Market Outlook | September 6, 2011

“There is nothing so strong or safe in an emergency of life as the simple truth.” - Charles Dickens (1812-1870)

At the start of the summer, very few ideas presented an excitement of innovation or growth. That did not change much throughout the season. The majority of the summer focused on the game of survival for investment managers. As August drew to an end it marked some relief for observers, after a month of discussions surrounding debt ceiling, downgrades, very sharp down days, escalated fears, system breakdown and rapid movement toward “safe havens.” The scramble away from risk is the glaring theme, and visible in lower treasury yields, for further shelter in Gold and rotation into the Swiss Franc. This shift is nauseating for the day to day news follower, but the currency, bond and commodity markets continue to point to the same message of seeking safety. Rather dull for those searching for growth ideas. Dreadfully, investors are adjusting to new realities and expectations.

The start of a new month and season does not erase all those fierce summer memories right away, or reignite confidence restoration at a desired pace. In fact, some are wondering if “safe” assets are forming a new bubble. Perhaps it is premature to declare that the obsession with risk-aversion is hitting extreme ranges. Importantly, traditional assets such as stocks and fixed income are failing to meet risk and return parameters. “In Europe, pension funds slashed their weightings for equities to an average of 31.6 percent in 2011 from 43.8 percent in 2006, while fixed income holdings rose to 54 percent from 47.8 percent in the same period, according to Mercer.” (Reuters, September 5, 2011). Clearly, this is a period where the appetite for risk is declining and kneejerk recovery thoughts are taking longer than expected. More so, the change in behavior by fund managers alters some patterns, while opening up few alternative opportunities, due to pending legal or mandate shifts.

The inverse relationship between stock prices and volatility appears to set the framework between now and year-end. In terms of judging sentiment, a break below 1120 for the S&P 500 would spark worrisome selling pressure, at least from a chart observer’s perspective. At the same time, the volatility index (VIX) is hovering above 30 range, which is less inviting for buy and hold managers. This makes it even less stable for businesses leaders to plan ahead with any clarity. Clearly, this creates a troublesome environment for policymakers, who must stay nimble in their messaging. In other words, it is vital to avoid adding fuel to the fire. Similarly, staying idle is merely not an option when facing the pressure of election year.

Naturally, the thought stimulus (i.e. QE3), which comes up at times as skepticism, remains too high along with lower cooperation. The growing “annoyance” theme is picking up momentum when considering recent discussions of bailouts, currency wars, taxes, and other trends in international business. Thus, sideline observers sense no rush to buy traditional assets while having the convenience of waiting for even cheaper prices in the future.

Two sensitive themes that can spark early hints for any imminent recovery:

1) Fragile Banking Status

In Europe the sovereign debt crisis is affecting banks greatly. As usual, Financials lead on the way up or down. Over two years of Euro-zone troubles, combined with bailouts and interventions, contribute to the selling pressure. The frenzy and panic is in full force as crisis resolution continues to play out.
For a few trading days investors realized that the euro zone problem is not quite the same as that faced by American banks. Despite US banks’ clean-up efforts of 2008, the ongoing worries are hard to shake off. Large US banks feel the residue of greed and neglect driven practices that continue to persist through headline risk. This is highlighted by Bank of America's heavy stock price correction, and other recent legal risks, that deflate any confidence in an already depleted macro climate. Regardless of the low borrowing rate, the sentiment is too beaten up. Calmer minds point out that banks were profitable in the second quarter, and value investors will flirt with entry points.

2) Economic Enigma

On one hand, the job discussion is, as usual, back at the social and political forefront. Meanwhile, the US GDP growth (or lack thereof) is in the minds of economic projectors, influencers and decision makers. Various observers are struggling to “spin” a good story as to the job’s report, which continues to restate previously known information.

For a decade, much emphasis in emerging market growth kept earnings of larger companies intact. These days, the much anticipated global indicator is closely tied to China’s growth. Recently, a bank reduced the Chinese GDP estimates to 8.2% from 8.5%, sparking some early concerns. Inflation worries have lingered, but any slowdown here is cautiously tracked, given the tense global market. Any upside surprise element in this data can spark a hint of recovery. Otherwise, reemphasis of the weakening trend is all too common these days.

Article Quotes:

“The current turmoil eventually will lead smaller European countries to look for ways to tie themselves much more closely to the euro. That is what happened in the 1970’s, during the original wave of currency turmoil: the Scandinavians and the Swiss negotiated to associate themselves with a European currency regime. Today, the logic of that strategy has become even more compelling. The benefits of euro membership are also clear to many other small economies. Slovenia, which entered the eurozone in 2007, and Slovakia, which joined at the beginning of 2009 – just as the cresting financial crisis slammed shut the door to further euro enlargement – have enjoyed much greater financial stability than their untied neighbors…. The turbulence reinforces the lesson – fundamental to the rationale of establishing the euro – that ordinary people and businesses should not be exposed to exchange-rate risk.” (Project Syndicate, September 5, 2011)

“Economies usually need around $4 dollars of capital to produce $1 of output. On this basis, China needed to invest 40 per cent of its GDP to create the capital required for its 10 per cent growth. To increase the ratio of capital to output (which is part of the convergence story), China's investment had to grow even faster – which it did. …China's huge saving reflects the high retained profits of state-owned enterprises, giving room to absorb the bad debts within the overall government sector. Thus it's possible to map-out a set of adjustments which would keep China on a high-growth track. …But China's policy challenges (reducing savings, getting consumption up and the current account surplus down) seem infinitely easier than the challenges faced by America, which has to narrow the huge budget deficit by raising taxes and rein in the external deficit by expanding exports.” (Business Spectator, September 5, 2011)

Levels:

Prices based as of September 2, 2011.

S&P 500 Index [1173.97] – New range between 1150-1200. No major changes since last week. Heavy resistance around 1200, while breaking below 1120 can spark further selling.

Crude [$86.45] – After failing to hold $100, the commodity is trading between $85-90 as a long-term trend is fuzzy.

Gold [$1875.25] – Brief pause followed by an acceleration nearly testing the August 22 highs of 1877.

DXY – US Dollar Index [74.75] – Four month average continues to hover within the current tight range, around 74.

US 10 Year Treasury Yields [1.98%] – Closing at annual lows as breaking below 2.00%, significant yet another decline in trends. Previously, the lows of December 2008 stood at 2.03%.

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