Investment Strategies for a Dysfunctional Government

There is an old saw on Wall Street known as the January barometer. The theory being that a strong stock market in January portends a rising market for the year. But like most theories actual results are hardly definitive!

What we do know is that equity markets throughout 2013 will be influenced by government actions or lack thereof. Witness the opening two day rally on the back of the fiscal cliff deal as a case in point. And that occurred despite the fact that the deal was a shell of the grand bargain President Obama envisioned.

Expect more of the same throughout the remainder of 2013. Not only will political grandstanding manipulate investor sentiment, but increased government spending or as Mr. Obama likes to say; “investment” will be a significant driver of growth.

Already spending at the State, Local and Federal levels account for 40% of US GDP and unless US consumers get religion and start spending, growth in government expenditures backstopped by the largesse of the US Federal Reserve will be the most influential contributor to GDP in 2013.

This is a marked shift from the way investors typically calibrate economic prospects. For the past six decades investors could focus on consumer spending as the main driver of GDP (as much as 70% of GDP in the 1990s). Since the great recession of 2007 consumption has been slowing and any pickup in that slack is not likely in 2013!

US consumers are simply facing too many headwinds including deterioration of the wealth effect, stagnant incomes, high unemployment or more importantly under-employment, tight credit and fragile confidence. Not to mention a real estate market that despite signs that it may be stabilizing is still well below 2007 levels.

Unfortunately offsetting the slowdown in consumer spending will not be easy because even at these contracted levels it constitutes the largest component of the US economy. Potential replacements such as business investment, government spending or a ramp up in exports takes time and can lead to unintended consequences most notably inflation and trade wars.

There is also the argument that government spending in not particularly efficient and can be counter-productive. Take “Obama Care” as a case in point. To fund that program government must assess new taxes on business which will have a dampening effect on business investment.

That said, there are some who believe that rampant spending by consumers is not necessarily good for the economy over the longer term. It is certainly the most volatile component of GDP and according to William R. Emmons writing in the Regional Economist a publication of the Federal Reserve Bank of St. Louis “the relationship between the share of US GDP accounted for by consumer spending and the rate of economic growth generally has been inverse – that is, they are negatively correlated.”

According to Emmons, over ten year intervals between 1951 and 2012 the correlation between the variables was -0.31. Taking the numbers to another level he compared decades using the two variables 1) average share of consumer spending in GDP correlated against 2) the average annual rate of GDP growth. The negative correlation between 1951 and 2012 is a monumental
-0.82 (correlations run from -1.00 perfect negative correlation to +1.00 perfect positive correlation) indicating that “decades of relatively high consumer spending in GDP, such as 2001 through 2010, to be ones in which economic growth was weak.”

In Canada with its abundance of social programs consumer spending has been more static and support Mr. Emmons’ thesis. In fact one might argue that this is the rationale behind President Obama’s hard line against spending cuts and if you believe the Republican mantra, his socialist leaning.

What does this all mean for the financial markets in 2013? If the US consumer is less influential that may have a longer term impact on market volatility and could be one explanation as to why the CBOE Volatility Index (symbol: VIX) is at historic lows.

It also implies that short term moves in the market will be amplified brought on by sentiment shifts in reaction to the dysfunction that permeates Washington. Witness the short term volatility resulting from the on again off again fiscal cliff negotiations. Look for more of the same in mid-February when the debt ceiling debate gets into high gear.

Like the fiscal cliff, the debt ceiling will ultimately be resolved. But along the way investors will be inundated with politicians playing to the gallery which will lead to sentiment driven rallies and sell-offs. Ultimately, mean reversion will act as a stabilizer when cooler heads recognize that while political points of view may impact sentiment only government action or lack thereof impacts GDP.

From a strategy perspective short term shifts in sentiment can stifle buy and hold growth mandates. But it also provides fertile ground for hedge fund managers who focus on short term trading strategies. That probably explains the resurgence in the hedge fund industry and lack of retail participation in the financial markets.

From a strategy perspective investors need to be in the game. As Cramer would say; “there is always a bull market somewhere!” The problem with the “bull market somewhere” approach is that it requires investors to consistently time entry and exit points. Historically that has proven to be a fatally flawed strategy for emotionally wrought retail investors.

A better approach I think is to focus on strategies that follow the hedge fund model but without the costs and the inherent leverage. Strategies that play on market volatility reduce downside risk and generate income.

To that end look at covered call writing strategies against blue chip high dividend paying stocks. Bonds may offer some defensive positioning within a portfolio but you will want to encourage short term maturities and / or real return bonds with an inflation hedge.

As for sectors, I would overweight banks and utilities given their stable and above average dividends. Look for blue chip stocks in those sectors that have a liquid option market for the covered call writing overlay.