Market Outlook | November 8, 2010

“The universe is change; our life is what our thoughts make it.” - Marcus Aurelius Antoninus, Meditations

As expected, election results reflected a message of change, and that provided a further jolt to the existing market uptrend. Now that we’ve seen this commonly reoccurring pattern of response to the shift in power, we can only conclude that one anticipated event is behind us. In fact, let’s not forget that a seasonal change from summer to fall somewhat sparked and revived the current run as well. So far, this year, the Nasdaq 100 and Russell Small Cap index are up nearly 18%. Interestingly, asset classes are rising together and, in some cases, leading to new yearly highs. For some observers, the synchronized price appreciation echoes a minor version of summer of 2007. However, the 2008 credit downturn is still lingering in the minds of investors. In other words, the crisis served as a reality check, while opening up a can of worms on worrisome issues. Sequentially, the post crisis response led to the following near-term trends that set the general tone:

• Overly aggressive regulatory discussions, mixed with political posturing
• Fear of rising interest rates
• Consensus agreement on higher volatility
• Lower willingness for capital commitment by larger companies

At this point, some of these responses can be labeled as an overreaction, but that would be too early to call. In addition, the consensus bet of rising rates and volatility proved to be grossly incorrect, despite the highly expressive statements by pundits and headline generators. In weeks ahead, tracking changes in these post-crisis factors might provide a better color on the overall attitudes of key decision makers.

Now, a slight improvement in labor markets gestures some perceived strength in the real economy. Any statement regarding recovery in economic data can trigger excessive skepticism and furious debate. Similarly, critics of the Federal Reserve point out and focus on the risk of pumping money. Maybe, those policies are desperately needed to refuel some optimism. Capital injection might be debated and, by some, negatively perceived. However, its benefits are less discussed and might be felt through near-term confidence. Of course, the consequences to quantitative easing are not fully known, but they are bound to create international conflict as seen earlier this fall. The recent measures have some taking on the belief of worrying about it in the future, and that has its own risks as well, as recently learnt. Interestingly, market cycles are known to have a short-memory (especially for negative outcomes) and adjust to the next relatively attractive movement.

Grasping Participant’s Mindset

In the current environment, the participant landscape of the stock market can be broken down into three segments. In short, the investor thought process can be classified as Daring, Neutral, or Cautious.

1. Early daring investors are glad to have entered at cheaper prices at the height of worrisome conditions. Now, these partially lucky and shrewd investors are presented with flexibility. Buyers that got in at the late part of this summer can now consider taking profits by selling, continuing to add to their gains, or seeking ideas in other areas.

2. Neutral observers are collecting data, reassessing timely entry points, and looking for a better perspective on global polices election results and ongoing asset class appreciation. In addition, the broad indexes appear extended, and waiting for a breather seems like an appealing move.

3. Cautious and relatively suspicious participants are not convinced that the Federal Reserve policy will come to fruition. Investors in this category have a strong view that the credit crisis will reinvent itself shortly in a different form.

Research & Article Quotes:

“..if weaker economic sectors in each country were allowed to go under. To compensate for the disruption this could cause, the state should encourage the development of new sectors and new points of production. There are factors making this a particularly good time to pursue such a strategy [quantitative easing]. The lack of investment in the West in recent decades means that some sectors are already hollowed out. This helps clear the way for new rounds of investment in other areas. The rise of strong emerging economies could also be an advantage for the West. A larger and more dynamic global economy presents the chance of a more developed global division of labour. Evading difficult challenges through measures such as QE means eschewing opportunities to generate real economic dynamism.” (Fund Strategy, November 8, 2010)

“Monetary expansion in the developed economies has confronted emerging markets with the trilemma. If they resist currency appreciation, they lose monetary control and get inflation and asset price bubbles (as well as political pressure over trade competitiveness). The alternatives are equally unpalatable. Reverse the trend of the past two decades towards freeing capital markets that has nurtured financial development; or accept exchange-rate appreciation and loss of competitiveness. The conventional prescription is to permit the appreciation – after all, it raises real incomes, and competitiveness is underpinned by rapid productivity growth – and switch away from export-led growth to more reliance on domestic demand. But many countries, China most vocally, are concerned that significant appreciation will hit marginal exporters, slow growth, and create unemployment.” (VOX, November 4, 2010)

Levels:

S&P 500 Index [1225.85] – Breaking out with strength above 1200 as near-term pullbacks appear inevitable. Nonetheless, a second wave of buyers is looking to reenter on weakness.

Crude [$86.85] – Flirting with annual highs after accelerating above $85, which signals strong buying and growing conviction. Meanwhile, poised for short-term correction.

Gold [$1395.50] – Continues to make an explosive run, while reaching unchartered territory. Any near-term weakness around 1350 is worth noting, given increasing buyer interest.

DXY – US Dollar Index [76.54] – Attempting to hold between the $76 and $78 range. Near-term observers will attentively watch the ability of the Dollar to sustain above the lows of November

US 10 Year Treasury Yields [2.53%] – Last month resulted in rates rising and marking some bottom. The true test is around 2.45%, according to recent chart patterns.





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