Market Outlook | June 27, 2011

“There is no rule more invariable than that we are paid for our suspicions by finding what we suspect.” - Henry David Thoreau (1817-1862)

Simple and Obvious?

One would think that the purpose of business or investing is to enter with the objective of winning as measured by profits. As simple as that sounds, there is losing in asset depreciation, defaults, and bankruptcy, as recently witnessed. Most can agree that a loss exists, and as to the type of loss, well, that’s where legal expertise can sort out the distinction and details.

The rules of engagement state that an investment manager makes a long-term bet to win, while not being blinded to potential losses. In that process, an investor deciphers the risk, and regulators set the parameters for a fair game, while not overly tilting to any particular side. In between, you have rule breakers and deceivers, but veteran participants know that's the additional risk of being a speculator. Unfortunately, this logic is not necessarily all thought out prior to the date of purchase. In addition, those burned in the last bull market have to comfort the harsh outcome, while not deviating from the basic concept of competition and consequences. For some generations, “losing big” used to sound conceptual rather than real. The last four years emphasize that asset value erosion is part of the game, and it happens despite marketing slogans, hopeful mind games, feelings of entitlement, or historically driven bravado.

Eluding Defeat

In any game, no one likes a sore loser (we'd like to think), as it’s not an admirable quality to deny a fair defeat—a lesson hopefully learned early on in the competitive field or middle school playgrounds rather than larger stakes in financial markets. After all, markets are a collective reflection of human emotion. Surely, we all have our own biases on accepting losses. Clearly, these dynamics are illustrated in the European Central Bank and other regulatory debates over the sovereign debt crisis.

Specifically, saving bondholders for the sake of financial systems at the cost of the common people (via future taxes) puts a dent on all of the above mentioned points. In fact, this conceptually echoes the US banks in 2008, when the bailout debates surged with outrage, filled with little shame and eventual concession of "too big to fail." Obviously, the pros and cons of letting Greece default are well documented. Either way, these are desperate conditions. These hints of system breakdowns remind us that there are a different set of rules for select groups versus the casual investor. That said, confronting the truth, such as default, may hurt in the short term, but the long-term outcome might be surprising:

“But while countries that default do find themselves locked out of markets for some time, any growth penalty from a default tends to be short-lived. Argentina saw its GDP decline by 10.9% in the year after its December 2001 default. But its economy bounced back smartly in the years that followed” (Economist, June 20, 2011).

Murky Definitions

When winning or losing is distorted by complexity or neglected, then major trouble arises, and undoubtedly, whining increases from all sides. The lack of value placed on accountability bruises investor confidence and mindset. If losing is not enforced in special situations, then the lack of punishment encourages further irresponsibility. Not to mention, if policymakers postpone losing, then it’s known for bubbles to form and form again, as witnessed many times in the past.

Meanwhile, political spin (a natural human behavior) shifts to blame businesses for competitive political points, yet most small to mid-sized US businesses rather play to win within defined rules. The large and privileged companies, or select countries, have developed crafty negotiation skills to delay results of their mismanagement. If this spectacle of putting out the next fire (Spain or Italy) continues, then “trust” in markets becomes a lost art, and eventually leads to further risk aversion. This theme is visible and loudly stated, when viewing Gold prices, as paper assets (bonds, stocks, currencies, etc.) are being restructured and redefined. Clearly, this showcases a growing number of hesitant participants left to own an appreciating commodity, while not enticed at the alternatives. This thought asks if capitalism needs to be redefined and repacked, but in practical terms, this is not easy to reform. Bottom-line, the murky definition of wins and losses deflates the spirit of competition, and sourness disseminates rapidly.

Near-Term Attitude

Transactional participants would rather apply a short-term memory for bad news, and most have little patience to dissect these “nauseating” philosophical debates, especially in the summer months. Instead, allocators of larger capital are desperate for ideas, and they will seek to buy recognizable companies shares at cheap prices. As mid-year approaches, various money managers would look to salvage annual returns, while ramping up on riskier assets as the pressure mounts.

Noise and confusion pile up at perceived inflection points, but most buy demands are likely to focus on relative opportunity in US and some emerging market equities. Volatility has risen in the last few weeks, but not as high as mid March 2011. Recently, buy conviction in liquid markets has failed to follow through as up-days were short-lived. Perhaps, the wise approach is to balance the mindless day-to-day chatter while being cognizant of the mind-numbing theatrics.


Article Quotes:

“During the1995-2005 period, when China fixed the yuan-U.S. dollar exchange rate at 8.28, China’s overall inflation rate mirrored that of the U.S. and was relatively “low.” Once China caved in to misguided pressure – notably from the U.S., France and international institutions, like the International Monetary Fund – and allowed the yuan-U.S. dollar exchange rate to wobble around, problems arose. The money supply growth rate surged in the wake of the Panic of 2008-09. And as night follows day, inflation has raised its ugly head in China. The monetary authorities are scrambling to cool down the inflationary pressures by slowing monetary growth – from almost 30% per annum to 15%.” (Globe Asia, July 2011)

“In a series of ongoing experiments, Montague has studied what happens when people compete against each other in an investment game. While the subjects are making decisions about the stock market, Montague monitors their brain activity in two different fMRI machines. The first thing Montague discovered is that making more money than someone else is extremely pleasurable. When subjects “win” the investment game, Montague observes a large increase in activity in the striatum, a brain area typically associated with the processing of pleasurable rewards. (Montague refers to this as “cocaine brain,” as the striatum is also associated with the euphoric high of illicit drugs.) Unfortunately, this same urge to outperform others can also lead people to take reckless risks.” (Wired , June 16, 2011)

Levels:

S&P 500 Index [1268.45] – Slightly holding above a much watched 200-day moving average. The established downtrend is attempting and nearing a bottom.

Crude [$91.16] – In a correction phase, especially after breaking the $100 mark. Downside momentum seems legitimate since the spring correction.

Gold [$1514.75] – Since July 30, 2010, the commodity is up nearly 36%. Further evidence of buyer interest and no signs of selling in the near-term.

DXY – US Dollar Index [75.66] – Remains above annual lows of 72.69 yet a strengthening dollar is a frail argument now based on recent evidence.

US 10-Year Treasury Yields [2.86%] – A well defined downtrend as the next key level is around 2.60%-2.80%.


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