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Cliff Diving
Flexible Plan Investments
By Jerry Wagner
December 18, 2012


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My dad was a swimming pool builder so he always had a good part of the winter off. In the early 1960′s, my parents started going to Acapulco each year for first one week, then two, and finally the trips would last for about three weeks. They loved escaping the blustery Midwestern winters for days in the warm Mexican sun.
Acapulco was a hot spot then, the first of what would become many Mexican tourist destinations. It was a frequent watering hole for the Rat Pack and other celebrities of that time, and Mom and Dad would come back from their stay at the El Mirador Hotel with tales of celebrity sightings, exotic food (or so we thought in that pre-Taco Bell time), and the world famous cliff diving.

Each day, cliff diving, as Mom and Dad described it, would begin with the solitary figure of a young Mexican boy clad only in his Speedo making his way, ancient handhold to tiny, rock outcropping, up the face of the La Quebrada cliffs overhanging the blue Pacific. Once at the top, a prayer to a small shrine, then a spider-like scramble across the stone face of the towering cliffs, a quick sign of the cross, both hands thrust to the sky and then the 125-foot plunge in a perfect swan dive into the rocky gulch and foaming surf below.

The water ranged from six feet deep (and certain death) to sixteen feet, depending on the wave action. The divers not only needed the courage to take the trend, but the knowledge of when to leave their rocky perch. Like we used to say here at Flexible Plan – timing is everything.

Today we face a different kind of cliff. A “fiscal” cliff potentially to be caused not by the confluence of divers, swirling ocean and towering cliffs, but by a huge impending tax increase and self-imposed unspecified cuts that must be made automatically at year end to essential defense and social welfare programs, all to deal with a tidal wave of government spending, resulting in a nation drowning in debt.

While the second part of the “cliff” problem – government spending – would cause two-thirds of the “cliff’s” economic impact, the country’s leaders and media have chosen to focus almost exclusively on the tax side of the equation. This, despite the fact that the latest government figures for November show, as they did in October, that government revenues (tax collections) are amazingly already up 10% ($30 billion) over the same period last year.

Yet the so far unaddressed spending side of the government budget is up 16% ($87 billion) in the same report, and no meaningful cuts in spending to replace the automatic, draconian cuts have been suggested. The result is that for just the first two months of the Federal government’s new fiscal year, the deficit is $57 billion higher. That takes the two-month deficit to $292 billion, well on its way to boosting the national debt to its $17.5 trillion 2013 projection.

Why is this important beyond the obvious? Because a year and a half ago we were facing a crisis. Bond ratings for US government debt were being lowered. This was being done because responsible people charged with the duty to gauge investment risk were appalled by the size of the US government debt and were becoming concerned with our ability to ultimately repay it with dollars that were actually worth something.

To deal with this, we imposed a deadline when a responsible budget cutting spending and reducing the debt would be in place. If we failed to do that, unthinkable cuts in essential services would be automatically imposed. Here we are a year and a half later, the unthinkable has now become a real possibility and the only thing we are talking about is the need to have the Republicans cave and increase taxes on the top 2% of wage earners (saving eight days of government spending) while restoring tax cuts for the other 98% at an additional cost in the trillions of dollars.

And when it comes to government spending, no meaningful cuts are even being discussed – yet they are the reason why we are facing the unthinkable automatic cuts. All that has been proffered are essentially cuts that were already counted in the spending “savings” the last time we went through this, accounting gimmicks and Medicare savings that have been announced before and deferred before. As to reforming entitlements that threaten to break the bank, they are either “off the table ” or can only be dealt with in another chapter of this bad story somewhere down the road.

Others see these same worrisome signs. While the latest University of Michigan Consumer Confidence Index (released a week ago) was extremely negative in and of itself, few have noticed that the Current Conditions portion of the survey was actually just flat. Instead, as the folks at the Bespoke Investment Group point out, it was the Expectations portion of the survey that fell so heavily. In other words, it’s the future that concerns most of us, not how we are doing right now. It’s what happens after the cliff dive, not before, that bothers us.

Source: Bespoke Investment Group

As further evidence, on Tuesday the National Federation of Independent Business (NFIB) Small Business Optimism Index headline reading fell 6%. Since the NFIB began releasing the results of this survey on a monthly basis in 1986, there has never been a larger monthly drop.

Source: Bespoke Investment Group

The reasons given for the record decline were many, but 42% of the responses cited Taxes and Government Requirements and Red Tape.

That’s my opinion, so you can guess that I’m not too enthused when we have what I really do feel is a Boehner-delivered breakthrough in the budget process. I see one side moving, offering solutions, and the other side doing nothing and ignoring the problems. Until both sides truly bargain in good faith, I find it difficult to see the safe water at the cliff’s bottom and instead can only spot the jagged rocks below.

Despite my pessimistic view of the likelihood of truly avoiding a fiscal cliff, I do believe that, absent a complete breakdown in talks, the outlook in the short term (through year end) for stocks is positive. We continue to benefit from low interest rates, positive year-end seasonality, and economic reports that are more good than bad (nine were better than expected and four were worse last week).

Looking farther out into the first quarter of 2013, I’m more concerned. Investor optimism has been rising to levels where on a contrarian basis it can be worrisome, and the first year of the Presidential election cycle is notoriously weak. In addition, we will soon be in the next earnings reporting period and prospects are rapidly deteriorating on the earnings front. We have reported for quite some time that revision of individual company earnings prospects has been more negative than positive in the last six months.

Now look at the trend for overall earnings per share growth of the S&P 500 as a whole. Each week it seems to be cut lower.

Source: Bespoke Investment Group

This is not likely to be good for stocks, even though they remain at positive levels. A significant slowdown of some kind seems likely in the future.

Combine this with the costs (both anticipated and unanticipated) of complying with a new regulatory insurance scheme for one-sixth of the economy (Obamacare) and the aftermath of the fiscal cliff, whatever the result, and it’s easy to see why there might be a pause in an already slow economy.

In anticipation of this, we have introduced a number of new strategies and have quite a few in the wings awaiting an unveiling in the new year. In addition, despite generally positive 2012 performance for the FPI strategies, our research department has been engaged in its annual review and update process. As always, improvements are in store.

In any event, like the cliff divers, let’s say a little prayer before we jump into the next two weeks of fiscal cliff discussions, and add a prayer for those who have lost so much in Newtown, CT and for our nation in these often trying times.

Like the stock market that seems able to divorce itself from the usual earnings and economic reports to enjoy a Santa Claus rally each year no matter what the longer term outlook, we here at Flexible Plan wish each of you a week full of Christmas joy, Holiday good cheer, and family love in this blessed season. Enjoy!

All the best…
Jerry Wagner

PS: If you’d like to get whisked away to cliff side for a little bit of Mexican vacation – (and also to work on your Spanish) – tune in to this YouTube video of the cliff divers at the El Mirador.

cliff-diving

 

(c) Flexible Plan Investments

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