Ordinarily, investors do their best to apply hard logic to decisions about how to deploy their money. But more than ever these days, investment decisions boil down to whether you're an optimist or a pessimist.
A lot of people who want to be optimistic are finding it tough to bet on the bright side. The festering debt problems in Europe are the biggest buzz-kill right now, with marginal steps toward a solution and even changes of government in Greece and Italy falling far short of the deep reforms investors want to see. Every supposed breakthrough seems to produce a truncated relief rally, with markets rising briefly before returning to the funk that has depressed stocks over the last several months.
The U.S. economy has its own chronic problems, including high unemployment, a paralyzed housing market, the world's largest sovereign debt load, and a bitter political environment that seems to preclude sensible, bipartisan economic palliatives. Emerging nations like China and Brazil have helped keep the global economy afloat, but those nations have growing pains, too, and can't really flourish if the world's most advanced economies are in the tank. The result has been a manic stock market causing prolonged anxiety. Despite a few breakouts, such as the robust October rally, the S&P 500 index is flat for the year and down nearly 10 percent from a peak reached in April, when the U.S. and European economies looked healthier.
The volatility that's become a hallmark of the markets—and seems likely to continue—comes from the outsized role that politicians and policymakers play in the global economy at the moment. Ordinarily, U.S and European government policy affects economic growth at the margins, with other factors like consumer demand, dealmaking, and entrepreneurship largely fueling profits and creating jobs. But those "animal spirits" have been subdued by a strange binary outlook: Markets seem likely to either surge or crash, depending on what politicians do. Merrill Lynch, for instance, predicted recently that the S&P 500 will end 2012 at 1350, which would be a 7 percent gain from current levels. But the investing firm also said the index could "test the lows" in 2012, scraping 1100. Now that covers just about all the bases.
In a related story, I detailed how political problems could soon send markets reeling. But if you're an optimist, you're inclined to believe that policymakers will find last-minute solutions to vexing problems, providing a needed spark to the economy and the markets. "A wall of money is waiting to be deployed when confidence returns," the huge money manager BlackRock advised clients recently. If policymakers could just turn the corner on a few big issues, the thinking goes, then investors would flood into the markets, with demand for virtually all assets fueling a healthy rally. Here's what it will take to draw that money off the sidelines:
Delicate debt reduction in Congress. To stabilize America's $15 trillion national debt, Washington needs to cut it by at least $3 trillion to $4 trillion over the next 10 years—and do so without upending the economy, which would make the whole debt problem worse. The first test comes soon, when a 12-member panel of U.S. legislators must publish its plan for cutting the debt by at least $1.2 trillion. Congress must then approve the plan, without backsliding on other measures, such as $900 billion in spending cuts approved over the summer. And after the 2012 elections, there will still be the need for additional measures, most likely including tax reform and the revamping of Medicare, Medicaid, and Social Security.
There are several thorough blueprints for how to reduce the debt by cutting government spending, raising taxes, closing loopholes, and ending subsidies. The problem is that politicians accustomed to promising a free lunch seem unable to do it, because every such measure would cause pain for somebody. Wall Street and the business community have low expectations for the 12-member "supercommittee" and for Congress in general, with many analysts expecting further delays until extreme market pressure forces Congress into unpopular action. To some extent, the markets have probably priced in the failure of the supercommittee to hit its $1.2 trillion debt-cutting target later this month.
That means it would be an upside surprise if the supercommitte hit or exceeded its target, especially if Republicans who have categorically refused to consider tax increases changed their minds and agreed to modest tax hikes as part of a debt-cutting deal. There would still be the tricky issue of timing spending cuts and tax increases so as not to harm growth over the next year or two, when the economy is still likely to be weak. But if Congress did what it's supposed to do, by acting responsibly on the economy, it would clearly cheer the markets—and mark a win for the optimists.
Aggressive reform in Europe. The European debt crisis is far from resolved. New governments in Greece and Italy seem to represent a step toward the kinds of fundamental fixes that are needed in Europe's less-competitive economies. But passing all the needed reforms in those countries is far from a sure thing, and there's sure to be more of the political brinksmanship that has characterized the whole crisis for the last 18 months.
Though markets have breathed a sigh of relief recently, more tension is on the way, and the breakup of the euro zone remains a possibility. As with America's debt problem, it's well-known what needs to be done, in general. Europe's leaders need to fully finance the bailout fund they've established and explain precisely how it will work. Greece and Italy need to pass and execute austerity measures that have already been laid out. Bondholers need to write down the value of Greek, Italian, Irish, and Portuguese debt. And Europe as a whole needs to bind its nations together in some kind of fiscal union that mirrors its monetary one.
But knowing and doing are two different things, and there's strong incentive for everybody involved to wait until the last second before making concessions, to maximize their leverage and shift as much of the cost as they can to somebody else. It's the job of political leaders to forge compromise out of chaos, and the real question now is whether Europe's leaders will pull a rabbit out of the hat, or a turkey.
Crunch time could come next February, when Italy needs to roll over a significant amount of debt. If investors demand interest rates of 7 percent or higher, as they have recently, it will signal a loss of investor confidence in the whole scheme and possibly force a decisive outcome. The worst-case scenario is a default not just by Greece but by Italy as well, which would probably mean the unraveling of the whole euro zone and a return to a patchwork of currencies. Markets would plunge until some sort of equilibrium emerged. But a negotiated outcome that leaves the euro zone intact, manages debt writedowns, backstops Europe's banks, and restores confidence would probably trigger a handsome rally. The fun part for investors is that Europe may march to the brink of catastrophe before political pressure becomes intense enough to make a grand bargain possible. That makes Xanax a strong buy.
More action by the Federal Reserve. Fed Chairman Ben Bernanke has become one of the most peculiar villains in America, with conservatives bashing him for loose monetary policy and liberals complaining about the Fed's role in the bank bailouts. But over the last few turbulent years, the Fed has been one of the best friends the stock market has ever had.
Two rounds of quantitative easing have lured investors out of safe, fixed-income investments and helped stocks recover some of the losses suffered in the crash of 2008-2009. Other Fed policies have helped ease the credit crunch, with big business being the biggest beneficiary. And record-low interest rates have helped big companies build a nest-egg of nearly $2 trillion in cash. If the economy rebounds, they'll invest much of that money, earning returns that ought to prime stock values further.
The Fed has pledged to stay the course and conduct further easing if the economy stagnates, and especially if problems in Europe seem likely to cause another recession. Investors need to decide whether they feel that will ultimately benefit or harm the economy. The old adage, "don't fight the Fed," suggests that it will pay to surf whatever waves the Fed creates. But some analysts fear the Fed has sown the seeds of runaway inflation, moral hazard, and other debilitating developments. By the time we know for sure, the entire investing herd will react to the news. So if you trust the Fed, place your bets now. And while you're at it, buy a lottery ticket.