Market Outlook | September 19, 2011

“Failure is not a single, cataclysmic event. You don't fail overnight. Instead, failure is a few errors in judgment, repeated every day.” - Jim Rohn (1930-2009)

Much attention is consumed on the “failure” of various systems, plans and policies. The European banking system is in shambles, and the residues of the sovereign debt crisis have not fully played out. These are tiresome topics desperately needing resolution, as the era of postponement is no longer viable. The pain felt from the real economy contributes to a lack of patience in the audience.

In the near term, the Federal Reserve is already providing dollar liquidity to European banks. In a sensitive environment bad news is magnified (downgrades or weak growth), while infecting or at least influencing other economies at a rapid pace. There is no escape from this matter, even for the strongest economy in Europe. “Germany's 10 biggest banks need 127 billion euros ($175 billion) of additional capital” (Reuters, September 18, 2011). This is a historic period where the Eurozone is being redefined, with desperate times leading to ugly and unimaginable results.

Harsh Landscape

Overnight scrambles, quick solutions and projection of confidence are required by European leaders during this “reconstruction” period. Plus, the details of the current banking procedures, along with consequences of alternative solutions, are sensitive just as much as complex. In other words, the pressing problems are too cumbersome for any political slogans in Europe or the US. Obviously, the nature of governing and conducting markets inevitably includes political and stimulus constraints. This theme merely sums up most of this year, especially in Europe when dealing with various nations. Interestingly, the bailout debate (similar to the US banks in 2008) is not erasable from near term memories, and heated debates are only normal at this point.

Relative Realities

Despite the backdrop of worries, the downtrend message took a brief breather in broad index performance. The S&P 500 index appreciated, by more than 5% last week. Major indexes are climbing back in an attempt to break even for the year. Albeit, it’s a slow and “temporary” recovery process, after the severe August demise. The relative argument of the US is on the radar for investment managers. Clearly, a significant shift to treasuries, as well as the Dollar, in recent months reiterates that message loudly. Select investors can afford to be choosy in purchasing as majority managers flirt with safer positions.

After the entire saga, the relative argument reminds us that the leadership in financial markets is in the US, at least for now. Growth seekers are not too impressed in this setup, as much as distressed, along with value asset buyers who can find opportune ideas. Further clues lie in the next few days, as to the faith of quantitative easing, and intermediate term interest rate policy. Curious minds have wondered if central bank tools are overly exhausted, especially with low historic rates. Others wonder if the summer sell-offs created such a deeply beaten up sentiment, in which a bottoming process formed in mid to late autumn. Continued stabilization in pricing, along with declining volatility, can provide an upside surprise in the fourth quarter.

Finally, emerging markets have not distinguished themselves in terms of absorbing the stock market in recent risk aversion. Brazilian Index (EWZ) is down 24% and the Chinese index (FXI) dropped by 20.4% since April 8. 2011. Interestingly, both countries are cooling off from multi-decade run, especially in housing. Meanwhile, during the same period, the S&P 500 Index lost 8.4%. That said, Brazil and China’s influential role for upcoming years is a vital macro mystery. However, the investor response showcases that many are not piling capital to developed markets. Instead, capital allocators are glued in on the survival tactics of the developed world.


Article Quotes:

“In the seven years from 2001-2007 (inclusive), not only did the middle class get at least its fair share of overall income growth, the income gap between the rich and the middle class actually got smaller. In an apparent paradox, the same Census Bureau database that told us that median household income was essentially unchanged in 2007 versus 2000 also tells us that the middle class enjoyed a higher income growth rate than did either the overall economy or the rich—and therefore that their income gap versus the rich had actually decreased… The key lies in the difference between the “median household” versus the “middle class.” The median household is a single theoretical household exactly in the middle of the entire income-ranked list of U.S. households. Conversely, the “middle class” has no official definition, but it is certainly tens of millions of households in size and presumably centered around the median household.” (The Journal of American Enterprise Institute, September 16, 2011)

“Local [Chinese] governments have created more than 6,000 arms-length companies to circumvent restrictions on bond issuance, creating a huge patronage machine for party bosses that has largely escaped central control. The audit office said the loans have reached $1.7 trillion (£1 trillion). While some of the money has been used to finance much-needed investments in water systems and roads, a large part has fuelled unbridled construction with a dubious rate of return. Mr Cheng said China is entering a "very tough period" as growth runs into the inflation buffers, threatening the sort of incipient stagflation seen in the West in the 1970s and leaving the central bank with an unpleasant choice. ‘The inflation rate and the growth rate are conflicting with each other: it is very troubling,’ he said, describing what is known to economists as the Phillips Curve dilemma. (The Telegraph, September 17, 2011)

Levels:

S&P 500 Index [1216.01] – Climbing back to 1200 within a new define range of 1160-1220. A consolidation period following the sharp and recent sell-offs.

Crude [$87.96] – Hardly any changes from last week, as the commodity remains fragile below the $90 range.

Gold [$1794] – Early phase of consolidation, as 1750 is the next worthwhile point to test investors’ buying appetite. For now, there are no signs of alteration to the long-term uptrend.

DXY – US Dollar Index [76.59] – The follow through to the recent rally is not yet fully determined. Uptrend is intact, as the index is above its 200 day moving average.

US 10 Year Treasury Yields [2.04%] – Slight breather from risk aversion has yields back up to 2%. The 15 day moving average stands at 2.06%.





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