Market Outlook | June 20, 2011

“Crisis and deadlocks when they occur have at least this advantage: that they force us to think.” - Jawaharlal Nehru (1889-1964)

Illusionary Comfort

For several months, the fragile credit conditions were occasionally forgotten or dismissed on some participants’ agenda. A rising or stable performance in global indexes created some illusionary comfort, until May came around the corner for a quick gut check. Today, the “peace of mind” in financial markets is under severe questioning, in which emotional responses are too charged up. This worrisome credit pattern is all too familiar and simply nauseating to address for government officials faced with restructuring loans. Wishful thinking of Greece not defaulting may signal a denial or postponement of the harsh reality.

The bail-out and bubble prevention debate is resurfacing, in which risk is infectious for inter-linked markets. At times, it has investors wondering about this philosophical or political debate for European leaders. Clearly, bail-out and bubble prevention boldly hint at a deviation from normal business conduct. Importantly, in practical terms, this European resolution attempt translates to flimsy investor confidence, while the social unrest adds to jittery headlines. The rugged and witty investors will attempt to decipher a long-term opportunity from this mess. However, this Greece case is a daunting task (measured by high risk) ahead for the visionary looking to bet on turnarounds.

Reminders

Conceivably, we’re in an era where bad news carries lesser weight than prior years. These credit concerns are bound to profoundly persist and cannot easily vanish for both the Euro Zone and US. In an awkward manner, the credit markets disturbance in Europe is mirroring the US investment bank collapse of 2008. The definition of “safer assets” most likely requires some adjustment for years ahead. Those engrained with the thought that safe instruments include CD’s, US treasury bonds, or government bonds will have to rewire that thought process. In fact, claiming emerging markets as a riskier asset might be a misleading statement as well, given the changing global landscape. The unknowns are plenty, but most can agree that a transitory period in financial systems is in full effect.



Near-term Matters

The S&P 500 closed the week slightly up and barely positive for this year (up 1.1%). Of course, we are only around the midway point of 2011, but the last few weeks have produced a clear negative message in investor confidence. The volatility index (a panic barometer) has nearly doubled since April 28th in conjunction with the early May sell-offs.

As usual, the crowds seeking buying opportunities will reexamine purchasing US stocks, which still have some relative appeal (perception based) for now. Similarly, chart observers are bound to point out the favorable odds for diving in based on discounted pricing. Frankly, the “buy” crowd would strongly argue that interest rates continue to decline along with the dollar; thus, the macro picture has not changed dramatically from the “steady up days.”

Yet, a confirmation is needed to claim that the recent blending has fully played out. Meanwhile, a trend reversal in US rates or dollar, combined with fearful mindset, can create a painful buyer scenario.

Article Quotes:

“Some argue that both the US Dodd-Frank Act and Basel III capital requirements have now ended US bail-outs. But these efforts do not solve the fundamental flaw in the system: there are highly complex and opaque banking organizations engaged in a variety of non-core, high-risk activities while backed by a public safety net. The problem is not that banks take risk, but that some are too complex for anyone to assess and control that risk...These new regulatory changes actually extend, or make more complicated, what we have tried to do before. For example, Dodd-Frank requires enhanced prudential supervision and regulation that increases incrementally with the systemic risk of the largest financial companies. Yet that design simply cannot be effective if the risk cannot be monitored or assessed.” (Federal Reserve Bank of Kansas City, Financial Times, June 16, 2011)

“First, we were asked, ‘How would you describe the US economic and financial positions relative to the rest of the world?’ The (rounded) responses came back: Getting Better (16%), Stable (26%), Getting Worse (47%) and In Permanent Decline (11%) – yikes! Those reactions seemed unduly pessimistic. America may be struggling, but compared to what? Look around. The European periphery is teetering; Japan is reeling from a nuclear meltdown; China appears to be slowing; and the Middle East is in turmoil…. The BRICs are hardly a well-kept secret any longer. They are battling inflation and have proved vulnerable to market volatility. Does valuation count for nothing? Over five years, emerging markets are up 12.2% versus the S&P, which has gained just 2.73%. Mean reversion and contrarian sentiment would suggest it is time to consider buying those American stocks!” (Fundweb, June 14, 2011)

Levels:

S&P 500 Index [1271.50] – Attempting to bounce back after briefly touching the 200-day moving average (around 1258).

Crude [$93.01] – Steep decline continues and, like equities, approaching a key technical range around $92.

Gold [$1537.50] – Unlike other commodities, the uptrend is in tact. Flirting and not far removed from all-time highs of 1549.

DXY – US Dollar Index [74.98] – The May recovery is not convincing of dollar sustainability for now. Follow through is desperately awaited.

US 10-Year Treasury Yields [2.94%] – In the near-term, holding at current levels while defining annual lows.

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