September 24, 2012
by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
Updated weekly, Schwab Investing Brief™ tackles questions about today's markets and investing environment including the latest stock market trends.
Does the stock market have potential to go even higher? What's the latest on the housing market? And what's going on in Washington with the "fiscal cliff," taxes and the debt ceiling? Liz Ann Sonders, Schwab's chief investment strategist, and Michael Townsend, vice president of legislative and regulatory affairs, shared their thoughts with Mark Riepe.
The stock market and (lack of) volatility
The housing market
The "fiscal cliff" and US debt ceiling
Tax changes in the New Year
High-frequency trading and the SEC
The stock market and (lack of) volatility
Mark Riepe: Does the current stock-market rally have potential to go even higher? If so, what are the driving factors other than the Federal Reserve's latest stimulus measures?
Liz Ann Sonders: Without trying to time the market, which we never recommend, it's presently a mixed picture and sentiment alone suggests a breather in the market wouldn't be surprising. Many short-term sentiment measurements show rising levels of optimism, a contrarian indicator; however, some sentiment measures—specifically the latest (September 20) American Association of Individual Investors Sentiment Poll—show a very high level of uncertainty.
As for driving factors other than the Fed's moves, corporate earnings have been the biggest support, and estimates are trending back up after dropping sharply the past two quarters. A wide variety of investors have been taking less risk and are generally defensively positioned, possibly providing ample fuel for rallies when the news hasn't been as dire as the consensus opinion.
MR: Why is the VIX [the CBOE Volatility Index, designed to measure the market's expectation of volatility over the next 30-day period] currently so low—and what might that indicate?
LAS: The VIX index has recently been in the mid-teens, which many view as a sign of investor complacency, since that's the lower end of the range it's been in over the past three years. Too many VIX watchers use time frames of analysis that only include the post-2008 financial crisis, and the VIX was around well before then. During the 2003–2007 bull market the VIX ranged between 12 and 20, and during the six best years of the 1990s bull market the VIX ranged between 10 and 20 most of the time, according to Bloomberg. A mid-teens VIX is not extreme when measured against other bull markets.
MR: The Federal Reserve's third round of stimulus measures includes a commitment to buy mortgage-backed securities and a promise to keep interest rates down. Could this cause a jump in the housing market?
LAS: The jump in the housing market already began earlier this year, not solely as a result of the Federal Reserve's previous easing measures. The past five quarters of residential investment (housing) have added to GDP, after six years of losses, according to the Bureau of Economic Analysis. "Real" mortgage rates (nominal rates minus home-price appreciation/depreciation) have dropped back into negative territory, thanks to rising house prices, and this—along with low nominal mortgage rates—is driving improved demand.
Ostensibly, the focus on mortgage-backed securities in this round of quantitative easing could help the housing market even more. Although spreads between US Treasuries and mortgage rates did narrow sharply after the announcement, the 10-year Treasury yield also moved higher, meaning the net effect on nominal mortgage rates has been minimal for now, according to Bloomberg. The more important factor has been and will be home prices, given the help they provide for not only real mortgage rates, but also for household net worth and in lifting many homeowners out of underwater status with their present mortgages.
MR: Could you explain the recent housing-market data? How solid is the housing recovery and when might it have a meaningful effect on the overall economy?
LAS: As the largest component of household net worth, housing's recovery has provided a nice boost to the economy, according to the Federal Reserve. Housing should continue to support gross domestic product by 0.5% to 1% into next year as housing grows again as percentage of overall GDP. Housing has a very strong jobs multiplier and the recent surge in the National Association of Home Builders (NAHB) housing index bodes well for a more accelerated move down in the unemployment rate.
The latest good news in the housing market was driven by several factors, including a three-point jump in an already improving NAHB housing market index, a nearly 8% rise is existing home sales (to the highest level in two and a half years) and the fact that median home prices are now nearly 10% higher than a year ago. Other contributing factors include an 8% jump in single-family home sales (which account for 90% of total sales), inventories of new and existing homes relative to working population decreasing to near-all-time lows, and housing completions now well-undershooting the recent surge in household formations, according to the most recent figures from Bloomberg.
MR: It appears as if every business sector other than construction is on the rise, yet it's not showing in the labor market—so why aren't businesses hiring? Is there any unmeasured pressure to hire developing in the labor markets?
LAS: Everything I've read and seen, and heard in conversations with leaders of both small and large businesses, suggests that the election and related "fiscal cliff" implications represent a level of uncertainty too great for them to increase either capital investment or hiring until at least some of it is settled. Businesses generally don't feel a short-term pressure to hire if their competitors aren't. So we're likely at a standstill until at least after the election and there's more clarity regarding the tax and regulatory playing field.
Most business leaders say they can suit up and play on any field as long as they know the rules, but with so much current uncertainty about the rules of the game, businesses are staying off the field. In our opinion, fundamental pressure to hire has been building, given that productivity is starting to slip from its recession-era highs.
