is only natural that he steps down if he sees that his fund investors are better served if his time and energy are invested elsewhere.

If you tuned in, even sparingly, to any financial news outlet lately you would have probably heard a talking head or two attribute the recent rise in stocks to improving earnings. While it is true that 2012 fourth quarter earnings for the S&P 500 came in better than 2011 fourth quarter earnings on a GAAP basis, the reality is if you strip out the allowed accounting shenanigans and other onetime items and compare Operating Earnings (Income from goods or services and excludes interest, taxes and one time and unusual items) you get a picture that is less rosy to say the least. The more troubling aspect is that Q4 is not the first quarter to experience a year over year decline in quarterly operating earnings growth. As we noted before, Q3 2012 was the first quarter since Q1 2010 to experience such a decline. Once you realize that these are EPS (earnings per share) growth estimates and that S&P 500 companies have actually been buying back their shares then the absolute level of operating earnings looks even worse.

 Source: Standard & Poors

While GAAP earnings were up 7 percent in Q4 2012 compared to Q4 2011, operating earnings actually declined 2.5% on top of a 5% decline in Q3 2012 versus Q3 2011. One can argue that Q1 2013 operating earnings are expected to grow by 5.4% according to S&P but if you realize that this was the case for expectations for Q4 estimates at the beginning of earnings season (estimates were for 6.5% growth versus 2.5% actual decline) and if you look at the trend for estimates (below) for Q1 2013 operating earnings then you realize that you should not put a lot of faith in estimates and wait for actual results.

Source: Standard & Poors as of 3/7/2013

Stocks have been off to a great start in 2013 with the Dow Jones Industrial average reaching new highs earlier in March and the S&P 500 advancing more than 9% for the year as of March 8. With (Q4) earnings season behind us, it may be safe for a casual observer to assume that these gains in stocks have been fueled by decent corporate earnings. We believe Q4 earnings were terrible but that will be the subject of another article.

As I mentioned in my 2013 outlook piece, stocks have been and will likely continue to be influenced by the actions of the Federal Reserve and its open-ended quantitative easing program. The Fed’s easing program is in turn influenced by the improvement, or lack thereof, in the economy and specifically with the unemployment rate. The monthly unemployment report for February was released last week showing an unemployment rate of 7.7% and an increase of 236,000 jobs in the economy while January’s report was revised lower to show an increase of 119,000 jobs. While February’s report came in better than expected, the economy will need many more strong jobs reports for the unemployment rate to come near the 6.5% threshold that the Fed has set for itself as the point at which to change its interest rate policy.

The Fourth quarter GDP report that was released on February 28 showed rather lackluster growth in the economy at 0.1% after being revised up from a -0.1% rate initially. While this lackluster growth should give further ammunition to dovish Federal Reserve governors who argue for continued quantitative easing, it is also a sign that the efficacy of QE is eroding (at least in the eyes of more pessimistic, glass half-empty type of economists).

So given the above, where are stocks going in the near term?

The reason for the lengthy introduction above is to illustrate that stocks have been going up in the face of mixed results for the economy. We should assume that the Fed will continue with its open ended QE regardless of the next unemployment report or two. Nonetheless, stocks can’t continue to go up, even with QE, if the economy and earnings start to dramatically deteriorate. But with earnings season behind us, we will not get another glimpse into earnings until Q1 earnings season kicks off in mid April and which is expected to go on through the end of May. Similarly, the initial reading on Q1 GDP won’t come in before April 26. Until then, and absent any exogenous event, we are likely to see stocks continue their upward advance over the next 4 to 6 weeks fueled by (likely misplaced) optimism and performance chasing.

Stocks ended 2012 with the best annual performance since 2009 with the S&P 500 index finishing up 16% on a total return basis. The financial and consumer discretionary components of the S& 500 were the best performers advancing 26% and 22% respectively. Utilities were the worst performers declining nearly 3% while energy producers were the second worst advancing only 2.3%. Equity investors clearly embraced risk in 2012 pushing up economic sensitive stocks while shunning more defensive ones. It is noteworthy that last year’s gains were mostly front-loaded with the first half of 2012 containing the bulk of the advance while the 4th quarter experienced a small decline.

Back in 2012 we predicted an S&P 500 advance of 20% by midyear. We came close as the S&P 500 peaked around an 18.5% (total) return in September. Looking further out into 2013 we think the stock market has to deal with 3 main uncertainties that will likely hold back the S&P 500 to no more than a high single digit return. Political and policy uncertainty, fears about corporate earnings growth, and increased ambiguity about the longevity of the Fed’s quantitative easing program and its eventual exit policy will be high on investors’ agenda in 2013.

Political & Policy Uncertainty:

It is no coincidence that stocks were flat to negative during the fourth quarter of 2012. Be it the ramp into Election Day or the lingering and excruciating fiscal cliff negotiations, the reality is that political uncertainty is not cost free when it comes to stocks. Investors typically lose their appetite for risky assets during these periods and head to the exits. The fact that the fiscal cliff deal reached by Congress only addressed the revenue side of the equation and delayed the spending part to later in the first quarter only heightens policy uncertainty. Even worse, this will coincide with the debt ceiling debate which will also fall during the first quarter. While we think that part 2 of fiscal cliff negotiations will be resolved in a less dramatic manner than part 1, the truth is that a varying severity of spending cuts is coming our way whose impact will be felt beyond the first quarter and that is really what will be the most important outcome of the upcoming policy debate. Based on the first few days of trading in 2013, we do not think that stocks have priced in any of this upcoming reality.

