Market Outlook | September 12, 2011

“Courage is the art of being the only one who knows you're scared to death.” - Harold Wilson (1916 - 1995)

The rules of engagement, these days, are being redefined for investors, consumers, borrowers and lenders. For one, the turbulent conditions of the developing world are beyond finding growth and more related to establishing stability in the system. This weekend, the fear of a Greece bankruptcy looms; which is not a surprise to anyone. Rather, past denials and delays are catching up rapidly in this bitter but well known matter. Meanwhile, chatter of the downgrade of French banks serves as another addition to the “fear” menu. Similarly, money market mangers continue to adjust overall risk exposure, which contributes further to an abnormal period in financial systems. Secondly, through this unstable sentiment, the emerging market growth rate is being questioned by investors who piled on with high return expectations from recent years. Inflation worries might be overblown, but remain a topic of high interest. When combining the preceding interlinked issues, it becomes quite inevitable to foresee heavy government involvement in currency usage, demand for problem solving and coverage of ongoing stimulus efforts.

The gigantic challenges misinterpreted by most and dramatized by others, for a recovery, are not easy when adding political constraints and a depleted investor sentiment. Clearly, the confluence of macro issues paints the chaotic landscape of major stock price swings that are biased to the downside. A synchronized global resolution that appeases all key economies is not practical. That’s the harsh reality facing global markets and stakeholders. Therefore, the consequence of select compromises and future pain can fuel conflicts in international rulemaking. It is a very edgy environment in which negotiations are tense, especially in the Eurozone. It is quite clear there are more questions at hand that hint to the magnitude of pending declines. After all, for years human behaviors have showcased big capital favors momentum, along with a sense of calmness to reestablish a new wave of growth ideas. Unlike 2008, we are not correcting from a new bubble, but rather confronting the residues of over-borrowing. There is a cost to ignoring and delaying, and that’s where we stand these days.

Rush for Hideouts

The highly trending behavior is focused on perceived safe instruments. The pace of rotation into US treasuries, Gold and other safe currencies has picked up investor demand. Basically, seeking a temporary shelter does not necessarily translate to long-term growth prospects. This era can be rewritten as the great rush for hideouts, which has been fruitful from a return perspective.

The US dollar recovery is receiving some attention after a noticeable breakout in its chart pattern. The dollar index (DXY) is witnessing a revival, given this recent one month run which is moderately newsworthy. One of the few big themes to see is trend reversals which trigger a sense of excitement, for good or bad. Of course, spurts of upside runs in the greenback have been seen before; however, the multi-year decline is the real story when looking at the full picture. Now, a rising dollar is anticipated to inversely impact crude prices and make a competitive appeal versus other currencies (e.g. Franc and Yen). This should have eager currency traders intensely awaiting a follow through in the days and weeks ahead. Glaringly, this rotation to the dollar is a further emphasis of present safety concerns, which matches the overarching theme that is too dominant.

Digest and React

Hedge fund’s August returns demonstrated that investment models were not quite equipped for the turbulent summer months. Especially when considering the year to date numbers in which the small cap index is down 14%, and the Morgan Stanley cyclical index has declined by 21%. That is a significant dent that leaves an impact for momentum chasers and casual purchasers. In addition, the recent selling in financials is caused by adjustment to risk management, while others sold on all out panic.

Yet, there is some value to decipher in US markets, while a sense of urgency is not required to reinvest in the same old models. Instead, enterprising leaders will have to adjust to new business models and valuation methodology. Similarly, at some point portfolio managers will have to dive in to some buy ideas while managing the new era expectations. Interestingly, sell-orders continue to come in from Japan to Europe which delays the bottoming process. Awareness of hold ups and the extension of irrational behavior may be prized for cycle winners. Courageous moves are discouraged for now, due to high volatility, but rebuilding portfolios today while seeing beyond the temporary madness is the bigger reward for next decade.

Article Quotes:

“In theory, making the state into a purely financial investor rather than an operating partner…should be beneficial: entrepreneurs, not bureaucrats, run the business. Practice is rarely so neat. Cities back companies that provide local jobs. That affects acquisitions and disposals, where factories are built and where research takes place. Worse, China’s private-equity industry has become another lucrative billet for the children of powerful officials. It is also troubling that little is disclosed about the operations and returns of these public funds. Many may be managed cleverly and provide money for municipalities and jobs for their citizens; others, though, may turn out to be financial black holes. Equally troubling, they receive favourable attention from local governments, to the disadvantage of China’s most dynamic sector, its truly private companies. ..Taken collectively, these iterations of state engagement reflect how China’s government has not only held on to economic control but found subtle ways to extend it. (The Economist, September 3, 2011)

“One significant concern is that, unlike Japan in the 1990s, the US is struggling at a time when growth expectations across much of the world are slowing. China is tightening policy and no one really knows the extent of contagion that may erupt from the denouement of the eurozone debt crisis, safe haven buying is pulling Treasury yields lower. While there are similarities between Japan and the US, there are crucial differences and 10-year yields below 2 per cent should be placed in context. For starters, the US does not face deflation at this juncture and also has a central bank that has been very proactive given its dual mandate of seeking stable prices and maximum employment. The US policy response since 2008 has been far faster than what occurred in Japan during the 1990s. Therein resides the hope for investors that the process of repairing financial and consumer household balance sheets will conclude well before the end of the decade.” (Financial Times, September 9, 2011)

Levels:

S&P 500 Index [1154.23] – Over the last 20 days the index averaged around the 1175-1177 range. Yet, it was not long ago when the S&P 500 traded around 1300. Thus, it is a fragile state indeed, where a move below 1120 can open flood gates for further panic.

Crude [$87.40] – There is a recent struggle to reach above $90. The 50 day moving average stands at 91.10, and serves as a near-term hurdle for buyers.

Gold [$1851.00] – Flirted with 1900, while uptrend is intact. Buyer interest remains around 1750 in the recent reacceleration.

DXY – US Dollar Index [77.19] – Up by 5.10% since August 29, 2011. A break above 76 signals a positive technical signal.

US 10 Year Treasury Yields [1.91%] – Closed at annual lows. Well below the 15 month moving average of 2.88%. Investor mindset is adjusting to a new range below 2%.

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