Market Outlook | July 5, 2011

“Faith begins where Reason sinks exhausted.” - Albert Pike (1809-1891)

Endings and Beginnings

A series of endings and new starts is a fitting description over a reflective holiday weekend. For one thing, the first half of the year reached closure with the S&P 500 Index up 6.52% for the year, following an impressive 5.6% run last week. Yet, since midwinter, we've seen suspenseful events of lingering debt issues and gut-wrenching realities of the global system filled with minor down hours and negative days.

Secondly, Quantitative Easing 2 (QE2) ended last Friday. Of course, that's the government stimulus program designed to spark a recovery (avoid further disaster) by mainly keeping interest rates lower after the 2008 crisis. Skeptics in the early stages warned of eventual inflation and dollar devaluation. Either way, it’s too early to judge, as inflation is reported not too high and the dollar has declined but not collapsed. However, that stimulus plan has expired, and investor reaction is eagerly awaited. In the meantime, the end of QE2 naturally raises questions on consequences of ungluing a sense of stability. The debate centers around intervention versus facing painful short-term measures. Yes! This is all too familiar to the financial and political world—yet again. Now, money managers ponder if the ending of the Fed policy will propel the beginning of rising interest rates and the strengthened dollar (anticipated incorrectly for many years now). Basically, a trend reversal in these two key macro indicators may not only impact the currency markets, but it also questions if this ends the momentum in Gold prices.

Finally, last week marked a minor closure or temporary relief to the Greece matter—a much needed pause to the glaring suspense and intense debate. For policymakers, the resolution gives much needed breathing room from a topic to be revisited and scrutinized in months ahead. Interestingly, the US Treasury Secretary appears ready for an exit while June marked the beginning of a new IMF chief—not to mention, the retirement of the Secretary of Defense, Robert Gates. These events are happening as we approach the early stages of the US elections. Clearly, much of the day-to-day news can shape perceived policy changes and sensitive response to near-term sentiment. Similarly, Europe’s mood for bailouts is bound to change, due to increasing political pressure, given recent decisions. How this plays out in Germany and other nations will have a say in regards to global financial stability.

Bad News Exhausted

By this point, the fatigued and battered investment crowd is into recreating some positive mental tune. Savvy front line money movers visualized a pent up upside move about a week ago, as June 17 marked a recovery point in which volatility reversed, while broad indexes found bottom. There is a difference between accumulating bad news and a sharp collapse.

Like a kid punished until he is remorseful for his bad behaviors, markets go through a correction and a taste of harsh reality. Then, shamelessly, we're temporarily back to humming the same tune driven by human nature, capital chasing growth, and paying up at debatable prices. The clouded directional view does not fully stop opportunistic players from making bets or having guts. Thus, a pure argument for logic may fail to explain the rationale in which systemic problems (i.e. sovereign debt) suddenly vanish, as outraged pundits are quickly silenced. Importantly, surviving this wobbly landscape requires one to quickly connect dots while accepting and playing the cards dealt. For now, economic and corporate earnings might not deliver an uplifting message, but selective opportunities are worth scrambling for, given scarcity in quality ideas.

Within this fragile macro climate, there is a boom in technology venture-backed IPOs— somewhat herding in Gold investments and an eagerness to restock into risky assets. This signals that few found robust ideas in the first half. Importantly, in planning forward, one can begin to selectively pick entry points to attractively valued themes.

Irrational Logic

At this point, it’s only normal to ask this question: how can these not-so-logical patterns re-occur? Some wonder if financial markets are a venue where the participant comes in saying, “I have money to burn!” Basically, this suggests that speculation is borderline entertainment on real events or alternative to traditional saving schemes. If this is too blunt of a description, then there is another approach. A buyer goes through a self convincing process in which he or she cleverly justifies actions in the name of long-term wealth creation. Others are limited by investor mandate or knowledge, and they prefer to stick to traditional investment patterns.

At least veterans know (or should know) that there is a tragic ending to too much hopefulness if not monitored correctly. Again, these greed-driven stories are glaringly obvious and easier to comprehend in the post mortem analysis of hyped investments—yet rarely are the mistakes not repeated. If the majority of account holders did not have clever self-justification processes, then surely the market dynamics would be drastically different than we know it. Therefore, savvy or lucky money managers have accounted and adjusted for the constraints of available ideas while emphasizing the human psychological response—a note worth applying to the quarter ahead.

Article Quotes:

“We have seen how "inflation hedger" investors aiming to avoid inflation have actually caused the very inflation they sought to avoid. The game-changing intervention by the IEA increases the supply of oil relative to the dollar, and therefore, it can be expected to deflate the price, at least temporarily. The most potent effect of what might be termed "quantitative greasing" with oil was—and was intended to—to deter speculators, and hedge funds are already licking their wounds and adjusting their strategy. But this action will also in all probability act to limit the inflationary expectations of the billions of dollars of "inflation hedge" investment also in the market, and will in all probability lead to a market collapse… So perhaps the dysfunctional and increasingly sociopathic oil market may at last be open to a new collaborative and transparent settlement, involving new market architecture; and new market instruments.” (Asian Times, July 1, 2011)


“Six years ago, when I first started writing about the credit markets, I often heard US financiers praise America’s capital markets as the most developed system of free market finance in the world. Indeed, techniques such as securitization were presented as a natural outcome of American enthusiasm for free market ideals. ..But the dirty secret behind this rhetoric was that government-backed institutions such as Fannie and Freddie were playing an important role in the modern financial system, even before the credit crisis erupted. And what is remarkable now, given that the role of Fannie and Freddie has swelled, is just how little debate this patter continues to generate. After all, with the US remaining wedded to free market ideals, it is uncomfortable to admit that “capital markets in the US have become reliant on government guarantees,” says Viral Acharya, an economist and co-author of a thought-provoking book.” (Financial Times, June 30, 2011)

Levels:

S&P 500 Index [1339.67] – An accelerated rally from 1260 level, which showcased a heavy buy-interest near the 200-day moving average. Meanwhile, 1320-1340 serves as a near-term range for a pause.

Crude [$94.94] – In late 2010, the $90 range has served as an attractive buying point. Similarly, the commodity bottomed on June 27, 2011 at $89.61. Attempting to break above $95 as investors debate the appropriate pricing and pending fundamental factors.

Gold [$1483] – Failed below 1500 after prices hit new highs of $1552 on June 22—the third time in the past few months where Gold struggled to stay above $1540 as a point where buyers’ momentum fades.

DXY – US Dollar Index [75.66] – Several days of trading don’t showcase a major trend shift. Avoiding new lows since May 6 but the follow through is not that explosive. Interestingly, the 50-day and 200-day moving average sit at or around 78.

US 10 Year Treasury Yields [3.18%] – Sharp spike above 3% caught the attention of near-term traders, given the downtrend established in early February 2011. A follow through is awaited, and the technical pattern suggests a rise in yields.


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