Market Outlook | May 8, 2011

“Fiction reveals truths that reality obscures.” - Jessamyn West (1902-1984)

The curiosity continues to build as many wonder if the recent upside run is fully justified. As usual with any mild correction, the thoughts and concerns of a trend shift begin to resurface. Last week’s action emphasized a potential trend reversal, especially with some bottoming in US Dollar, and sharp commodity declines. At this junction, it only takes a few minor knocks to get heads turning towards a cautious state. The suspense is already brewing after the lackadaisical Volatility Index (VIX) got a wake-up call last week. The “turbulence” indicator witnessed its calmest point of 14.27 on April 28, 2011. Since that point, the Volatility Index ended the week at 18.40, following a noteworthy spike. Therefore, it is worth asking this question: Can a herd-like mentality of trend following sustain itself in the weeks ahead?

As a start, the momentum buying in the past few months can be categorized by the following three key themes:

1. Shift Towards Hard Assets

As witnessed for several years, there is an increased rotation to Gold and Silver while reducing exposure to paper assets in the developed world.

2. Demand for Higher Yields

Investors that are fed up with low interest rates are desperately searching for an alternative. Therefore, managers are forced to step up risk exposure with the hopes of the attainment of desired returns.

3. Search for Growth

Longer-term participants project higher growth potential in emerging markets.


These well-documented trends are interrelated and soon to be challenged. Interestingly, the low rates that are influenced by central bankers greatly contribute to the themes above. Similarly, these policy driven actions explain the synchronized pattern among asset classes. In addition, inflation worries are becoming a popular global discussion, and it is nearly inevitable for that to turn into a political matter. As central bankers begin to address the inflation issues, these dominant themes may fail to satisfy the consensus expectation. Basically, this current condition showcases that the pace of the market’s appreciation is not in-line with the economic recovery. For now, timing is the tricky part, but staying alert for a series of catalysts is essential for a risk manager. Meanwhile, value oriented investors may find that entering here is less enticing when reviewing the pricing of specific ideas. Perhaps, an 8-12% broad market correction can make the playing field more attractive to those looking to accumulate US stocks at reasonable to low prices.

Specific Ideas:

AWR (Amer States Water): Having stayed mostly idle in the recent 2009-2011 recovery, the stock price of this water company are far from being overpriced, at least on a relative basis. This conservatively managed company has paid dividends for 57 years while being in a less glossy industry. Growth-like returns may not be visible in the near-term, but bargain hunters are likely to take a closer look.

UMPQ (Umpqua Holdings): Technical indicators would argue for an attractive intermediate-term outlook for shareholders of this Portland, Oregon, based bank. UMPQ’s longer-term core business is appealing on a fundamental basis despite the fragile conditions of the financial service sector. Recovery in lending (desperately needed for business managers) bodes well for a company that’s cleaned up its balance sheet, while in the past few quarters.

ROCK (Gibraltar Industries): A profitable first quarter is barely hitting the radar of many observers. Owners of this stock gain exposure to a manufacturer of buildings as part of an infrastructure play. Cost reduction efforts contributed to a recent 12% (1st quarter) increase in sales growth. Any pending weakness around $11 per share offers an early look at a buying opportunity.

Article Quotes:

“As unequal as America was before the Great Recession, the crisis, and the way it has been managed, has led to even greater income inequality, making a recovery all the more difficult. America is setting itself up for its own version of a Japanese-style malaise. But there are ways out of this dilemma: strengthening collective bargaining, restructuring mortgages, using carrots and sticks to get banks to resume lending, restructuring tax and spending policies to stimulate the economy now through long-term investments, and implementing social policies that ensure opportunity for all. As it is, with almost one-quarter of all income and 40% of US wealth going to the top 1% of income earners, America is now less a “land of opportunity” than even “old” Europe.” (Project Syndicate, May 5, 2011)

“I take strong exception with Bernanke's framework. His analytical focus rests upon the policy response to a crisis, while the lessons of history point rather directly to uncontrolled credit expansion and attendant speculative excess as the root cause of major financial crises. It is crucial to have a framework—a doctrine of clearly defined "rules of the game"—that protects the integrity of the system against the type of excesses that risk a crisis of confidence and systemic collapse (such as massive federal deficits and a ballooning central bank balance sheet). This is foreign to current Federal Reserve doctrine…. We're in need of some rules. We need rules that would ensure that the Fed never again accommodates a doubling of mortgage credit in about six years. We need rules that ensure that the Fed is not complicit in double-digit-to-GDP federal deficits and a doubling of federal debt in less than four years.” (Asian Times, Doug Noland, May 3, 2011)

Levels:

S&P 500 Index [1340.20] – Charts point out early signs of vulnerability, especially above 1340. Day-to-day action should determine the magnitude of a pending pause. Yet, the overall trend is positive from longer-term indicators.

Crude [$97.18] – A sharp and ‘bubble’-like decline as the commodity fell from $110 to $97. The 3-month run is under pressure as the confirmation of recent moves is eagerly awaited in upcoming trading days.

Gold [$1486.50] – Indication of pausing while the uptrend is setting up for a correction. Next noteworthy target is the 50-day moving average of $1454. A major move below $1400 may trigger worries of this run.

DXY – US Dollar Index [72.93] – The bleeding appears to have paused moderately. After making annual lows on May 4th, the week ended with a sharp spike.

US 10 Year Treasury Yields [3.28%] – Nearly a 3 month decline in yields is beginning to dampen the recovery above 3% that began in fall 2010.



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