Market Outlook | August 15, 2011

"Courage is fire, and bullying is smoke" - Benjamin Disraeli (1804-1881)

Volatility like fire burns the fearful dangerously or feeds the daring sizably. The outcome depends on the participants’ firm stance especially in periods where rational thinking has taken a major backseat. These panic driven periods have been shown to favor the cool headed, who’ve adequately geared up for looming surprises. Officially, we've moved from a bombardment of bad news to all out frenzy, resulting in an undue responsiveness to the headline noise. Beyond policy makers, gimmicks, snap back rallies, and a lack of feasible alternatives, it is awfully hard to find a positive substantive argument. Moreover, last week provided wild swings as desperate observers awaited market stabilization. As usual, executing on the unthinkable might be the most rewarding as one extreme follows an opposite extreme (rising stock prices) while understanding that some extremes last longer than imagined.

Throughout history, autumn has produced memorable hysterias, notably in 1929, 1987 and 2008. Despite this history, many speculate the summer turmoil collectively captured the majority of this year’s grief. On the other hand, the S&P 500 index declined 18% from July 21 to August 9. That is a dramatic move in and of itself relative to past performance, which may prove a simple and effective catalyst to tempt buyers. Value seekers argue for "cheap" timely entry into areas of fundamental strength, including selected technology and banking stocks. Meanwhile, cycle examiners remind us that shareholders may benefit during the run-up to the U.S. presidential election. Importantly, the current state of safety and risk are consciously being reassessed. Yet, it remains a tricky period to evaluate risk, and safer investment options remain in U.S. debt and Gold which continue to experience inflow.

More Politics than Usual:

It’s quite convenient to draw direct links between market behavior and political sentiment. Typically, the largest market fluctuations tend to stir up popular conversation. Of course, the U.S. sovereign debt downgrade raised questions of political leadership. Consequently, the U.S. “political risk” is higher than usual, reflecting the underlying bitterness and stalemate. To be fair, this was equally reflected in the rise of volatility and poor sentiment. Similarly, when leaders attempt to calm markets it backfired, especially during trading hours. This was especially apparent when examining the remarks by the President and Fed chairman last week. Thus, there are some financial professionals requesting less government involvement in U.S. and European markets. Unfortunately, that's mostly wishful thinking, and makes for better political rhetoric than confidence restoration. Practically, the political constraints are a growing risk for asset managers. Navigating shrewdly is the only option for risk allocators.

Further Disruptions

A series of interventions has added further suspense to the ongoing turbulence. First, the ban on short selling by various global regulators revisits the knee jerk reaction of U.S. equities in 2008 (SEC ban of shorting financials). The countries, among others enacting this practice, include South Korea, Turkey and Greece. Although, disallowing investors from betting on declines does not necessary translate to stopping price declines. It leads to less liquid markets, while asset managers scramble for near-term solutions. Secondly, the more substantial intervention is related to currency depreciation, encapsulated in the larger “currency wars”. The U.S. Dollar Index has stayed above annual lows since May 4, 2011, and for macro observers this is a noteworthy inflection point as the much feared demise of the greenback has not materialized. However, the plot has thickened, as central bankers used their influence to weaken the Yen and Franc. At the same time, significant correction in Gold prices may contribute to further instability in the currency markets. This may not be enough to claim a 6-9 month trend, but it certainly underscores a potentially developing macro shift.

Finally, the much heated debate of quantitative easing is bound to resurface. The mixed message from the Federal Reserve of targeting lower rates is being contemplated, but skepticism of pending plans is growing rapidly. Generally, the saying goes “Don’t fight the Fed!” However, with the lack of trust in intervening parties and the failure of QE2, a daunting task lies ahead for all involved parties. For now, the observer is left to speculate on outcomes, as policy makers dig to find a positive spin in various data releases. It certainly makes for a sensitive and tense period.

Article Quotes:

“Our main finding is that outward spillovers from Germany’s growth to other countries have been low and have remained modest in recent years. In contrast, spillovers, especially from the US, followed by the UK as a distant second, have been larger and have increased over time, even after controlling for the effect of outsized spillovers during the crisis. Based on full sample estimates including a crisis dummy, the effect of a 1% growth shock in Germany measured by the peak cumulative response of other countries is about 0.1%, the lowest of all the large countries. Moreover, spillovers from Germany have decreased in recent years, halving to only 0.05%. Japan’s impact on the rest of the world has similarly decreased. The analysis suggests that countries reliant on external rather than domestic sources of growth generate smaller spillovers. This is the case with Germany, whose growth is powered by global growth, which implies that inward spillovers are large but the outward spillovers are small.” (VOX Centre for Economic Policy Research, August 15, 2011)

“Some in Beijing understand how lopsided their development has been. So over the next 10 years, policy makers have said that they will try to raise consumption to 50% of GDP. Even that is a low number; it would put China at the bottom of the group of low-consuming East Asian countries. But achieving this goal is problematic, since it requires that household consumption grow four percentage points faster than GDP. In the past decade, Chinese household consumption has grown by 7% to 8% annually, while GDP has grown at an astonishing 10% to 11%. If one expects Chinese GDP to grow by 6% to 7%, Chinese household consumption would have to surge by 10% to 11%. Such consumption growth is unlikely because powerful structural factors work against it. The Chinese growth model transfers income from households to the corporate sector, mainly in the form of artificially low interest rates.” (The Carnegie Asia Program, August 12, 2011)

Levels:

S&P 500 Index [1178.81] – Attempting to stabilize at 1150-1200. It was deeply oversold, and remains in a fragile zone.

Crude [$85.38] – The commodity peaked on May 2, 2011 around a period where the Dollar bottomed. Once again, the $85-90 range can define a new trending range.

Gold [$1742.60] – Taking a breather after sharper moves towards historic highs. In the near-term, the narrow range resides somewhere between $1740 and 1780, while maintaining a well defined uptrend.

DXY – US Dollar Index [74.59] – A bottoming process developing around $74 in the past three months.

US 10 Year Treasury Yields [2.25%] – Rush to safety has driven yields to levels last seen around December 2008. For now, gains hold slightly above the lowest point of the year at 2.03%.

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