Market Outlook | October 31, 2011

“Free will is an illusion. People always choose the perceived path of greatest pleasure.” - Scott Adams (1954 - Present)

Connecting Puzzles

Last week, lots of attention revolved around the temporary European deal. However, the recipe for increased risk tolerance and market uplift has been in the making, apparent when looking at recent trading days. Hints of an improving October go back to earlier in the month. October 4 presented a noteworthy minor trend which may extend into a larger intermediate-term trend. On that day, the Volatility (VIX) peaked from high turbulence, S&P 500 Index set a bottom after harsh September sell-offs, strength of the dollar broke to the usual downtrend, and finally the commodity index (CRB) rose from its lows. All these patterns accelerated to shiny headlines, illustrating a very strong month by historical measures. Ironically, this run is highlighted by the combination of a deprecating dollar and higher asset prices, which ends up revisiting the all too familiar theme of last decade. Puzzling indeed, if lessons from past cycles have yet to be fully learned in favor of near term pleasures.

As usual, the interrelation of macro indicators is driving the prevailing theme. Much of the month end discussion circles around the explosive stock market run, as the series of events are tilted to paint a positive picture. Quantitative Easing 3 discussion points may surface around the corner, and serving as recent momentum they can set the stage. Not to mention, an improving third quarter growth in consumer spending brought some relief as well. Market "catalysts" vary from cycle to cycle, but this type of recovery pattern and policymaking is typical. Specifically, the overly negative sentiment became quite at a rapid pace. The curiosity of observers will shift to impact on interest rates and inflation. Clearly, sentiment or market patterns are shifting at a rapid pace.

Grasping and Digesting

Taking a breather for a second, it is fair to rationalize that few issues contributed to the uncertainty. In a glaring way, the S&P 500 Index mirrored the Euro for several weeks. That reflected emphasis on the power of sentiment, rather than trading on fundamentals. “The 50 stocks that were down the most from July 7th through October 3rd are up an average of 35.3% since then! Conversely, the 50 stocks that held up the best during the summer correction are only up an average of 6.9% during the current rally, which is severe underperformance.” (Bespoke Investment Group, October 28, 2011) Similarly, the connection between the currency and stock markets feels more like a sentiment poll, as much as an index. Eventually, worn out money managers are caught in the usual state of confusion. Surprises seem uncommon, but who would've thought the S&P 500 would flirt with 1300? Perhaps some did but not many, especially not in the dark days of July or September’s worrisome lows. Again, fathoming the unfathomable is yet again the reoccurring lesson. Clearly, social debates or political quarrels dominate airwaves, but are not always reflected in broad index performance. These concepts are hard to grasp when applying logic while disregarding psychology. In fact, casual observers are confused by the discrepancy of downgrade implication, sluggish economic factors, bubble talks in China and political power shifts in key geographic areas. These issues remain mostly unresolved from a practical angle, but shrewd observes have acknowledged long ago it is a game of perception.

Deliberation

Finishing out the year on a positive note is commonly desired and witnessed. In fact, it appears to be in the minds of most, and can be easily converted into a self-fulfilling prophecy. Fatigue of bad news is only natural, but temporary urges may not cover up the existing pain. Within a few hours after the European solution, several skeptical opinions circulated stating that sustaining “comfort” will be daunting. Interestingly this week, the Federal Reserve will host a press conference at a time its members internally disagree on methods of fueling the economy through monetary policy. Balancing investment performance with reality is the internal dilemma that haunts long-term participants. An illusionary backdrop persists for fund managers to showcase net gains or to further cut into losses. Discomfort continues in formulating a thesis, but the mystery is in visualizing the magnitude of accumulated damages yet to play out.

Article Quotes:

“Since July, real disposable incomes have been declining. Although the decline in September was modest, it still helps to explain why consumers are so gloomy: their disposable incomes have been falling over the past three months. Really, they had been virtually stagnant all year leading up to July too. The income growth we saw from late-2009 through mid-2010 sort of just stopped. Now it has reversed. The September value was the lowest since April 2010. Prior to the recession, disposable income per capita hit and blew past its September 2011 level in September 2006. In other words, over the past five years Americans, on average, have seen no disposable income growth if you adjust for population and inflation. This also explains why they're spending like it's 2006 -- because they don't have more money to spend. No wonder the recovery continues to feel like a recession: that's an awfully long time to go without a raise.” (The Atlantic, October 2011)

“One of the curious paradoxes of population growth is that the more able people are to sustain large families, because they become wealthier, the less inclined they are to actually have more children. So, while greater affluence is often blamed for increasing the strains on the world's finite resources, it is possible that a richer world may be a more sustainable one because it will cause a natural leveling off in population growth. That is some way off, however. In the short term the number of people will continue to rise and this has a number of implications for investors. Three of the more important are related to food, urbanization and growth in consumption. It is estimated that food production will need to rise by 50pc by 2030… The solution cannot simply be to bring more land into cultivation because the most productive has already been used and industrialization and urbanization are eating into what is already under the plough.” (The Telegraph, October 29, 2011)

Levels:

S&P 500 Index [1285.09] – Notably breakout of the multi-month sluggish range. Next, key target sits at July’s peaks between 1300-1350.

Crude [$93.32] – Further reacceleration as the commodity nearly approaches the 200 day moving average of $94.76.

Gold [$1741.00] – Recovering from a short-lived pause in which 1600 showcased strong buyer enthusiasm.

DXY – US Dollar Index [75.06] – Dropped nearly 6% for the month so far. Resorting back to the well-known range $74-76 range which was seen in spring and summer months.

US 10 Year Treasury Yields [2.31%] – The trade away from risk aversion drove yields higher from historic lows. Ability to hold to surpass, and hold above 2.40%/2.50%, will be a key test in upcoming days.


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