Market Outlook | December 19, 2011

“The courage to imagine the otherwise is our greatest resource, adding color and suspense to all our life.” - Daniel J. Boorstin (1914-2004)

Suspense & Setbacks

Hopes for a recovery in the financial markets find a way to fade away after a few spurts in the day to day action. Marching to the tune of positive economic data has mostly failed to spark a rally. The reality, and perception, driving barometers are at a standstill where trepidation plays a bigger role than confidence restoration. Clearly, over the past three years debt concerns are slowly being understood as the discovery process reveals more complexities than imagined. Yet policymakers might be running out of tools or flexibility. That’s the question plaguing participants who feel the suspense of currencies, interest rates, stocks and elections.

As to the reaction of liquid markets, we can surmise that near-term disappointment explains the majority of the story. Firstly, the realization of the European summit resolution was hardly a declaration of victory which became too clear. Secondly, the desperate expectation of easing by the Federal Reserve did not quite deliver a message of further “medicine,” as desired by most. Perhaps the overreliance on a “fix” or “injection” is a problem in itself, but the short-term solution continues in seeking the cheers of the crowd. The mantra is to simply survive another month while delaying the inevitable crisis that has shaken, but not broken, the system.

Further attempts by leaders to “sweet talk" the markets has so far failed to muster the much publicized year-end rally. Plus, some would point out that a QE2 style stimulus is already priced into the market. Improving labor numbers remains the wildcard to take optimism from a thought to a believable trend. Either way, the stakes are high, as they’ve been elevated for several quarters, and sensitive reactions are bound to continue.

Currency Waves

The anticipated deciphering and speculation of the relationship in key currencies creates unease, which is looming as volatility is increasing, given the chatter over faith in the Euro. In addition, with over 46% of S&P 500 companies’ earnings coming from overseas, the impact of currencies is at center stage for decision makers in equity markets as well. Much focus on the currency markets is attributed to the messy Euro concerns. On the other hand, the Dollar bottomed and continues to appreciate in the second half of the year. The greenback reasserts its strength as the world’s reserve currency, at least for now, given its attractive liquidity and lack of competing options, not to mention the capital flight from euro-zone banks. Furthermore, this invokes existing doubts and mixed feeling for owners of Gold who are looking at the popular commodity as a tool for expressing a currency view.

Basically, Gold is commonly viewed as the alternative to paper assets, and even claimed a safe asset. For chart followers, it is the momentum of trade that captured further fans across key milestones. Generally, the assumed thought process suggested further easing policies by the Federal Reserve were viewed as a damaging blow to paper. In turn, that attracted several gold bulls ranging from retail to institutional investors. Perhaps this is another reason for Gold’s resurgence? The downtrend invites participants who waited for a discount. However, if the stimulus efforts do not come to fruition, others wonder if the selling in Gold will continue given its current downtrend.

Rotating Themes

Courage may pay more than imagined, even if talks of recession and political deadlock continue to reemerge in common conversations. The unknown is what scares and excites participants bracing to map out the first quarter. For a while themes around finding higher yields dominated the herd mindset, given the low rate environment. Then, paying up for safe haven assets became in high demand. The “do nothing” approach works for few, and some wait to buy on discounts based on a favorable valuation phrase thrown by long-term investors. Relying on the influential theme patterns may not answer long-term needs and has proved to be riskier than advertised. Of course, blindly accepting fear driven tools is a costly proposition, in case opportunities are missed. The puzzle continues, but the worst case scenarios have been pondered enough to overly shock observers. Nevertheless, upside surprises are available today on a selective basis, for those patient enough to dig deeper.

Article Quotes:

“I maintain that no matter how much cash you have on your balance sheet, or how compliant your banker might be, or how cheap the cost of money, you will not commit substantial capital to expanding your payroll or investing significant amounts to expand plant and equipment until you know what it will cost you to run your business; until you know how much you will be taxed; until you know how federal spending will impact your customer base; ….. From my standpoint, resorting to further monetary accommodation to clean out the sink, clogged by the flotsam and jetsam of a jolly, drunken fiscal and financial party that has gone on far too long, is the wrong path to follow. It may provide immediate relief but risks destroying the plumbing of the entire house. It is a pyrrhic solution that ultimately comes at a devastating cost. Better that the Congress and the president—the makers of fiscal policy and regulation—roll up their sleeves and get on with the yucky task of cleaning out the clogged drain” (Richard Fisher, Federal Reserve Bank of Dallas speech, December 16, 2011)


“Back in 1951, the Fed minutes record central bankers discussing to what extent they should help the White House fund its growing deficit, what limit to set on long-term interest rates, and how much debt they should monetise. Go back to Greece. It is able to issue bills at such low yields by manipulating the banks – bankrupt without the help of the central bank, they have little choice but to do what it wants – and by ignoring the legal terms of its bonds. Greek bills and bonds should have equal status in the “voluntary” default being negotiated with European banks. But Greece has ruled that bills will not be subject to the losses being discussed for the bonds. The European Central Bank, perhaps the biggest holder of Greek debt, will also be excluded from losses, even as Europe’s commercial banks are pressured by their governments to take part. All of this manipulation amounts to different forms of taxation, often well-hidden. The bill issues are a tax on Greece’s savers, who could have earned far more if their bank bought similar-maturity bonds. Likewise, the Fed’s actions back in 1951 were a tax on bond buyers, who earned less than they would have done without Fed manipulation.” (Financial Times, December 18, 2011)

Levels:

S&P 500 Index [1219.66] – Attempting to hold a familiar 1220 range slightly below the 50 day moving average. If there is failure to hold above this point, technical observers will point to 1160 as the worst case near-term set up.

Crude [$93.53] – In a minor downtrend after failing to hold $100. First peak on November 18 at $103, and a recent on December 5 at $102, showcases the lack of further catalyst for an upside move.
Gold [$1594] – A four month decline remains in place. Buyers’ appetite at $1600 to be tested in the near-term. Any further break will spur doubts of a stalling momentum.

DXY – US Dollar Index [80.29] – The strength in the Dollar is a noticeable trend since last May with the index up around 10%.

US 10 Year Treasury Yields [1.84%] – Below 2% begs the question of the established downtrend combined with a reflection of risk aversion. Since the summer, the inverse relationship between the Dollar is noteworthy, setting the stage for early 2012.


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