Earnings Growth Uncertainty:

In theory, corporate earnings and the trajectory of earnings growth are two main drivers of stock prices. However, in an era of quantitative easing it is expected that asset prices will deviate from that fundamental theory. When quantitative easing becomes endless in nature and seems to be the norm then it is expected that its effectiveness will wither away with time and exhibit negative returns to scale making earnings growth more relevant again. Looking at the diagram below one can’t miss the steady downward trajectory of operating earnings growth form early on in the economic recovery in 2010 till now. The first quarter in 2010 exhibited the first, and best, post-recession quarterly earnings growth with subsequent quarters exhibiting mostly lower and lower quarterly growth with minor exceptions.

Source: Standard & Poors

This does not mean that slow single digit or negative earnings growth will persist in 2013 or beyond. Standard & Poors expects S&P 500 earnings to grow in 2013 by 13.3%, however, we think this is a bit ambitious and more difficult to achieve in the absence of clear catalysts. So far the main catalyst is a bet that the economy will continue to improve with a steady decrease in the unemployment rate. While likely, we expect this outlook to be fraught with risks and very uncertain as we start 2013.

Fed’s Policy Uncertainty

On January 3rd, the FED released the minutes of its December 2012 FOMC meeting that showed some members divided over when to stop its bond purchases. While it is no surprise that the Fed will eventually stop its purchases at some point, this was a reminder that this end-point is coming up soon – but not clear how soon. Regardless when this end-point comes, it is logical to believe, as stated above, that the Fed’s bond purchases will slowly become less effective, everything else being equal, as time goes by. If you subscribe to this logic then assets that benefited from QE will benefit less so going forward and vice versa – everything else being equal being the main caveat here. If the QE trade was to inflate commodities then the 2013 move is to step away form those commodities. If it was to push investors towards riskier assets then scaling back on risk is the move in 2013. I am not advocating to “fight the Fed” but rather to realize that you should at least temper your expectations for the traditional QE-related trades and look elsewhere. Betting with Central banks is a profitable endeavor but that trade in the US is almost exhausted and is closer now to its culmination rather than its inauguration. You should look elsewhere around the globe, particularly in Japan where the Bank of Japan is likely to embark on a more serious version of its own quantitative easing program that is already in place.

Where to put money in 2013

While we expect a high single digit return in the S&P 500 in 2013, it is important to note that the range of returns for the 10 S&P 500 sectors in 2012 was 29%: a low of -3% (Utilities) and a high of 26% (Financials). We do expect less dispersion in the range of performances for the 10 S&P sectors in 2013 but we nevertheless expect that range to be in the high teens. We plan to scale back risk by overweighting defensive sectors such as Utilities, Consumer Staples, and Healthcare while taking a neutral to negative approach to more economically sensitive sectors. We do not anticipate the mass exodus from Treasury bonds to happen in 2013 and think that the status quo in fixed income of 10-year treasury yields of less than 2% to persist for most of 2013. The best trade in fixed income land is NOT to short bonds but rather to bet on an increase in spreads between High Yield and Treasury bonds in the latter half of 2013 – particularly if corporate earnings growth stagnates or disappoints. We are avoiding the QE reflationary trade by staying away from gold but keeping an eye on oil as we see increased likelihood of geopolitical risks impacting oil in 2013.

When it comes to politics, it is fair game to assume that whoever is in the White House gets the credit, or the blame, for the performance of the economy regardless of whether this performance was a result of their policies or the normal cyclical nature of the economy. So it is fair to assume that if the economy goes into recession in 2013, or beyond, the White House and President Obama will be blamed for it no matter how “obstructionist” the Republicans are deemed in Congress. It will further cement the label given to President Obama (rightly or wrongly) that he is highly partisan and unable to work with others across the aisle.

It is said that in any negotiation whoever has the power to say “No” has the upper hand. Given that Democrats control the White House and the Senate and need the Republicans in the House to agree to any deal, the Republicans in this dynamic have the power to say no. Making your best offer, not budging, and having the other party walk away is the ultimate bargaining position if you have the luxury to be in this position. Right now, the GOP is in that position and, as I explained above, it is the White House and the Democrats who will get the blame in case of any recession in 2013. Any recession between now and the next mid-term elections in 2014 will likely cause Democrats to lose seats in Congress and not the other way around.

Because of this, I expect the Democrats to give more concessions and eventually reach a compromise deal that is satisfactory to Republicans. Until then, the market will be choppy and likely to remain under pressure until a deal is reached. Once a deal is reached, probably at the last minute but can be well into 2013, I expect a relief rally particularly if we had a decline in stocks in December and/or January.

See my other article on Fiscal Cliff impact on Stocks and Bonds

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