A Pullback Is Coming But Here Are 8 Reasons To Stay In The Market

This article was written with Oliver Pursche, the Co-Portfolio Manager of GMG Defense Beta Fund. It was part of a series of articles developed under an agreement with forbes.com to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site, forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

Short-term pullback is coming, but so is 1,600 for the S&P this year: Be greedy when others are fearful, and fearful when others are greedy goes the old chestnut by Warren Buffett.

The underpinnings of the market are flashing some warning signs. For instance, the number of stocks trading above their 50-day moving average has declined from above 80% to around 60% as of the end of February.

The equal weight Guggenheim S&P ETF (RSP) has begun to lag the traditional market cap weighted SPDR S&P 500 ETF (SPY), a sign that market breadth is narrowing. And, most obviously, the market has risen sharply through the first 2 months of the year.

Based on these tea-leaves and other metrics, I expect a 5% to 7% short-term pullback for major market averages. However, as I’m not particularly skilled at market timing, I prefer to focus on the reasons I believe will drive the market higher by another 5½% or so before year-end. At the time I am writing this article, the S&P sits at 1,515, an 85 point move higher represents a 5.6% gain—meaning that 1,600 isn’t as bold of a call as it may appear to be.

Here are the reasons why, though your heart may be filled with fear, you will be better off staying the course in 2013.

1. Sequestration
Obviously, the eventuality of this draconian measure is not, in and of itself, a reason to jump into the equity market. It is not, either, a reason to back down. First, sequestration is not permanent. It can— and believe me—will be repealed. I’m not happy our political parties are playing a frightening game of brinksmanship, but in the final analysis, that’s what it is. This crazy thing we call democracy does from time to time resemble a chocolate mess, but ultimately, sequestration, will pull the parties back to the bargaining table. More importantly, all of the projections I’ve seen on sequestration ignore the impact of additional spending on Sandy relief, pegged at some $60 billion.

2. Confidence will be bolstered in other ways
Fourth quarter GDP, which was initially thought to have contracted by 0.1%, has been revised upward to +0.1%—a disappointment to revised expectations, but an improvement nonetheless. Consumer spending and other measures of economic activity have also been revised upward and continue to surprise on the upside.

3. The way I see things, there is substantial pent-up demand for autos
And if I am correct, this big-ticket item will impact our GDP going into the summer months. I base this assessment on the market for used cars, which if you have not noticed, is going through the roof. Dealers are scrambling for used cars, putting up billboards, and calling on customers to make trade-ins. It’s simple supply and demand. As prices for used autos climb, the benefits of buying new become more compelling for consumers to realize.

4. Housing inventories are light
I attended the Ibbotson Morningstar Conference in Hollywood, Florida last week, and one of the pearls dropped by St. Louis Federal Reserve Bank economist Kevin Kliesen, in his presentation there, was that housing inventories (the number of homes available for purchase) are below 2001 levels. When he said that, I veritably fell out of my seat.

That’s 12 years ago, and adds more firmament to the argument that housing starts and price appreciation may be at hand. And of course, housing ripples back through every sector of the economy from construction equipment to durable goods like washers and dryers, so all in all, investors should be encouraged by these inventory levels. Keep in mind, the risk to this thesis is the “shadow inventory,” so called because it’s the homes owned by banks, and does not necessarily figure into market estimates.

5. A positive backdrop to the positive signals coming from housing inventories are interest rates that show exactly no signs of rising
And I am on record offering they will remain low throughout the balance of the decade. But to connect the dots, rising home prices and low interest rates? And like the construction of new homes, the purchase of existing homes also ripples through the economy as new owners buy carpet, paint, appliances, hardware and electronics.

6. Another positive impact of sequestration will be a reprieve in the rise of gasoline prices
I do expect prices to rise again later in the spring, but the temporary drop in gas prices will also help offset the negative impact of higher payroll taxes, which has been blamed for a raft of recent consumer woes.

7. Stability in interest rates and inflation
Yes, there’s noise coming out of the Fed that policies may shift toward higher rates sooner than promised, but I don’t believe it and neither should you. I don’t expect a change in policy in 2013 or 2014, and as this belief becomes more widespread, in combination with a rising GDP, the improved fundamentals will power U.S. equities higher.

8. “The great rotation” has begun
For years, strategists and soothsayers have been predicting that low rates on bonds, generally benchmarked by a 10-year Treasury bond rate that has largely remained under 2%, would force investors into riskier assets. Just like Vince Lombardi, who said he never lost a football game, but rather simply ran out of time, I think the strategists and soothsayers are finally right. The great migration has begun. Fund flows from money markets in December and January (and most likely in February as well) into equities that have steadily gained steam.

Of course there are risks to this outlook, but investors who have been bearish have lost out on significant gains so far. I’ll stick to my optimism all the while remaining somewhat defensive in my investment strategy.

P.S.: As we move into tax time, God Bless if you have gains from your investments. My father told me never to be unhappy with a profit. And in fat years, my accountant tries to make me feel better by saying that all the taxes I’m paying are because of my success. I use these two precepts as my guiding light during tax time.

In a more technical vein, I came across this summary of tax law wrinkles for business owners from Carolyn Linkov, a principal in the New York City tax office of ParenteBeard. Some of these, such as changes to depreciation will save you money, while other suggestions, such as the extension of the Voluntary Classification Settlement Program—which will allow you to reclassify personnel that were ‘erroneously’ tagged as independent contractors—could save your . . . you get the picture. See below for further details.

Extended Deduction and Spending Increases
IRC Section 179 has offered businesses the ability to immediately recover, through current expensing, the cost of qualified purchases. The maximum deduction for capital purchases grew to $500,000 during 2010 and 2011 in an attempt by Congress to help businesses during the recession. The “American Taxpayer Relief Act of 2012” (the Act), passed on January 1, 2013, extended the $500,000 expensing maximum through 2012 and 2013. And the phase-out of the deduction does not begin until the total purchases for the year exceed $2,000,000 (note that the Section 179 deduction cannot exceed the taxable income for the year in which it is taken).

Extended Bonus Depreciation
In addition to IRC Section 179, a bonus first year depreciation is also available for certain new fixed asset purchases. The Act extended the 50 percent bonus deduction for businesses through 2013.

One Hundred Percent Gain Exclusion from Sale of Small Business Stock
In a little-known provision of the Act, Congress extended the effective tax rate of zero percent on the sale of qualified small business stock (Section 1202 stock). The Act modifies IRC Section 2012 to provide 100 percent of eligible gain received by an individual taxpayer from the sale of qualified small business stock. To qualify for this exclusion, the small business stock must be acquired during 2013 and held for at least five years. Only 50 percent of the gain from the sale of small business stock acquired after 2013 and held for at least five years will be eligible for exclusion. The Act both extends favorable tax treatment for such stock acquired in 2013 and retroactively applies it to such stock acquired in 2012.

Modified Voluntary Classification Settlement Program
The IRS has extended its Voluntary Classification Settlement Program, whereby taxpayers who believe they have erroneously classified workers as independent contractors instead of employees may file an application with the IRS. This allows them to have federal payroll tax exposure drastically reduced (by as much as 90 percent for some) for the years in which workers should have been treated as employees. The program also bars the IRS from auditing the taxpayer for payroll tax issues for those prior years.

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