Market Outlook | October 24, 2011

“Sentiment is the poetry of the imagination.” - Alphonse de Lamartine (1790-1869)

Inescapable

Key market forces cannot vanish or evaporate fast enough to revive a healthy uptrend. Eurozone suspense fails to create comfort for those betting on politicians reaching a resolution. Basically, “hope” is a risk that’s hard to quantify in a period of rapid sentiment shifts. Importantly, debt issues continue to prove that positive public messages are not sufficient. Meanwhile, the ongoing trend of downgrades by credit agencies is now a common persistent theme within the gloomy side of an inevitable cycle. As to the actual shock factor of further downgrades that's to be seen, and remains difficult for currency or bond market observers to gauge. In any case, participants have accepted the increased lack of uncertainty that is beyond the traditional asset management of recent generations. Clearly, the much discussed volatility index has remained in abnormal territory for longer than desired. Frankly, frantic patterns cause one to question the overall faith of the banking system as well as the readjustment in currency values.

Glimpse of Liveliness

In the past three weeks, a growing camp of optimists continues to emphasize “recovery,” especially in anticipation of quantitative easing. This is a puzzle in itself, since an operation twist is being digested in the recent Federal Reserve decision. The element of interventions finds a way to spark reversals, while skeptics view it as a plague to overall confidence. Yet, it is hard to deny the noticeable and mild resilience for scoreboard observers. Perhaps some will argue that a pause in the selling pressure leads to cosmetically appreciating global indexes. For example, the S&P 500 Index showcases adamant buyer interest between 1100 and 1150 levels. In some ways overall positive earnings, improving technical indicators and the presence of bargain hunters contributes to this psychological bottoming process. The market is betting on near/intermediate term mood swings rather than any long term clarity on fundamentals. Pursuing and executing profitable ideas on short-term biases are intriguing to some, frustrating to others and increasingly disinteresting to the rest. However, remaining open to surprises has proved to be valuable in making vital calls.

Untangling

The Federal Reserve’s active involvement continues to entertain buying further securities in a stimulus attempt. This leads to furious policy debates when mixing low historic rates along with the pending election year and weak economy. At the same time, short-term memory reminds us that when QE2 ended abruptly, it opened the doors for heavy sell-offs. It is fair to assume the stakes are high for stability, but clarity is hard to reach when a series of inflection points continue to accumulate. Among pundits, inflation is not viewed as a short-term concern in the US, but high inflation down the road cannot be dismissed. Similarly, an emerging market slowdown has arrived, but the magnitude of declines is not fully understood. Meanwhile, commodities have taken a breather in the past several weeks, yet now reappear set to retest buyers’ appetite. All points state that comfort zones of all sorts are indeed challenged, and risk takers can patiently begin to map out the current maze.

Article Quotes:

“In Europe, banks and investors advanced credit to countries lacking even a pulse. By this I mean that their population was known to be rapidly aging, that some were mired in black markets, had a happy-go-lucky preference for leisure and "apres-moi-le-deluge" mentality, and were subsidized by a legacy of entitlements based on the assumption that the demographic pyramid would have an expanding young base forever - never mind the demographic realities. What blinded Europe's politicians and bankers? Decades of easy living weakened many of the institutions that once built up Europeans' "character". Unfortunately, no financial engineering can offer short- or medium-range solutions to restore "character". It can take a generation or more. The uniqueness of the dozen Western type democracies after World War II and until 1990 permitted the continuous misallocation of capital and the destruction of character. The capital and talent flocking to their shores from the rest of the world, escaping dictatorship of one kind or another, helped cover the compounding mistakes.” (Asian Times, October 22, 2011)

“China’s government will be reluctant to ease monetary or fiscal policy while inflation remains high. That limits its scope to respond to a sharp slowdown in exports, if Europe and America continue to falter. But weakness in foreign sales will itself ease inflationary pressure, reducing the competition for men and materials. After exports fell off a cliff in 2008, Chinese prices began to drop. Thus the more the economy needs looser macroeconomic policy, the more scope the authorities will have to provide it. What about the bad debts left behind by past excesses? Although some homebuilders are heavily indebted, households are not. Even if the price of their home falls below what they paid for it, it will be worth more than the mortgage they took out on it. Since the central government’s explicit debt is low (about 20% of GDP) it can afford to bail out lower tiers of government and the banks they borrowed from. Because the banks have ample deposits, and savers have few other options, banks can also earn their way out of a hole by underpaying their depositors. And since the banking system is still dominated by the government, the banks will not refuse to offer new loans, even if old loans sour.” (The Economist, October 22, 2011)

Levels:

S&P 500 Index [1238.25] – Closed at the higher end of the recent range. A pending test to retest overall buyer appetite closer to 1250, followed by the 200 day moving average of 1274.70.

Crude [$87.40] – Several attempts to surpass $90 failed few times in the last two months. A third attempt is looming given the recent short-lived run.

Gold [$1642.50] – Following the correction from last month, the commodity has establish a vicarious range around 1620-1680.

DXY – US Dollar Index [76.39] – Further deterioration despite September’s appreciation. Setting up for a minor near-term recovery.

US 10 Year Treasury Yields [2.21%] – Trading above the 50 day moving average with no major change since last week.

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