China, the Fiscal Cliff, Energy Prices, Profits, and QE3 and Their Effects on the Stock Market

China, the Fiscal Cliff, energy prices, profits, and QE3 are the primary concerns in today's worldwide  economy.  How will these effect the stock market?  This is the point of the article by A Gary Shilling.

The article is in italics and the bold is my emphasis.  From Bloomberg.com:

The growing gulf between the behavior of investors enamored with monetary and fiscal largess and the reality of globally weakening economies -- a phenomenon I call the Grand Disconnect -- is profoundly unhealthy.

It will end, sooner or later, in any case. One way it could be eliminated is through the rapid expansion of economies globally. The past and current massive monetary and fiscal stimulus or other forces might rekindle growth. Some investors point to the recent stabilization of U.S. house prices as the beginning of a revival.

I have my doubts. The huge deleveraging in the private sector in the U.S. and abroad; the unresolved odd-couple tensions between the Teutonic North and the Club Med South in the euro zone; and the needed shift in China from an export-led economy to one powered by domestic consumption suggest that “risk on” investments will collapse to meet recessionary and chronically slow-growing economies.

What will cause the agonizing reappraisal by bullish investors? Probably a shock, as was the case in limited ways with the euphoria over the first two rounds of quantitative easing by the Federal Reserve and Operation Twist. The Greek debt crisis in early 2010 ended the QE1 stock rally. The QE2- spawned bull market ended in early 2011 with the second flare-up of Greek worries and the widening European financial and economic woes. The optimism generated by Operation Twist concluded with the realization that Europe’s travails may be unsolvable, and with worries about the fiscal cliff in the U.S.

Forecasting specific jolts is hazardous, though I can list several possibilities.

A hard landing in China might do the job, with growth slowing to between 5 percent and 6 percent, especially after the effect is felt in world trade, commodities demand and prices and commodity producers’ currencies. There is a growing consensus that this is in the cards. That view could account for the recent embryonic shift from “risk on” positions -- the quartet of short Treasury bonds, long stocks, short the U.S. dollar and long commodities -- to the reverse “risk off” trades.

A fall off the fiscal cliff is another possibility. If Congress and the administration don’t act by the end of this year, the Bush-era tax cuts will expire, the payroll tax on employees reverts to 6.2 percent from 4.2 percent, unemployment benefits drop from a 99-week maximum to 26 weeks, and $1.2 trillion in mandatory federal-spending cuts and tax increases over 10 years begin to kick in. The nonpartisan Congressional Budget Office estimates that the fiscal cliff will cut 2013 gross domestic product by 4 percent. In itself, that has the makings of a major recession, and its effects would be compounded in an already recessionary economy.

I believe that the U.S. government will avoid the fiscal cliff, at least temporarily. Even the representatives and senators affiliated with the Tea Party want to be re-elected, and telling their constituents that austerity is good for their souls won’t garner them many votes. With the current Congress and administration gridlocked, they could use a so-called lame- duck session after the election to postpone the tax increases and spending cuts, leaving the next Congress and administration to deal with the mess. That’s what happened last December --when they negotiated a three-month respite -- and again in February, when they delayed action for the rest of this year.

Or they could wait for a new administration to be sworn in and tackle the fiscal cliff retroactively.

One way or the other, I doubt the economy will go off the fiscal cliff. An old friend, former Representative Barber Conable of New York, who served as the ranking Republican on the House Ways and Means Committee and later as president of the World Bank, often told me that “Congress ultimately does the necessary thing, but only when forced to and as late as possible.”

Few in Washington are likely to stand on principle and let the economy fall into an abyss.

I doubt that many U.S. business people and consumers believe the fiscal cliff won’t be averted, even though many cite the threat as a rationale for the general uncertainty that is retarding spending and capital investment. Note, however, that defusing the fiscal-cliff menace won’t add stimulus to the economy. It will simply keep existing government spending and tax rates intact.

Another possibility is that a surge in the price of oil, possibly triggered by an Iran-related crisis in the Middle East, shatters investor euphoria. That’s what happened with the oil embargo in 1973 and Iran’s Islamic Revolution in 1979. To be sure, the U.S. is becoming less dependent on imported energy, and little of the imported oil is from the Middle East. But petroleum is fungible and price increases elsewhere will affect the U.S., along with Europe and China. A huge energy-cost increase would be a debilitating tax on already-stressed consumers.

There also is the danger that a major European bank will fail, generating a global financial crisis. Banks are so intertwined through loans, leases, derivatives and other instruments that a blow in Europe would be felt around the world.

Banks normally look at their derivatives exposure on a net basis after hedges and other offsets are accounted for. But the gross or notional value of derivatives is 26 times the net, according to the Bank for International Settlements, and if a bank goes belly up, the counterparties are stuck with the notional amount.

Add major corporate-earnings disappointments to the list of possible shocks. Ever-optimistic Wall Street analysts believe S&P 500 operating earnings fell slightly in the third quarter compared with the year-earlier period, but a 14 percent revival is expected in the fourth quarter. Yet suppose my forecast is correct and operating earnings drop to $80 per share over four consecutive quarters, due to recession-induced declines in corporate revenues, a narrowing of profit margins from record levels and currency-translation losses as the dollar strengthens. That $80 is more than 20 percent lower than analysts’ estimates, and would be a big disappointment to many bullish investors.

QE1, QE2 and Operation Twist got increasingly larger bangs for the buck. But that isn’t the case with QE3 and recent actions by the European Central Bank, at least so far. Each successive announcement by the Fed and ECB got less pop in the S&P 500. Since peaking Sept. 14, the day after QE3 was announced, that index has been relatively flat, in contrast to gains in comparable days of trading after the three earlier quantitative easings. Treasuries, which changed little after the first rounds of easing, had a brief rally.

It’s early into QE3, but does this suggest that investors are getting cautious and wary, and believe the Fed has gone back to the well one time too often? Are investors anticipating a hard landing in China or one of the other shocks I outlined?

This series makes clear that I disagree with the “It’s so bad, it’s good” crowd. Conditions are so bad, they are just plain bad. The huge monetary and fiscal stimulus in the U.S. and elsewhere in the past five years has failed to offset the gigantic deleveraging in global private sectors. And such measures are unlikely to do so until that process is completed in another five to seven years.