Market Outlook | October 19, 2009

Macro Perspective:

Given the sharp declines of 2008 and corresponding recoveries this year, investors are left with fuzzy data points in making historical comparisons. Also, following an outlier year, it is difficult to analyze trends and gauge expectations. This is a key lesson learned by many, especially in drawing market conclusions. Sharp peaks and quick rallies are evident in stocks, commodities, yields, and currency. Basically, this sums up the reshaping of financial markets, and it stresses the importance of staying flexible in eventful markets. On a calendar basis, a quick glance reminds us that the S&P 500 is up 20% year-to-date. For longer-term participants, that’s a fruitful reward compared with previous years. Importantly, this signals a natural recovery and sets the stage for a new cycle. On the other hand, pure fundamentalists point out that these markets are disconnected from their fundamentals.

Days Ahead: Micro Expectations

At this point, public companies are meeting or exceeding analyst’s expectations. In fact, 85% of companies have beaten expectations, according to Bespoke Investment. This showcases increasing optimism, as some managers continue to raise guidance. Of course, majority of quarterly earnings are ahead of us, and they will catch the attention of many observers. Perhaps, this contributes to a near-term pause within a defined uptrend. Earnings are usually a game of expectations, and there is always room for disappointment. Also, options expired last week as investors shift to fundamental focus. Any disappointment is bound to create a sensitive response in investor sentiment. However, the buying momentum is a strong force, especially as buyers reconfirm an appetite for risky assets. In addition, few indicators are suggesting the end of recession. For example, FOMC minutes and Philly Fed report data confirm economic improvement. The accumulation of these factors points to a positive building momentum.

Actionable Thoughts:

A growing skepticism continues to plague credit markets. Weakness in commercial real estate, small bank failures, and growing foreclosures contribute to lack of confidence. Similarly, funding for venture capital is relatively low, and banks are not lending as desired. Therefore, financial sectors remain vulnerable and require additional time. This is part of the acceleration in commodities and confirming its multi-year leadership.

Despite headline worries, inflation is not a concern, at least not in the short-term. Similarly, as expected by many, interest rates have not risen. As usual, eliminating noise is crucial in generating ideas and building an investment thesis. It’s hard to point out a consensus view, but most would agree that markets have stabilized and are far removed from major extremes. That said, finding specific fundamental and sector growth can be highly rewarding in the upcoming cycles.

Stock Specific Ideas:

ASEI (American Science and Eng.): Stock is maintaining its strength above $60. A developer and provider of innovative X-ray detection solutions is set to benefit from increased deals, especially in developing markets. This bodes well for future revenue growth. Pending declines in the stock price offer an entry point as investors seek innovative based companies.

SXE (Stanley Inc): Recent deals with Intel and government agencies showcase upside strength. The company is exposure for a positive, technology business. Additionally, technicals suggest that attractive risk/reward is around $26.

RVBD (Riverbed Technology): Set to benefit from an increase in IT infrastructure spending by private and public sectors. The stock price is significantly removed from the all-time highs that were reached in October 2007. It is a small cap stock that gains from demand in defense related applications. Since last fall, continued uptrend attracts momentum chasers, seeking to bet on bullish markets.

Article Quotes:

· “The dollar’s correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global “imbalances” that helped cause the crisis….Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar’s only serious competitor. At present, 65 percent of the world’s reserves are in dollars and 25 percent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro’s fate is less certain.” (Martin Wolf, Financial Times- October 13, 2009)

· "The volume of delinquent commercial mortgages jumped sevenfold last month as borrowers who got loans with lax terms faiedl to make debt payments amid sinking real estate values, according to Credit Suisse Group AG. In September, installments on $22.4 billion of mortgages were at least 60 days late, up from $3.2 billion a year earlier... The delinquency rate rose 33 bps to 3.34%..." (Bloomberg – October 12, 2009)

Levels:

S&P 500 [1087.68] Index is slowly climbing back and restoring losses from the 2008 collapse. Index is approaching 1100 where long-term buyers would look to accumulate.
Crude [$78.53] Solid uptrend remains in place. Next key point is around $90, which serves as a midpoint between July 2008 highs and December 2008 lows.

Gold [$1047.50] The commodity is up 50% since the lows of October 2008. A breakout above $1000 convinces more buyers to step in. Plus, the decade long commodity uptrend is powerful to ignore.

DXY– US Dollar Index [76.45] Peaked on March 4, 2009, at a period where investors shifted towards risky assets and spurred a market recovery. Now, a roundtrip to levels was reached in the early part of last fall and marking annual returns.

US 10 Year Treasury Yields [3.41%] No major changes in the past few months. It’s establishing a defined range between 3.42% and 3.18%.

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