Beyond the 'fiscal cliff,' reasons for optimism
NEW YORK (AP) — Forget about the "fiscal cliff."
That might be hard, considering the drama of last week. The stock market had its worst two-day plunge in a year after voters returned President Barack Obama, a Republican House and a Democratic Senate to power.
Investors fear the approaching cliff — tax increases and government spending cuts that begin to take effect Jan. 1 unless Obama and Congress can work out a compromise.
Economists say the hit to the economy next year could be $800 billion and be enough to push the United States back into another recession. And financial analysts are predicting more market turmoil as the deadline approaches.
But lawmakers almost certainly will work out a deal — perhaps messily, unsatisfyingly and with lots of theatrics, but a deal nonetheless. But what happens after that, and to the market in Obama's second term?
Home prices are rising again in many parts of the country. Job growth is much faster than it was last spring. Consumer confidence is up. So is retail spending. And so is the stock market, last week's jitters notwithstanding.
Even some of those who think the economy and markets will run into trouble soon see better times on the other side of the cliff.
David Kostin, Goldman Sachs's U.S. equity strategist, expects a budget battle in Washington to send the Standard & Poor's 500 index down to 1,250 by the end of the year, about 10 percent lower than where it closed Friday.
Once the fight is finished, however, things should turn around quickly, he says. By the end of next year, the S&P 500 will reach 1,575, Goldman says, clearing its previous all-time high by 10 points.
There are factors that could still hobble the economy, of course.
Median household income has dropped every year since 2007, after adjusting for inflation. The unemployment rate is still high. The Federal Reserve warned last month that job growth, like U.S. economic growth, remains slow.
Here are three things you should watch as you plot an investing strategy for the next four years.
THE BOTTOM LINE
The traditional thinking is that a Democratic president equals higher taxes for businesses. But financial analysts at UBS aren't so sure. In a report before the election, they predicted that the corporate tax rate would drop under Obama or Romney.
And anyway, says Carol Pepper, CEO of the wealth management firm Pepper International in New York, companies aren't going to stop growing just because they're faced with higher taxes.
"That," she says, "is cutting off your nose to spite your face."
Also, for more than three years, companies in the S&P 500 have improved earnings every quarter compared with the year before, according to market research company S&P Capital IQ.
Often, their growth has defied expectations. At the beginning of October, analysts were predicting that third-quarter corporate profits would fall nearly 2 percent compared with a year ago.
With about 90 percent of the companies in the S&P 500 turning in results, they're expected to be up more than 2 percent. And higher earnings generally send a company's stock higher.
That's no guarantee, of course. Revenue for the third quarter so far is up only about 0.6 percent, which means that companies' profit growth is driven not by selling more goods and services but by cutting costs, which can mean laying off workers or trimming salaries.
And compared with a year ago, the earnings and revenue growth is downright anemic. In the third quarter of 2011, earnings grew more than 17 percent over the previous year, according to S&P Capital IQ. Revenue was up more than 11 percent.
Still, if companies managed to grow profits during a slow economic recovery, they should have no trouble doing it if the economy really picks up.
THE CHINA MACHINE
You can't consider the future of the world economy, and therefore the future of the U.S. stock market, without considering China, the world's second-largest economy behind the United States.
You've probably heard that economic growth in China has slowed. But China's economy is still growing at an annual rate of 7.4 percent, more than triple the U.S. rate, and far better than the contraction in most of Europe.
China's middle class is huge and expanding. That makes it more expensive for U.S. companies to produce goods there because of higher living standards, but it also means more customers for American companies to sell things to.
Adrian Day, president of Adrian Day Asset Management in Annapolis, Md., says he's optimistic on China, though it's not without risks. Young people moving en masse from the country to the city can fuel social tensions, and the country's rules still prove baffling or impenetrable for many foreign investors.
"However pessimistic people are about China," Day says, "China's economy is still growing."
One popular theory for why the economy is set to improve: Companies hoarded money during the financial crisis and now sit on record piles of cash. The Fed says nonfinancial companies hold about $1.7 trillion in cash and other liquid assets.
Companies have cut back spending on machinery, tools, software and other so-called capital goods, resulting in the slowest growth in "capital stock" in nearly 50 years, notes Michelle Meyer, the U.S. economist at Bank of America Merrill Lynch.
"The positive story is that once the fiscal cliff is resolved, even if it's a messy process, some of the uncertainty hanging over businesses will be removed," she says.
Pent-up demand from corporations could turn into spending in the spring and pick up through next year.
Jeremy Zirin, chief equity strategist at UBS Wealth Management, says the cash heap is the "dry powder" that will fuel growth.
A major caveat: Market watchers have been talking about companies sitting on cash for a long time. The amount has been roughly the same nearly three years, and nothing so far has convinced companies to spend it liberally.