Market Outlook | October 3, 2011

“We must embrace pain and burn it as fuel for our journey.” - Kenji Miyazawa (1896-1933)

Realignment and Realities

At this point of the cycle, the question is whether or not we have endured enough pain. Following a lost decade, triggered by the peak in 2000, the longer-term cycle supports a few ugly years ahead for traditional assets. It’s quite evident we are in a period of deleveraging, with a reassessment of sovereign risk and a makeover of financial systems. Through this cycle, Europe reminds us of the consequences of a fragile banking system and the interlinked nature of the debt crisis. For strategists, this fails to restore confidence in previous models designed to forecast the next five to ten years. There will indeed be reshuffling in sectors where unraveling constrains the pace of a recovery.

Beyond the political noise and radical financial resolutions, the markets themselves demonstratively showcase the lack of confidence coinciding with the failure of stimulus efforts. As usual, reacting to the truth is unfortunately more painful than the artful process plaguing fund managers. Of course, weak periods spark further emotional responses as frustration echoes in participants and even politicians. Usually an election year in the US has some relevance on market behavior; notably, the third year of a presidential cycle typically generates some optimism for a turnaround. However, this time the impact on the business cycle may be unlike previous years, given the growing list of financial and economic worries. The robust status of the developed world, or capitalism, is not too comforting for a global investor. This is entering unchartered territory for private and public decision makers and risk managers of this generation. The stakes are higher, while the experience to deal with crisis is rarely taught in business schools or banking training programs.

Essentially, more time is needed to accept the new realities before sparking a tangible change. Common bullish clichés have been nearly used up since February 2011. Examples include: valuations are cheap, faith in pending intervention, “Don’t fight the Fed,” and historical evidence of markets ending up higher. Those applying these concepts have noticed the market forces are too entrenched in lingering debt and economic issues. Therefore, when making timely trades one should stay cautious, so as to not lose the essence of this backdrop. Basically, denial was the mistake leading to and from the events of 2008. Thus, maybe now enough observers, consumers, and policymakers are begrudgingly adjusting overall expectations in line with truth. Before being washed up with growing negative sentiments, one should not forget that in its current state the US offers relative attractiveness, even in this secular bear market.

Safe for Now

Accumulating shocks forced investors to scramble for liquidity or safety. After all, when in crisis human nature dictates self-preservation behavior. It is simply a collective response to cling to basic investment approaches while deleveraging. Gold, Treasuries and the US dollar remind us that a “reset” of new realities translates into inflow toward the liquid assets which are perceived to be safe. In looking ahead, assuming that “safe” assets are immune to underperformance may be equally troublesome once the dust settles. In due time, tracking movement away from liquid instruments can provide some clues as to shifts in risk appetite. For now, shelter is in high demand while other benchmarks are not putting up a relative fight to attract risky capital.

Navigating Year-End

Entering a new season, and a new quarter, brings some hopeful thoughts for those with the ability to quickly erase memories. Last quarter damaged most equity and commodity managers. It was a historic July to September period, when considering annual lows in stock markets, very low yields, currency adjustments and interventions, low bond offerings and tense government deliberations. Interestingly, last month witnessed the Dollar higher, while Gold showed its first major dent in a while. Now, the S&P 500 and the commodity index (CRB) are down over 10% for the year. Managers are faced with either doubling down to play catch up before year-end or throwing in the towel with desperate macro conditions. Surely, both positions are discomforting in a period of liquidity, obsession and increased sensitivity. Therefore, in the near-term, closely watching the impact of currency adjustments, actual results of the European resolution and Federal Reserve action can serve as indicators for potential catalysts within this downturn.


Article Quotes:

“Why should we have any confidence that a deal can be done this year, given how badly the Greek support package has been handled? Since most of the public thinks a default has already taken place, would there really be that much of a shock from a ‘hard default’, as distinct from a negotiated exchange offer? Yes. It’s not the write-offs of Greek state debt as such that would be the problem, but the possible consequences to the stability of the euro area payments system. If the Greek government does not have the cash to pay for essential services as well as debt service, say in December, then it might have to resort to its powers under Article 65 of the latest version of the European treaty. Those allow for limits on the otherwise free movement of capital for the purposes of taxation, or ‘supervision of financial institutions’, as well as “public policy or public security.” (Financial Times, October 2, 2011)

“From 2002 to 2008, the states had piled up debts right alongside their citizens’: their level of indebtedness, as a group, had almost doubled, and state spending had grown by two-thirds. In that time they had also systematically underfunded their pension plans and other future liabilities by a total of nearly $1.5 trillion. In response, perhaps, the pension money that they had set aside was invested in ever riskier assets. In 1980 only 23 percent of state pension money had been invested in the stock market; by 2008 the number had risen to 60 percent. To top it off, these pension funds were pretty much all assuming they could earn 8 percent on the money they had to invest, at a time when the Federal Reserve was promising to keep interest rates at zero. Toss in underfunded health-care plans, a reduction in federal dollars available to the states, and the depression in tax revenues caused by a soft economy, and you were looking at multi-trillion-dollar holes that could be dealt with in only one of two ways: massive cutbacks in public services or a default—or both.” (Michael Lewis, Vanity Fair, November, 2011)

Levels:

S&P 500 Index [1131.42] – Flirting near annual lows and few points removed from 15 day moving average of 1171. Meanwhile, the glaring lows are being closely watched and sit at 1101.54.

Crude [$79.20] – Buyers in the past few weeks found $80 attractive after heavy selling at $92 and $100. Buyers’ patience is tested as the commodity continues its five month decline.

Gold [$1622.30] – Back to early August’s pre-frantic ranges, between 1600 and 1650. From September 6 peak to September 26, the commodity declined over 15%. The ultimate test will come in weeks ahead while the uptrend and positive annual return remains intact.

DXY – US Dollar Index [78.55] – Maintaining an uptrend that sparked last month, however the follow through is not fully convincing. Next key and previously familiar level stands around 80.

US 10 Year Treasury Yields [1.91%] – No major signs of a recovery while trading at the lower range of recent lows.


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