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Stock Market Lingers At A Precarious Place

February 20th, 2013

by Gary Halbert

of Halbert Wealth Management

IN THIS ISSUE:

1.Good News & Bad News on the Economy

2.Record High Gas Prices Could Go Even Higher

3. CBO Issues Latest Long-Term Forecasts

4. Stocks Pause Near All-Time Highs – What Next?

5. The Debate Over Increasing the Minimum Wage

Overview

The Dow Jones Industrial Average has flirted with its all-time high of 14,198 twice in February as the Dow managed to rise above the 14,000 mark but then fell back. The S&P 500 Index is not quite as close to its all-time high, but it is within striking distance. There is widespread optimism that both indexes can break-out to new record highs, which would likely spark a new buying surge.

On the other hand, if the Dow and S&P fail to break out, the result could be a nasty selloff to follow. The stock markets shrugged off the fiscal cliff melodrama at the end of last year and then rallied strongly. But there are reasons to believe that the upcoming “sequester” fight could unsettle the markets and derail the attempt to make new highs. We’ll talk about that possibility today.

Before we go there, we take a look at the latest economic reports. There’s good news and bad news – no surprise there. We’ll also look at the latest surge in gasoline prices and why that is more bad news for consumers and the economy. And I will summarize the latest economic forecasts from the Congressional Budget Office. Finally, I will give you my thoughts on the issue of raising the minimum wage.

Good News & Bad News on the Economy

Obviously, the most significant economic news in recent weeks was the surprising January 30 report showing that 4Q GDP declined by 0.1% (annual rate). While that report may be revised slightly upward later this month, it was still a big surprise. As a result of that unexpected report, most economists have been revising their 2013 growth forecasts down.

The bad GDP report came just one day after the Conference Board reported that the Consumer Confidence Index plunged far more than expected in January. But at least there is some good news on this front. On Friday, the University of Michigan’s preliminary Consumer Sentiment Index climbed to 76.3 this month from 73.8 in January, the best reading in three months and well above the pre-report consensus.

The University of Michigan cited increased property values, a strengthening job market(?) and stocks at five-year highs as reasons for the boost in consumer sentiment this month. They suggested that the increase in personal wealth from the stock market advance is helping to make up for the recent sharp increases in gasoline prices and the hit to take-home pay from the resumption of the full payroll tax.

Retail sales rose a modest 0.1% in January. On the manufacturing front, the ISM Index improved from 50.1 in December to 53.1 in January (latest data available). On the housing front, data overall continues to improve modestly, especially compared to year-ago readings. Tomorrow we get the housing starts report for January, followed by existing homes sales for January on Thursday.

The next really big report this month will likely be the second estimate of 4Q GDP which will be released on February 28. While there is a general feeling that this report will be revised slightly higher, it is too early to know what the pre-report consensus will be. I’ll know by next Tuesday and will pass it along.

Record High Gas Prices Could Get Even Higher

If the economy weren’t sluggish enough already, there is yet another significant drag on growth. Gasoline prices have spiked so far this year. The national average price for a gallon of gas was $3.73 as of the end of last week. That’s a jump of40 cents, or more than 13% in the last month alone. In California and New York, the average gas price is $4.16 per gallon.

Gas prices are the highest they’ve ever been in the month of February. So what’s driving this? It’s a confluence of factors, from rising crude oil prices, to production cuts and refinery closings. The price of crude oil – which is two-thirds of the price of a gallon of gas – has jumped over 10% in the last two months. OPEC is believed to have cut oil production by one million barrels per day in the last 2-3 months.

Adding to that, several refineries are either preparing to, or have already, shut down for maintenance before their annual switch to summer gasoline, which is formulated differently. As more refineries close temporarily just ahead, this could put more upward pressure on gas prices, which increases the drag on consumer spending and the economy.

CBO Issues Latest Long-Term Forecasts

Earlier this month the non-partisan Congressional Budget Office released its latest Budget and Economic Report for years 2013 to 2023. I won’t bore you with all the details, but here are a few highlights.

