Fear + Uncertainty = Opportunity

Linda A. Duessel, senior equity-income market strategist at Federated Investors, keeps close tabs on trends and attitudes among financial advisors and investors. And she’s seeing a lot of pessimism these days, especially among retail investors. “People are in a bad mood,” she says. “Everyone seems to think the world is coming to an end.” She doesn’t believe it is, of course, and notes such environments often can be opportunistic for equity investments. It may be understandable for the average retail investor to be worried—and wary of stocks but Duessel contends that those who spend so much time with their heads in the sand are missing the big picture. For investors prone to anxiety attacks over market ups and downs, Duessel prescribes long-term investments in solid, dividend-paying companies, whose stock prices have typically been less volatile than their non dividend-paying counterparts.

The Fear Factor
A big part of this doom-and-gloom attitude is because equity investors, in fact, got
burned during the dot.com collapse and the global financial crisis. Behavioral finance studies show that the suffering an average person feels when they lose money is somewhere around two to three times that of their joy at making money losing hurts more than winning feels good. So when investors lose money, they become very reluctant to expose themselves to the same risks again. When they lose a lot of money, as happened in 2008, they remember it even more. And when they lose money twice in 10 years, they become particularly skittish.

Duessel believes that over the past four to five years, the market has run the risk of losing a generation of investors, as younger people have gotten the idea that the stock market is nothing more than a casino. After the global financial crisis spawned sell-off in 2008—capped by the unveiling of the massive Bernie Madoff fraud— analysts waited to see how long it would take the retail public, the average individual investor, to come back into stocks. They saw some movement in that direction in 2009, but then came the May 6, 2010 “Flash Crash” in which an unusually large trade in a volatile market sent the Dow plunging around 1,000 points in a matter of minutes, only to recover those losses immediately. With that jolt to their still fragile psyche, retail investors continue to pull more money out of the market than they are putting into it, even though the major equity market indices have more than doubled from their early 2009 cycle lows and the bellweather S&P 500 nearly reached a five-year high in early October 2012.

A Cliff-Hanger in the Nation’s Capital
The stock market is not the only monster hiding under retail investors’ beds. Fear is one thing, uncertainty is another. The latest battlefield in the fight over our country’s path to the future has become the “fiscal cliff,” the combination of expiring Bush tax cuts and steep spending cuts mandated by last year’s debt-ceiling compromise. If nothing is done, it’s estimated that 83% of U.S. households would pay higher taxes, with the average tax increase totaling $3,701, and that gross domestic product (GDP) could take a hit hard enough to push the current weak economic recovery back into recession.

Very few retail investors could give you the details of the fiscal cliff, other than to note it’s been in the headlines a lot and appears to represent yet another threat on the horizon, coming on the heels of last year’s debt-ceiling showdown that ended with the country receiving its first-ever downgrade of its debt and with the markets suffering a broad sell-off. That debacle produced a general sense that political leaders in Washington were willing to take their ideological battle to the bitter end, even when warned that their inability to compromise could cause major disruptions in the markets. Retail investors may not have an interest in how we came to the fiscal cliff, what our options are or what the fiscal cliff even is, but they see it as yet another Capitol Hill showdown in the offing with the potential to inflict casualties on bystanders.

The consequences of failure are not small. Barring U.S. politicians steering the country off the fiscal cliff, it’s estimated that real GDP in 2013 will expand approximately 2.6 percent. To put that in some perspective, 2012 is likely to end up with GDP growing around 2 percent—an extremely subpar rate this far into an expansion. If the fiscal cliff occurs, virtually all forecasts see the economy falling back into recession though the magnitude of the decline is wideranging. The equity markets don’t do well going into and during the early stages of recessions.

Of course, this is all hypothetical for now. Congressional leaders did manage to reach a tentative agreement to keep the government financed through March 2013, thus avoiding a potentially rancorous debt-ceiling showdown in the weeks leading up to and following the Nov. 6, 2012, election—an outcome neither side particularly favored at this juncture. But while it removed some of the nexus between the issue and the election, the decision leaves little time for a reasoned discussion about taxes and entitlement reform before the new year hits. That’s when the Bush tax cuts are set to expire by law, and also when the mandated spending cuts are set to kick in.

