Market Outlook | September 26, 2011

“Considering how dangerous everything is, nothing is really very frightening.” - Gertrude Stein (1874-1946)

When weakening economic realities are mirrored in financial markets, then there is not much debate as to the current conditions. In other words, previous stimulus efforts may have held up equity markets while failing to inspire tangible growth. The low rate policy and other stimulus efforts are not deceiving those involved, as the truth is slowly being discovered. In short, when reality harshly confronts subjective perception the outcome is profound. That’s the daunting downtrend in nearly all asset classes and developed economies. Importantly, the financial system is less welcoming for those mapping out plans from six months to three years. Price declines tend to flush out existing fears and “deflate” prior hopeful estimates. Of course, this is an ugly but necessary process that’s taking place as the S&P 500 Index attempts to hold 1120, while other international indexes sit at annual lows.

Fragile Banking

Through this puzzle, the central banks are trying to restore confidence against an less forgiving crowd. When Quantitative Easing 2 ended in June of this year, a dose of uncertainty was already looming, and clearly contributed to July’s explosive negative market response. Perhaps, medication creates more side effects, and the rest is more about clinging to survival. This theory will be tested especially after the disappointing result of QE2, which has augmented the number of skeptical observers. Thus, participants will digest the pending results of further low rates, along with the potential Quantitative Easing part 3. Let’s not forget, three Federal Reserve officials dissented last week, showcasing lack of agreement. It remains a tense period in which the central bank can hardly afford to lose credibility from participants or political establishments. However, the verdict of recent Fed actions remains too early to judge.

Simply put, it’s hard to dismiss bank downgrades (US and Europe), and ongoing legal and balance sheet pressures persisting daily. Interestingly, Bank Index (BKX) peaked on February 18, 2011 a few months ahead of the rest of the broad and emerging markets. Thus, this negative sentiment in place has been noticed by insiders. Clearly, the environment is beyond bubble bursting, or reshuffling of risk appetite by investors. Basically, the current banking environment remains too tricky to deal with and fragile.

Directional Discomfort

There is enough discomfort to go around for buyers and sellers of various asset classes. As a start, Gold owners feel slightly shaken by the recent pause within the well-defined upside momentum. Plus, fund redemptions are forcing mangers to sell winners, with Gold being one of the few winners in recent months. Thus, selling pressure in the commodity (i.e., quasi currency) is triggering some questions for future trends. At the same time, the US dollar uptick is now a mild trend that is slowly making a strong macro statement against other currencies, as well as the “inverse Gold” trade.

In terms of global equities, heavy betters against emerging markets or US stocks fear a potential sharp recovery heading into year-end. There is not much comfort in doubling down on downtrend moves after the Emerging Market index (EEM) has already dropped nearly 30 percent since May 2, 2011. Although it has been a profitable trade to go against markets, reversals are inevitable which can test even the strongest convictions. This seems comforting to those who envision a sustainable downside move that would take us back to 2008 ranges. However, this remains a rather aggressive point to claim, even with a battered sentiment.

On the other side, buyers looking for “cheap” value are contemplating the realities behind improving fundamentals. The pace of M&A deals has slowed, and hesitancy has increased in business decisions. Therefore, sticking to previous estimates leads to mismatched expectations. Value seekers sway between deciding if prices are cheap enough and exercising further patience. Waiting for confirmations seems like the easier path, but with year-end approaching risk takers may look to jump in ahead of the fourth quarter. To add further spice, a slowing China, increasing volatility and an unresolved Europe can drive many more to the sidelines or hunting for “safe” assets. Yet, cash does not pay much with low rates, equities have not paid due to weak performance and momentum themes such as commodities are slowing. Thus, pent up demands for new investments are bound to light up soon enough.

Types of Sellers

1. Profit takers on previous positions
2. Unenthused by fundamentals and earning potentials
3. Forced to sell based on fund redemptions or liquidation
4. Reducing overall exposure due to a lack of faith in the financial system

For any participant, understanding the nature of sellers in each asset might provide the next clue for when to buy, or the magnitude of the selling pressure. During jittery periods, investment models will have to adjust to these dynamics, as emotional responses are leading decisions. Most can agree that comfort is a scarce commodity, discomfort appears relatively normal, and fear is in abundance.


Article Quotes:

“The biggest emerging markets, with their huge foreign-exchange reserves, appear to be almost crisis-proof (at least outside eastern Europe) in contrast to the seemingly crisis-prone rich world. But setbacks in making the shift from poor to rich are inevitable. Indeed a lesson of recent economic history is that countries and regions that ride out a crisis well are all the more vulnerable to the next one. Hubris leads to policy mistakes, as the developed world has proved so devastatingly. So thick is the gloom pervading the rich world that the once-regular emerging-market crises have almost been forgotten. But this makes it even likelier that they will one day return. … A less frantic rate of growth in the developing world would also slow the relative decline of the West and allow it to cling on to some of its privileges for longer. The dollar and the euro could maintain a reserve-currency duopoly for longer; commodity-price pressures on businesses and consumers would ease; and the impact of developing economies on relative wages and jobs turnover might be less jarring.” (The Economist, September 24, 2011)

“Although China may look like a rising economic and political competitor today, that situation could quickly reverse. The wildly erroneous predictions of "Japan as Number 1" three decades ago should warn the outside world not to over-react to the "China threat". Punitive US measures in response to China's mercantilist trade and currency policies and disregard for intellectual property rights, however justifiable on the merits, could create the impression in China that the US has created, or at least hastened and deepened, its economic stagnation. The United States should avoid providing the CPC regime any excuse to claim the United States is the cause of China's woes. If the Chinese people as a whole ever adopt that view, US-China relations could be poisoned for decades… The United States and the international community should also recognize that, as China's economy deteriorates, any confrontational military maneuvers are likely to be met with escalation rather than compromise. (Asia Times, September 15, 2011)

Levels:

S&P 500 Index [1136.43] – Barely holding above early August lows, while attempting to bottom out above 1120. It closed at the lower end of the recent range.

Crude [$80] – Along with global equities, the commodity topped out in early spring. Currently the challenge is to stay above $80.

Gold [$1689] – Previously, 1750 marked a key level for buyers to reenter. Yet, the selling pressure is mounting in the near-term, as it remains above its 200 day moving average of 1520.

DXY – US Dollar Index [78.50] – April to August provided a dull and neutral period. There has since been an explosive upside move of 7% as of August 29.

US 10 Year Treasury Yields [1.83%] – Multi-generational lows. 1.67% marks the intraday lows reached on September 23.





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