The CBO lowered its economic forecast for 2013 to only 1.4% GDP growth. It forecast unemployment to remain above 7.5% through 2014, which would mark the sixth straight year with a jobless rate above that mark, the longest stretch in 70 years.

The good news in the latest CBO forecasts (if you can call it that): The federal budget deficit is projected to fall to $845 billion in 2013 and to $430 billion by 2015. The CBO forecasts only consider current laws on the books. They do not address the myriad of new federal spending programs outlined by President Obama in his inaugural address and his State of the Union speech.

Even without those new spending programs, the CBO’s long-term forecast projects that budget deficits will near the $1 trillion mark again by 2023, when it forecasts a $978 billion budget deficit. But it could happen as soon as next year or the year after, especially if the Democrats retake the House of Representatives in 2014. Fortunately, that doesn’t look likely – for now.

The CBO forecasts are always helpful, but they are limited in scope in that they do not take into account potential new federal spending programs. Nevertheless, one of the CBO’s charts is especially insightful. Take a look:

Percentage of GDP

This chart shows the federal “debt held by the public ” at apprx. 80% of GDP. The chart shows that this debt held by the public will remain at 80% of GDP until at least 2020. It never goes down materially over the next eight years, and goes up significantly beyond 2020 (not shown).

But as is consistently the problem with almost all federal reports on the national debt, they only show the debt held by the public. Currently that debt is apprx. $10 trillion. What these graphs fail to include is the apprx. $6 trillion in additional debt held by various government agencies. Add this in and the national debt is now apprx. $16.4 trillion.

Plug that into the chart above, and the national debt is now over 100% of GDP and rising. Without meaningful federal spending reduction, this number is headed for 150% of GDP and even higher longer-term. Think Japan.

Stocks Pause Near All-Time Highs – What Next?

The Dow Jones Industrial Average climbed above the magical 14,000 mark ever so briefly in the first week of February and then sold off over 100 points. It crept above 14,000 again last week, but dropped below it again. Then today, it is back above 14,000 as this is written.

The 14,000 number is very significant because 14,198 was the all-time intra-day high reached in late 2007 before the Dow began its jaw-dropping 50% plunge to the low of 7,000 in January 2009. Most any technician would agree that the Dow has heavy overhead resistance at the 14,000 level.

What happens next is critically important. If the Dow closes decisively above 14,000 this could spark another buying rush, and a significant run-up could follow, especially if the S&P 500 Index hits new highs as well. On the other hand, if the Dow fails to get above 14,000 just ahead, a nasty sell-off could follow. Not exactly rocket science.

Dow Jones Industrial Average

In addition to the technical significance of what happens next, there is also another big unknown coming on March 1 when the sequester may kick in. Obviously the equity markets weathered the fiscal cliff better than just about anyone expected, in large part because most investors and traders were confident that lawmakers would reach a deal at the last minute.

The sequester, on the other hand, has the potential to play out differently and could well be a much bigger threat to the markets than was the fiscal cliff. The sequester is the set of automatic spending cuts originally stipulated as part of a 2011 agreement to extend the federal borrowing limit. Those cuts, totaling about $110 billion per year for a decade, were supposed to kick in on January 1, but Congress delayed them for two months as part of the fiscal cliff deal. So now they’re due to go into effect March 1. That is less than two weeks away.

Most economists agree that the sequester, if it happens, will be sudden, harsh and arbitrary, as President Obama warned in his State of the Union address. That’s because it would equally cut spending by most government agencies without prioritizing what’s most important. The cuts would be split 50-50 between defense and non-defense spending.

Even if Congress comes up with a better plan, or simply does away with the sequester, it’s not likely to happen until the very last minute, in a replication of the fiscal cliff negotiations. And it may not get resolved at all this time because the Republican leadership in the House seems more than ready to let the sequester happen – if Obama does not back off on his demands for more taxes on upper income individuals and families.

If the sequester is allowed to take place, that will mean over $100 billion in automatic across-the-board federal spending cuts beginning on March 1. By some estimates, millions of federal workers will be furloughed and a bevy of programs and services across the government will be curtailed if the sequester actually happens.

