Market Outlook | August 22, 2011

“If everyone is thinking alike, then somebody isn't thinking.” - George S. Patton (1885-1945)

As the last days of summer approach, they may provide a breather to participants from the ongoing negative sentiment. There aren’t many magical descriptions to summarize the sharply fallen markets, which continue to witness a frenzy like behavior. The S&P 500 is nearly down 11% for the year. This somewhat reflects the slowdown in global economy, along with waning investor expectations of future earnings. As usual on price declines, the correlation between various sectors is high in a period where volatility increases. That's simply a textbook setup, and reiterated the obvious, in which irrational behaviors are quite vibrant. As Birinyi Associates reminds us, that stock correlations are at all-time highs. “The average 50-day correlation of S&P 500 members to the index has risen to the highest levels since the market bottomed in 1987.” (August 19, 2011).

Navigating the Mess

Unfortunately, it is only natural to lump all bad news into one big “fire.” Specifically, when political matters are blended into market behaviors, it can be confusing and lost in translation. Similarly, grasping the ongoing finger pointing of economic decisions should not be confused with a nostalgic reflection of past economic policies. The subsequent kneejerk response fails to address the richness of the current multilayered mess. Frankly, debating the merits of the recent correction is not a fruitful practice for an investor, given that we’ve already established weakness from all angles (at times nauseating). At this point, blindly picking broad market bottoms is rather bold even for the seasoned observer. Yet, stashing away cash or over reliance on “safe assets” should present worries itself to those feeling too comfortable.

Importantly, isolating the magnitude of each worrisome item shall be the artful skill needed for weeks ahead. Staying firm and not making definitive statements is the challenge for any participant. Distinguishing labor weakness from European bank risks, to visionary long-term growth stories, is vital. Of course, all themes have their own place, and each carry a varying risk and reward. For example, US banks are underestimated for the cleaner balance sheet, as compared to 2008. Yet, the European bank noise makes it blurry, and leading some companies to trade cheaply. For example, the US Bank index (BKX) is down over 36% since February 2011, as the declines are at a much more rapid pace than any other sector. “At the moment, the Financial sector has the lowest trailing 12-month P/E of the ten sectors at 10.62” (Bespoke Investments, August 19, 2011). In due time, rational drivers can overtake emotional responses. Today, that is not visible in the trading patterns, and further fear can linger through the fall.


Digging Through the Maze

In extreme periods, such as the current market state, it becomes easy to conclude or muddle along with consensus. As volatility declines and perception normalizes, the hunt for fundamental ideas is bound to resurface. Even in the heart of this turmoil there are selective companies that held in on a relative basis. For example, retailers such as BJ Wholesale (BJ) have demonstrated increased revenue in their grocery stores and specialty services. Similarly, the pharmaceutical researcher, Pharmaceutical Product (PPDI), showcased solid fundamentals last quarter while a potential takeover is being discussed. Thus, few companies, from Consumer Staples to Utilities, can offer dividends and longer-term appreciations for those who are patient and slightly imaginative.

Clearly, picking “growth stories” is very spotty and frustrating. Yet, given the limitation of investment ideas, it helps to prepare purchasing ideas to fully benefit from pending momentum. To reach that point, broad indexes would need to showcase price stabilization. For now, the attention on stimulus plans by the Federal Reserve, and slowdown rate in emerging markets, will serve center stage.


Article Quotes:

“One of the most striking aspects of the eurozone crisis is that bond markets have not discriminated between causes of excessive debt. Greece was denied credit and had to go begging to Brussels for a bailout, not because it had taken part in the real estate bubble but because it had abused entry to the eurozone to enjoy a public borrowing spree. Ireland was denied credit because, even though its public finances were in solid shape, it had allowed its banks to overwhelm them. Italy is perhaps the most remarkable case of all. It is now threatened with loss of credit, not because of any post-euro borrowing, nor because of its current budget deficit (which is not much higher than Germany's). Rather, it is being punished for sins committed in the 1980s and early 1990s when it built up its public debt to levels that the markets have suddenly decided are unsustainable. What we are seeing, in other words, is a wholesale revision of the rules about debt that have held true for decades.” (Foreign Policy, August 18, 2011)

“The only quantitative evidence offered for this is that stock market turnover is now 150%, which, after a quick piece of mental arithmetic, implies that investors are holding stocks for an average period of only 8 months. So over the last ten years there seems to have been no discernible move to shorter holding periods – indeed the numbers are if anything a little higher at the end of the decade than at the beginning. And where turnover does increase this is unsurprisingly during the highly turbulent times of the dot.com crash from 2001 to 2003, and the credit crunch in 2008 and 2009. That apart, holding periods are pretty steady at around 3-4 years. And that of course doesn’t mean that managers only stay invested in companies for that length of time: a lot of turnover is because of investors coming in and out of the fund, or decisions by the manager to increase or reduce holdings, rather than to sell up and walk away. (Fundweb, August 5, 2011)


Levels:

S&P 500 Index [1123.53] – Trying to hold 1120 while approaching intra-day lows of August 6 at 1101.54.

Crude [$82.26] – Since May 2, the commodity has decreased by 28%. Failing below $85 signifies a new era of weakness.

Gold [$1848.00] – Since January 25, Gold has risen by nearly 40%. Uptrend intact as a shelter against paper assets.

DXY – US Dollar Index [74.24] – Barely above annual lows reached on May 6, 2011 at 72.96. Interestingly, since that period the Dollar has mostly hovered around 74 as the 50 day moving average stands at 74.71.

US 10 Year Treasury Yields [2.06%] – The intra-day lows of 1.97% on August 11 were a few points below the 2008 mark of 2.o3%. An illustration of the rush to treasuries as yields has declined from annual highs of 3.76% in February 2011. Basically, from a historical perspective this is an unchartered territory.


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