As the year 2010 approaches its fourth quarter, there is a significant likelihood that anticipated 2011 fiscal policies will impact financial markets.  The S&P 500 has recently leveled off from a precipitous drop after the financial crisis of 2008 and retreated from its 2010 peak of just over $1,200 that was achieved in advance of fears over a systemic debt crisis in the European Union.  Implicit within the current market valuation is an assumption for future growth in earnings per share.

By comparing the current market value for the S&P 500 index of nearly $1,100 with the next four quarters of forecasted earnings per share for the index, it results in a forecasted P/E ratio between 15.0 and 15.5, assuming the forecasted earning growth unfolds as anticipated.  Unfortunately, there are many factors currently in play that will make those growth targets difficult to achieve.

At Business of Life LLC, we believe that the stock market is poised for a sharp downward correction in the second half of 2010.  This prediction is based on multiple factors that span fiscal, political, and fundamental weaknesses in the prospects for future growth of corporate profitability.  Our reasoning forecast of a downward correction in 2010 is based on the following factors:

• The long-term capital gains tax rate will increase from 15% to 20% on January 1st, 2011.  This will prompt many individuals and fund managers to capture gains achieved since the post-crisis lows at the more favorable current tax rate.  As the end of the calendar year approaches, investors will need to anticipate when the sell-off to lock-in gains will begin or risk being caught in the depressed prices that result from multiple simultaneous sales orders.
• Scheduled tax increases for 2011 will directly impact the disposable income for the top 53% of income earners.  Since ~71% of US GDP is comprised of consumption spending, it naturally follows that a reduction in disposable income will result in a spending compression.  This is reinforced by the tight lending environment that is making it more difficult for people to acquire credit for the purpose of financing consumption spending.
• The government “deficit reduction commission” is scheduled to report after the mid-term elections in November.  The motivation for this timing is clearly to avoid burdening incumbent politicians with the bad press that accompanies likely recommendations for reductions in spending and increased taxes.  Both of these actions will have a negative impact on corporate profitability.
• Persistent high unemployment will make it difficult to retain past levels of profitability that have been based on stimulus and subsidies from the government.  As government entities retreat from these programs because of large debt burdens and low tax revenues, corporate profits are likely to be impacted.

The combination of these factors create a high probability of volatility in the stock market as 2010 draws to a close and 2011 unfolds.  Investors who have diversified into cash are expected to have ‘value buy’ opportunities in the coming months when reactions to economic news or strategic selling drives down the index values below the levels justified by fundamentals.  However, the stresses on future corporate profitability makes this strategic buying a more appropriate long-term strategy, since the regression back to fundamentals may be interrupted by erratic government policy and further difficulty with European nations attempting to climb out from underneath their sovereign debt burden.

On balance, the overall stock market presents a favorable value at an S&P 500 value near $1,000.  Volatility in advance of expected tax increases are likely to present multiple opportunities for strategic buying at attractive prices.  The attractive returns previously realized by ‘buy and hold’ investors have dissipated in recent years as the market has descended into a seemingly permanent state of volatility.  In this environment, strategic value buying appears to be a more beneficial strategy.

Recommendation for Action: Begin diversifying your funds before the correction in advance of higher capital gain taxes begins.  It would also be advisable to either hold onto your capital in the form of cash or money market funds if it is in an IRA or diversify into income properties if the capital is not constrained by a retirement account.  This will allow you to either capture the anticipated market correction and buy-in at lower prices or purchase income properties at the current low rates and suppressed prices while locking in a 30-year fixed rate loan.