Market Outlook | February 8, 2010

“You cannot depend on your eyes when your imagination is out of focus.” - Mark Twain (1835 - 1910)

Markets Sway

It is hard to deny the eventful and tricky week that witnessed significant swings. Perhaps, the VIX (volatility index) chart paints a better picture of this trendless action, causing mild unrest. Last week started on a positive note, followed by sharp sell-offs in-between, and ended with a late Friday recovery. That mostly sums up a lively five days of trading at the start of February.

Through this maze, the S&P 500 held above 1035 which marks a 10% correction since January highs. Of course, one should not assume that 10% is a magic number, yet it serves as a gauge to distinguish an inevitable short-term correction from a long-term breakdown. Labor data, earnings results, and investment sentiment remain fuzzy, which frustrates those seeking bold answers. Perhaps, these answers are rarely bold and require flexibility when analyzing ongoing data points. In many ways, those investors, accustomed to trend-following and simple momentum, might have to adjust their strategy.

Perceived Risk

In terms of big picture themes, Europe, along with emerging markets and commodities, are inter-linked in the current weakness. The last few days, financial headlines have highlighted the debt crisis in Spain, Greece, and Portugal. This contributes to a strengthening Dollar, falling currency prices, and a general bias towards risk-aversion. Generally, it’s safe to assume that high volatility leads to moderate panic, which ends up favoring “safer” assets. European conditions are weakening, which is an erosion that stems from the recent credit top. That said, some worries are too early to conclude, especially with only 1/3 of the US stimulus being spent (ProPublica.org). Therefore, one should leave some room for upside surprises to come, despite the recent negative tone.

Positioning

Money managers, whose skills are measured by annual returns, might be less willing to take on significant risk here. It’s too early to risk performance returns at this early stage of the year. Similarly, some wonder if investors sold their winning positions from 2009 in the recent weeks. At least, the turnaround in the US Dollar confirms a further shift towards risk aversion. On a similar point, there is an early movement away from emerging markets and commodities. After a multi-year run, global demand from hard commodities, especially crude, is slowing. Finally, Chinese regulators are recognizing the bubble-like behavior that can put a pause in the explosive run.

Given the points above, a rotation into US equities can be an increasing possibility. At the same time, interest rates are relatively low and some fixed income groups are extended. This sets the stage for a potential capital inflow from foreign investors into US companies. This bodes well for companies reviving their innovation efforts, especially groups related to media, communication, and biotech. For example, in the media sector, a company like FMCN (Focus Media) offers a favorable cycle entry point, management changes, and products with growth potential. Similarly, healthcare companies, like VRUS (Pharmasset, Inc.), are worth a closer look. For instance, Pharmasset, Inc. discovers antiviral drugs and presents a relatively attractive exposure in small cap stocks.

Article Quotes:

“If the Greeks do not regain the markets’ confidence, they may fail to refinance the €20 billion ($28 billion) or so of debt that falls due in April and May. At that point, the government would default or would have to be bailed out. And Greece is not the only country about which the bond markets are worried. On the same day as the commission approved the Greek plans, investors were selling Portuguese bonds. The spread of ten-year bonds against bunds widened by 0.16 percentage points, to 1.43 points.” (The Economist, February 4, 2010 )

"China's government, seeking to stem property speculation, told banks to raise interest rates on third mortgages and demand bigger down payments for such loans... The China Banking Regulatory Commission warned lenders of the risks associated with 'hot money' flowing into the property market... Tighter rules on third mortgages 'should have some effect on home prices, especially in regions such as Hainan,' said May Yan, a...analyst at Nomura International HK Ltd." (Bloomberg, February 3, 2010)
Levels:

S&P 500 [1066.19] is trading near 1060, similar to levels last seen in November 2009. The index remains above its 200-day moving average, standing at 1018. S&P 500 is poised for a near-term recovery in spite of the established downtrend.

Crude [$71.19] has had a recent trading pattern that is in-line with a multi-month range, which is forming between $70 and $75. A step back reminds us that the commodity is establishing a downtrend. Crude struggled to hold above $80 twice in the last 4 months.

Gold [1058] shows no signs of recovery, although, at this point, sellers appear to take a breather. Importantly, Gold peaked earlier than other assets. Perhaps, this selling pressure can provide clues to the condition of this decade-long uptrend.

DXY– US Dollar Index [80.41] is showcasing further evidence of strengthening, as the index surpassed its 200-day moving average. Technicals argue that a key trend reversal is taking hold.

US 10 Year Treasury Yields [3.56%] is hovering above 3.50% as the rates remain in a sideway pattern.

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