Retail sales during Thanksgiving weekend — the traditional start of the holiday shopping season — climbed 13% as more shoppers hit the stores and spent more money, according to the National Retail Federation, wildly exceeding consensus estimates. The news helped to lift stocks on Friday, making for the strongest week for stocks since early June 2012.

Retail sales matter to the stock market mainly because they reflect the health and sentiment of the consumer and investor [Figure 1], but also because they contribute to the growth of the economy and corporate profits.

Does a Black Friday for retailers assure a green holiday season for investors? Not necessarily; there have been years where positive fourth quarter retail sales did not bring positive results for the stock market. In fact, there is not even much of a relationship between how well holiday sales results fare against forecasts and stock market performance. To illustrate this point, over the past 20 years, the performance of the S&P 500 during the period from Thanksgiving through year-end was about the same (2.7% vs. 2.5%) when retailers exceeded the widely followed forecast from the National Retail Federation compared to when they were in line, on average.

The question of what Black Friday means for investors actually has the relationship backwards; it is instead the gain in the stock market that is the predictor for retail sales during the holiday season. This makes sense since the stock market is one of the best barometers of consumer confidence and, if it is rising, it stands to reason that consumers are feeling a bit more confident and willing to spend.

With the S&P 500 Index having gained 12% this year, it should be no surprise that early reports of sales this holiday season have been solid:
• The National Retail Federation reported Thanksgiving weekend sales up 12.8% over last year. Shoppers spent $59 billion over the weekend, with the average shopper spending $423.
• Online sales trends have been very strong, with sales estimated up 26% from last year on Black Friday. Tight inventories may have forced many to go online in search of favored styles and colors. Strong online sales have prompted shipping companies to issue solid outlooks, with UPS predicting a 6.2% increase over last year and boosting seasonal hiring by 10%. Federal Express is forecasting a gain of 12% between Thanksgiving and Christmas.

What Is Driving All This Demand From Consumers?
• A rising stock and housing market has helped consumers feel wealthier, plus the modest increase in jobs and paychecks may have given consumers the confidence to boost purchases during the holiday season.
• Consumers’ balance sheets look a lot better. The percentage of income consumed by financial obligations, such as a mortgage, rent, auto, and student loans has fallen to a level not seen since well before the financial crisis and is below the long-term, 30-year average.
• Consumers are starting to borrow again. U.S. consumer debt has fallen by about $1.3 trillion since the pre-recession peak, according to the Federal Reserve, with credit card debt being one of the most sharply contracting categories. But in four of the last six quarters, American households’ credit card borrowing has increased after having fallen for 11 consecutive quarters.

Stocks, particularly those of the retailers, have reflected the improving consumer incomes and balance sheets, and now sales may begin to reflect the release of pent-up demand. While stocks are already signaling gains in sales this holiday shopping season, the performance of retailer stocks has been pointing to solid gains with the S&P 500 Retail industry group of stocks posting a gain of 2.4% relative to the decline of -1.8% in the S&P 500 so far during the fourth quarter.

However, one weekend does not make a season. Stocks have slumped so far in the fourth quarter, and retail sales have yet to break out of their slump. The widely watched weekly measure of retail sales from the International Council of Shopping Centers has averaged a relatively consistent year-over-year gain of 2 – 3.5% during the second half of 2012. If sales do begin to accelerate, it may be good news for the economy. A more confident consumer leads to more confidence in corporate America, which may lead to brighter prospects for job and economic growth in 2013.

The recent presidential and legislative elections did not change the players negotiating our country’s budget issues. Barack Obama, a Democrat, is still President and the House of Representatives is still Republican. Our divided government must face the budget issues that they have kicked the can on multiple times already, but now with the added pressure of avoiding the fiscal cliff. We see three scenarios:

1) The parties kick the can farther down the road. The fiscal cliff deadline is pushed into 2013. Government tells us it’s “not fair” for a lame duck session to make such important decisions for America.

2) The parties reach a grand bargain. Revenue is raised by potentially increasing capital gains and estate taxes, reducing deductions for the wealthy (e.g., a phase-out on mortgage and charitable deductions), and changing the income ranges on tax brackets, as opposed to changing rates. At the same time, future liabilities are reduced by fundamental reform to entitlement programs. One potential reform would be to phase out Medicare benefits for higher net worth individuals; these types of agreements are unlikely to impact current recipients of benefits or those very near retirement age, but those in their 40s and early 50s could be affected.

3) The parties fail to reach any type of agreement, and the tax hikes and spending cuts of the fiscal cliff go into effect, with big headlines and with lots of finger-pointing in Washington. The debate rages well into 2013, with the eventual outcome uncertain.

Of these outcomes we think that the first scenario is the most likely. We believe that the second scenario would be the best for the markets and the economy in both the short and long runs. And, we think there is very little chance of the third outcome; allowing the fiscal cliff to impact the economy would jeopardize the already anemic recovery. Politicians like getting reelected and we believe it is unlikely, but not impossible, that our elected officials would knowingly cause their constituents, and maybe more importantly, their donors, to suffer unnecessarily.

We are not alone in our view. Most major investment managers, Wall Street bankers and hedge fund managers agree that the United States is unlikely to head over the fiscal cliff. As a result, the markets are reflecting only a very small probability of the economic impact of the government not reaching some type of agreement. While most investors are relatively sure that some sort of agreement will be reached, when evidence surfaces that increases the probability that agreement may not be reached (e.g., reading the tea leaves of the President and the Speaker of the House), the markets react strongly. As a result, we expect there to be considerable volatility in the equity and credit markets between now and the end of the year. The volatility is short-term in nature and totally unpredictable. We believe that markets will fall on days when an agreement looks out of sight and rise on days when a grand bargain looks possible. While it might seem like a good time to be active with your portfolio, trying to time the ups and downs is not possible.

Managing markets like these requires effective diversification. On days when agreement seems difficult to achieve, Treasuries have rallied, while equities rallied on days when agreement seemed possible. Also, keep in mind that most people are investing for the long term; even if we head over the fiscal cliff and the stock market goes with it, the intermediate-term outlook is for a pickup in growth. In fact, we believe that due to improvements in housing, manufacturing, energy production and exports, the United States could see surprisingly strong growth at the end of 2013, or the beginning of 2014. Trying to time your investments to protect yourself from the volatility of the fiscal cliff, while still hoping to capture the upside of a continued U.S. recovery, is a losing game; it just doesn’t work. It doesn’t work for institutional investors, for hedge fund managers, for the wealthiest families. Short-term market timing works once in a while for people who are lucky. We never bet on being lucky; instead, we bet on having a tested investment approach, rooted in historical experience and academic research.

In times of volatility, the key is to control what you can: taxes and portfolio costs. We can help clients plan for higher taxes and our investment team is helping take control by cutting overall portfolio costs for our clients. We believe in building all-weather portfolios. In August, we proactively added both purchasing power protection strategies and risk/volatility dampening strategies to most portfolios in an effort to further diversify portfolios for multiple economic scenarios. For instance, we added fixed income securities, which generally perform well in a low-inflation and recessionary environment, and we added purchasing power protection strategies to take advantage of current inflation levels and to hedge against the potential of high inflation, which may occur if the solution to the fiscal cliff ends up being more monetary easing.

If there’s a silver lining to the fiscal cliff, it’s that any solution to it has to involve the beginnings of a solution to the long-term budget issues.

We’ll be here for discussion; please continue to visit our website for the latest news from Wealth Enhancement Group.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.