Market Outlook | January 25, 2010

“Sanity calms, but madness is more interesting.” - John Russell

Absorbing Results:

As anticipated, markets that started the short holiday week extended and remained in a decline mode. On Friday, January 15, 2010, right before options expiration; Technicals gave early clues of a peaking market. A week later, investors are wondering as to the magnitude of this selling pressure. That said, veterans and well experienced pattern observers noticed the early possibility of pullbacks. Importantly, news flow anxiety was building with increased sensitivity for bad news, especially heading into earnings season and regulatory chatters. This is highlighted by a one-day, 22% jump in volatility this past Friday. This was a favorable action for short sellers and served as a minor surprise for the casual participants. Nonetheless, it is important to distinguish short-term behaviors versus long-term outlook. Again, fighting the wave of fears and staying focused on investment thesis is the challenge ahead for professional money managers.

Reassessing Previous Points:

Global assets are declining in a synchronized manner, which looks familiar to 2008 corrections. Yet again, it was commodities and emerging markets that led this retracement along with Financials. Clearly, higher beta themes are more sensitive. This is explained by the weekly results in which key lagging sectors included Gold -9.59%, Alternative Energy -9.96%, and Steel -11.28%. In upcoming days, these performance results can shape investor sentiment for the rest of the quarter.

Similarly, Asian stock markets declined for six consecutive days. To put things in perspective, it was only a period of a few months ago in which global policymakers discussed various tools to cool several overheating economies. Now, this early negative market tone has the potential to produce plenty of arguments of support for a significant market decline. These arguments might gain traction, especially with the S&P 500 being down 2.1% so far this year. Partially, this is understandable after a profitable 2009, where investors are deciding to take profits. Also, given uncertainties and slowing momentum some managers will seek the sidelines as a safer route.

Balancing Extreme Views:

It might be wise to digest earnings, interest rate policies, and pending regulations, while accepting the inevitable results of an overbought stock market. In looking ahead, there are two extremes that can be classified as potential knee-jerk reactions. First, optimists might decide to buy on weakness without closely examining the macroeconomic and sentiment environment. On the other hand, investors might sell on panic without evaluating the upside potential of select quality companies. In both cases, one must stay patient to understand the market performance drivers and to dismiss short-term noise. That said, quality companies with innovative growth potential might be offered at a discount, and they may be worth a look at attractive entry points in months ahead. Meanwhile, themes related to China, Credit, and Crude are less favorable in the current cycle. A step back reminds us that these groups were clear winners in the last decade, and they appear pricy when applying basic valuations.



Article Quotes:

“The recent rise in inflation was caused mainly by higher food prices as a result of severe winter weather in northern China. In many cities, fresh-vegetable prices have more than doubled in the past two months. But Helen Qiao and Yu Song at Goldman Sachs argue that it is not just food prices that risk pushing up inflation: the economy is starting to exceed its speed limit. If, as China bears contend, the economy had massive overcapacity, there would be little to worry about: excess supply would hold down prices. But bottlenecks are already appearing. Some provinces report electricity shortages and stocks of coal are low. The labour market is also tightening, forcing firms to pay higher wages.”(Economist, Jan 21, 2010)

“The main focus of financial reform should be to address such systemic risk. Separating commercial banking and other forms of financial intermediation from proprietary trading is a step in the right direction, since it limits systemic risk without affecting the financial sector’s ability to perform its core functions. This is because there is little evidence of any economies of scale that argue persuasively for principal investing to be located inside a financial conglomerate. In fact, the primary advantage appears to be that these institutions become too big to fail, and end up with access to a low cost of funding as a result of government guarantees. But, as seen from this crisis, the direct and indirect costs of government forbearance in a systemic crisis can be huge.” (Financial Times, January 22, 2010)

Levels:

S&P 500 [1091.76] has significant downside moves that are taking hold after stalling. Currently, index is nearly 8% removed from its 200 day moving average.

Crude [$74.50] is defined in a short-term weakness that began two weeks ago. Next level that’s highly watched is based on a previous pattern around $70. That’s close to its 200 day moving average of $69.35. Both add up for further selling pressures, which can decelerate price movement given this technical set up.

Gold [1084] has increasing odds for the commodity to trade between 1100 and 1150. Further unwinding is ahead, following a strong, multi-month run. Gold maintains its long-term uptrend above $980.

DXY– US Dollar Index [78.27] has had a 3 month recovery that’s over 6% from November 2009 lows to January 2010 highs. There will be a highly watched trend-shift regarding a weak Dollar policy ahead. Again, it may be too early to call a bottom, but the pattern suggests a shift.

US 10 Year Treasury Yields [3.60%] stalled at 3.80% yet again, while attempting to hold above 3.60%. However, rates singled some recovery point around the 3.20% range, which impacted the outlook of many investors.



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