Some Cliff Notes
A look at the details of the upcoming fiscal cliff debate shows just how wide the divide is between the two very different visions for our economic and fiscal future. These include:

• Bush tax cuts Much of the coming fight will center on what to do about the 2001 and 2003 tax cuts enacted under former President George W. Bush. The combined tax cuts are estimated to total just north of $200 billion a year, and neither party appears willing to roll them back to their earlier levels. Most Democrats insist on allowing the tax cuts to expire for the “rich”—which they define as individuals who earn more than $200,000 or households earning more than $250,000.They propose restoring the maximum marginal tax rate to 39.6 percent from the current 35 percent, and adding 3.8 percent in additional taxes on unearned income associated with health care reform if it remains, as well as lifting the maximum capital gains tax rate to 20 percent from 15 percent and the dividend tax rate to 39.6 percent. Republicans favor making the Bush cuts permanent for everyone.
• Alternative Minimum Tax (AMT) and the Buffet
  Rule The AMT sets a minimum tax rate of about 28 percent on income above a certain exempted level to make sure upper-income households with a high number of deductions still pay a minimum level of taxes. But the AMT, enacted in 1969, does not index exempted incomes for inflation, so a growing number of middle-income households found themselves hit by this tax in the past decade. This has prompted Congress to adopt an annual “ATM patch’’ that adjusts the minimums to eliminate this so-called “bracket creep.’’ If it doesn’t adopt a patch this year, the exempted income threshold for married couples filing jointly would fall to $45,000 from last year’s $75,000—a tax increase totaling an estimated $38 billion, according to Washington Analysis.

• Payroll tax holiday and extended unemployment
  benefits Also on the table is the expiration of the two percentage-point reduction in the Social Security payroll tax on employees enacted in 2010 and extended through 2012. But an extension of the Social Security payroll tax hurts Social Security funding, and was not deemed to have sparked economic growth. Unemployment insurance was extended through 2012, but the maximum length of the benefits was reduced from 99 weeks to 79 weeks because many economists believe the extended benefits actually deter those who are out of work from seeking new employment.

• Sequester and defense spending Along with the Bush tax cuts, this is the biggest ideological battle ground. Almost as quickly as they signed off on the defense cuts mandated in November last year when the Super Committee failed to reach an agreement (mandated cuts roughly split between defense and nondefense discretionary outlays), Republicans—and some Democrats—have been looking to undo much of them, focusing instead on making more cuts to social programs such as foods stamps and Medicaid. Even Defense Secretary Leon Panetta believes the proposed cuts in defense spending are simply too extreme, leaving the U.S. militarily vulnerable.

Waiting for the Fog to Lift
Retail investors may not be up on the details of the fiscal cliff, but business leaders know all about it. Not knowing the outcome may make it difficult to plan or make decisions, especially when it comes to hiring. Given that a large portion of the cuts to be ordered under sequestration would come from defense spending, defense contractors and aerospace manufacturers across the country are stalling new programs, waiting to see which way the dust settles. Their employees (an estimated one million employees work for defense contractors, with approximately 2.5 million working in related industries that depend on defense spending) are doing the same thing with their family budgets. Business analysts also are factoring in all the fiscal cliff uncertainties when projecting expectations for both investment and consumer spending in 2013.

All this fear and uncertainty has many investors focusing on the negatives and ignoring the positives right in front of their faces. If the market rallies, they write it off as a “suckers’ rally.” Positive economic releases are met with caution rather than enthusiasm. Indeed, many people will tell you that we’re in the middle of a recession right now. They don’t realize that we’ve been out of a recession since June 2009, because the recovery has been so weak.

A Dividend Strategy
With so much fear and uncertainty in the markets, Duessel sees an alternative for skittish equity investors seeking to dip their toes back in the water: a dividend oriented investing strategy, which has the potential to generate more predictable and better returns over the long term than a strategy geared solely at price appreciation.

According to Ned Davis Research, 90 percent of returns since the 1920s, encompassing good times and bad times, have been from dividends and dividend growth.* The world has come to an end many times over the past 90 years, but dividend-paying stocks have doggedly plugged along, ignoring the threatening clouds.

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