The conventional wisdom is that Americans have become numb to Washington’s dithering, and learned to carry on as if everything will work out okay. Exhibit A is the stock market, which was expected to sink as the fiscal cliff deadline drew near without a deal. Instead, it remained firm, and then soared by more than 6% during the first five weeks of 2013.

It might be unwise, however, to think that’s how the sequester will go for the stock markets, before or after the March 1 deadline. The stock market has flatlined in recent days, as investors try to gauge whether a correction is coming. Positive signs include consumer spending, which has held up better than many economists expected following the payroll tax hike that hit everyone’s paycheck in January. As noted above, consumer sentiment has rebounded sharply after plunging late last year.

But stock-market analysts are starting to worry that investors are becoming too complacent. Patrick O’Hare of Briefing.com warned last week: "It is at times exactly like this when it is necessary to offer a reminder that things can turn bad in a hurry when the market ignores the potential for bad outcomes." He could be right.

If all the spending cuts kick in on March 1, it is expected to cut 2013 GDP by almost 1%. Since the economy is only expected to grow by 2% or less this year, that would be a significant impact, especially since it comes after another hit to GDP from the resumption of the full payroll tax at the start of this year.

The sequester deadline on March 1 will be followed by the expiration of the government’s funding provision – the “continuing resolution” – a few weeks later on March 27. That could trigger a federal shutdown and more damage to the economy if there’s another budget battle. Then, over the summer, Washington will hit the debt ceiling again, forcing yet another possible showdown. There could be other tense decision points if Congress delays action on any of these matters, as it often does.

The Debate Over Increasing the Minimum Wage

In his State of the Union address last Tuesday, President Obama called for raising the minimum wage from $7.25 per hour to $9. This was the one surprise in the speech that did not get leaked to the media in advance. I doubt he’ll be successful in getting it raised by that much all at once, but we will see. The debate over raising the minimum wage is always a spirited one.

Raising the minimum wage is good politics, since polls generally show solid majorities support raising it. And it is true that the minimum wage of $7.25 set in 2009 is worth less than that today since things get more expensive over time. The Labor Department’s inflation calculator tells us that $7.25 in 2009 is worth only $6.77 in today’s dollars.

But there are pros and cons to raising the minimum wage, of course, and I will touch on a few of them below.

Liberals argue that raising the minimum wage is good economics, and that it does not hurt job creation (questionable). Further they argue that lots of low-paying American companies, including some extremely large ones (e.g. - Walmart and McDonald’s), make a good chunk of their money peddling goods and services to those on the lower rungs of the income ladder.

Lower-income workers tend to spend almost everything they make, so more wages would very quickly translate into higher spending at a lot of businesses. That assumes, of course, that few or none of minimum wage workers get laid off as a result of the increase.

In addition, the libs point to the fact that CEO pay in the US has never been higher, while average family incomes have languished for years. Thus, it’s time for the government to ensure that ordinary workers get a larger share of the fruits of whatever prosperity is being created.

Conservatives, on the other hand, cite figures which show that raising the minimum wage actually destroys jobs. In addition to job losses, the increase to $9 represents a 24% wage increase for businesses that employ minimum wage workers.

Likewise, they argue that raising the minimum wage means increasing their product prices to consumers. This is inflationary. If they don’t raise prices, then they will have to cut staff to pay for it in many cases.

And conservatives argue that if employers are forced to pay higher costs for entry-level workers, they are likely to stick with experienced workers rather than younger workers entering the workforce.

Finally, conservatives argue that raising the minimum wage disproportionately hurts small businesses. With three million more people out of work today than in 2007, why would we want to make it harder for small employers to hire people, they ask.

There are more pros and cons than those noted above, but you can see why emotions tend to run high on both sides of this issue.

And my opinion: We should raise the minimum wage when the economy is strong, not when it is weak. Obviously, President Obama doesn’t agree.

Best regards,

Gary D. Halbert

© Halbert Wealth Management

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