Soon investors will close the books on 2012. The focus will be squarely on the New Year and what the economy and financial markets may have in store for 2013.
Considering the market turbulence experienced at times during 2012, some are surprised at how well stocks performed. At the end of last week, U.S. stocks had gained 12.5 percent year-to-date, even though Europe was a source of high anxiety for investors earlier this year.
But many markets on the other side of the Atlantic performed even better …
For example, stocks in Germany gained 24.3 percent. And France is up 15.4 percent so far this year. Asia too was a great place for equity investors in 2012 with India up 26.7 percent, Hong Kong gaining 24.3 percent, and Thailand up 25 percent — among other leading markets in the region. I have high hopes for emerging markets in the New Year too.
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If we somehow manage to avoid plunging over the fiscal cliff, investors will be making their allocation decisions for 2013 with an eye toward the asset classes with the best potential over the next 12 months. But in spite of the good performance this year, there are several reasons to be cautious about stocks as we enter 2013 — let's take a look at the evidence …
Slow Growth Economy
First, our economy continues to sputter along at stall-speed.
Whether or not we actually go over the fiscal cliff on January 1st doesn't really matter at this point, because anxiety about the cliff has already taken its toll on business and consumer sentiment in advance …
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* Sentiment among small business owners has rarely been lower than it is today. The National Federation of Independent Business optimism index plunged to 87.5 last month, down from 93.1 in the prior report. That's one of the lowest levels ever recorded as many businesses put hiring and investment decisions on hold due to uncertainty.
* Real gross domestic product (GDP) growth in the U.S. expanded a weak 2.4 percent in 2010, the first year after the Great Recession. But real GDP fell to just 2 percent in 2011 and slowed even more to only 1.75 percent this year.
* Consumers have been one of the few bright spots in an otherwise anemic economy. But as you can see in the graph below, disposable income growth has been weak during this recovery and is getting weaker.
Click the chart for a larger view.
Consumers have been a key pillar supporting the U.S. economy because they've continued to spend in spite of the uncertainty causing businesses to pull back. That's why consumer discretionary stocks, particularly retailers, have been some of the best performers in 2012.
Hopes are high for the all important holiday shopping season. But persistently weak income growth could undercut consumer spending. So keep a sharp eye on tomorrow's personal income and spending report.
Bull Market Turns 4 Years Old in March, 2013
Turning to stocks, 2013 could be a difficult year with more volatility ahead. That's why it will be more important than ever to be selective with your stock-picking in 2013.
Assuming there's no last-minute plunge over the fiscal cliff, stocks should wind up with decent gains in 2012, as mentioned earlier.
If a deal gets done to avoid the worst of the cliff, a year-end relief rally should carry over into January. In this scenario, stocks could easily retest the highs near 1,475; or even 1,500-plus on the S&P 500. But after that risks could rise.
After all, 2013 marks the fourth birthday for the bull market that began at the S&P 500 low of 666 in March 2009. So the current bull-run is getting old.
Since 1929 there have been 25 bull market cycles when stocks gained 20 percent or more. These upswings lasted only about 2.5 years on average.
The current rally is also better than most in terms of magnitude. With the S&P 500 up 166.7 percent so far since the 2009 low, this is the eighth largest bull market rally over the past 80-plus years.
Here's one key indicator to keep an eye on in the year ahead …
Bad Breadth and Earnings Uncertainty
It's always important to monitor the internal strength or "breadth" in markets. But it's especially critical when a rally gets long in the tooth. That's why a glance at the graph below showing the cumulative number of advancing vs. declining stocks on the New York Stock Exchange (NYSE) gives me pause.
Click the chart for a larger view.
In a healthy bull market run, especially during the early phase, you would expect to see a gradual but persistent rise in the slope of the advance-decline line along with the rising trend in the major stock market indices. But here you can see that although the S&P 500 Index moved to new highs in 2012, above the mid-2011 level, the number of advancing stocks hasn't exactly kept pace on the upside.
In other words, the recent rally has been accompanied by fewer and fewer individual stocks advancing along with the index — a potential warning flag for the overall market. Likewise, measures that track the number of 52-week new highs vs. new lows among individual stocks on the NYSE have also not confirmed recent market strength.
I suggest you keep a watchful eye on these market breadth indicators along with key technical levels for the markets, such as 200-day moving averages, as we enter the New Year.
Finally, earnings estimates for corporate profits in the fourth quarter of 2012 and into 2013 have been falling fast. In fact, analysts have slashed their estimates for S&P 500 fourth quarter earnings by two-thirds in just the past two months! On September 30, the consensus forecast called for S&P 500 profit growth of 9.3 percent during the final quarter of the year. Now, the number has dropped to just 3 percent.
So pay close attention to sales and profit warnings heading into reporting season, which kicks off in January.
Bottom line: Stocks should have room to run higher near-term, especially on any deal to avoid the worst of the fiscal cliff. The upside should easily carry into 2013. But whether share prices can continue to move higher deep into the New Year, and if so how long, is the real question. Closely following the indicators mentioned above can help provide the answer.
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