The "fiscal cliff" and US debt ceiling
MR: There are a lot of pieces of the so-called "fiscal cliff" looming at the end of the year, but which are the most important that are driving the need to reach an agreement in Washington?
Michael Townsend: The expiration of the Bush-era tax cuts gets the most attention, but they could be allowed to expire and then be reinstated retroactively without too much disruption in early 2013 by the new Congress. So we believe the most important drivers will be the Alternative Minimum Tax (AMT), the federal debt ceiling and the automatic spending cuts that are set to go into effect January 1.
The latest "patch" for the AMT expired at the end of 2011. Because the AMT was never linked to inflation, it captures more middle-class taxpayers every year. For the past decade or more, Congress has approved "patches" that increase the amount of income exempt from the AMT. Without a patch, the number of taxpayers hit by the AMT would jump from around five million to more than 30 million. Trying to fix the AMT retroactively in 2013 would be very complicated—a big incentive, we believe, for a post-election compromise.
It's likely the debt ceiling of $16.4 trillion will be reached before the end of the year, and no one wants a repeat of what happened in the summer of 2011. Look for a compromise package at the end of this year that includes a relatively small increase in the debt ceiling—something that will ensure the issue won't come up again until well into 2013.
With regard to the automatic spending cuts, $55 billion in defense cuts and $55 billion in non-defense cuts will kick in come January. The defense cuts are particularly worrisome to both Democratic and Republican members of Congress—many have defense installations or big defense contractors in their districts, and they don't want to see jobs lost as a result of these cuts. So that's another piece of the puzzle that many lawmakers from both parties want to solve.
MR: Congress raised the debt ceiling last year. How close are we now to hitting that higher limit, and will the ceiling need to be raised again after all this added borrowing? If so, when might that happen?
MT: The current debt ceiling is $16.4 trillion, and reports are we've already passed the $16 trillion point. So it's very likely we'll hit the ceiling before the end of the year. The Treasury Department has a number of ways it can delay a US default—that's what happened in the summer of 2011, when Treasury extended the deadline for a couple of months. But probably no one in Washington wants a repeat of that scenario, so we think there will be a strong push for a modest increase before the end of the year.
Raising the debt ceiling doesn't do anything to slow the debt itself, and doing things like postponing the scheduled January 1 automatic spending cuts will only add to the debt. So we wouldn't be at all surprised to see Congress have to raise the debt ceiling again sometime in 2013.
MR: If no compromise is reached in Washington before the end of the year, what happens on January 1 to various taxes rates for investors?
MT: It will depend greatly on which party controls Congress and the presidency after the fall election; for details on all of the tax issues, you can read Are Taxes Headed Higher? and Health Care Taxes, recent articles by Schwab's Vice President of Financial Planning Rande Spiegelman.
MR: How might taxes on dividends change depending on the outcome of the election?
MT: It's an interesting situation in Washington. President Obama believes dividends should be treated as ordinary income for taxpayers in higher income brackets (individuals earning more than $200,000 and couples earning more than $250,000). The Republican-controlled Congress approved a bill this past summer that would extend all Bush-era tax cuts for one year, which would keep the dividend tax rate at 15% for all filers for another year. The Democrat-controlled Senate approved a bill that broke with President Obama, setting a top rate of 20% for both capital gains and dividends for higher-income filers, while keeping the rate at 15% for filers below the $200,000 level.
As a result of this split, it's not clear how things will play out after the election. The President has said he wants to let the Bush tax cuts expire for higher-income taxpayers, and if he's re-elected, he'll probably get his way. However, Senate Democrats may push back on the issue of letting dividends be taxed as ordinary income.
High-frequency trading and the SEC
MR: What's the latest on the Securities and Exchange Commission's (SEC) probe into whether stock exchanges sometimes allow high-speed trading firms to trade ahead of other investors?
MT: Earlier this month, the SEC announced a $5 million penalty assessed to the New York Stock Exchange for sending market data to certain clients ahead of the consolidated feed that makes the data available to the public—the first-ever SEC penalty against an exchange. We wouldn't be surprised to see rules proposed, perhaps next year, on high-frequency trading.
The fine is the latest in a growing list of problems undermining the confidence of individual investors in the integrity of our capital markets. It follows the "flash crash" of 2010, problems in the Facebook IPO, the Knight Capital glitch this summer that resulted in losses of more than $400 million and a host of other incidents. The growing presence of high-frequency traders and "dark pools" are a huge part of the debate over whether the playing field is level for all investors.
Next week, the SEC is hosting a daylong roundtable on technology issues, which will focus both on how to prevent glitches and how to respond when they do happen. An SEC roundtable is usually a first step in the process that leads to a regulatory proposal. Congress can also be expected to pay more attention to this issue in the coming months—Chairman of the Subcommittee on Securities, Insurance and Investment Jack Reed (D-Rhode Island) said he would hold additional hearings on this complex issue.
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