Market Outlook | January 9, 2012

“Storms make oaks take deeper root.” - George Herbert (1593-1633)

Quarreling with Growth

As usual, plenty of skeptics and experts are cautiously digesting the improving labor numbers. Yet, the Friday job data generated a sense of improvement and enhanced the curiosity of investors’ reactions. Of course at this junction, the labor debate sparks more political fireworks than an increased curiosity on market directional view. Clearly in an election year, data can be misinterpreted or understated to fulfill self-serving political messages, as expected. Therefore the scrutiny will continue, and at times the interpretations of “true” employment data can lead to some confusion. Meanwhile, savvy and seasoned investors are gearing to look past the rhetoric while grasping the impact of economic improvement in the stock market. Grasping the disconnect between the economy and stock market is both a puzzling and rewarding task.

One noticeable trend from the labor data showcases the growth of manufacturing in the US (302,000 out of 2.4 million jobs created since February 2010). This is a growing theme that should be explored for years ahead. The last six months have showcased manufacturing job growth. “The United States is particularly strong in machinery, chemicals and transportation equipment, which together make up nearly half of the exports.” (New York Times January 5, 2011). This can set the stage for 2012, when selecting manufacturing related stocks can be a fruitful investment exercise. In addition, the broad market environment favors stocks, given the low returns in fixed income. As risk tolerance returns to normal levels, the appetite for risk can translate to inflow into stocks. For now, the volatility index (VIX) is showcasing some form of calmness as it trades below its 20 month moving average.

Leftovers

At the start of last decade, observers dwelled on the meaning of bubbles. Last year, plenty of time and energy was spent deciphering the ugly truth, or associated risk, of sovereign debt. A generation of participants is now quite accustomed to bubbles, such as the NASDAQ in 2000 and credit markets in 2008. Therefore, these events are influential in stirring further fear of additional bubbles. For example, during the last three years we have collectively witnessed the bubble discussions transforming to governance risk, and that lingers as a global concern in any given trading day. Basically, the pressure of financial leadership shifted not only to central banks, but to policy makers. Although this fact is hard to swallow for the business community, it ends up being a necessary process in facing up to accumulating debt concerns. Similarly, correcting past mistakes is not a novel or pretty task when confronting the harsh truth.

Entering this year, doubters will continue pounding the table on a few potential bubbles linked to commodities and emerging markets. There are numerous points to address with matters related to peaks in Gold and China. Both themes are on the radar and rank high among bubbles of interest. The concern with China hovers around the peak in residential housing and potential social unrest. However, even though the case for bubble bursting will resurface in daily journals, the timing remains tricky, given that it’s a weak year for emerging markets, and surprises are usually on the menu.

Banking on America

If the relative strength of the US is a reoccurring theme, then the relative attractiveness of US banks should not be easily dismissed. First, US banks appear to be in better shape than European banks, which have to restructure their debt ($1.3 trillion in 2012). Secondly, banks have traded at cheap valuation, to a point where taking the risk is worth an early look. The Financial Index (XLF) is down 64% since peaking in June 2007. For example, a company like Bank of America was battered and bruised in the headlines as it flirted with $5 per share, given the associated risks. Yet for speculators seeking “not so overvalued” ideas, there are not many places to go, and banks are appealing. Clearly, there is no denial that banks are a neglected theme where fear of ongoing bad news clouds the perception of many. However, those betting against the US financial sectors may eventually realize very bad news eventually becomes grossly exhausted.

Article Quotes:

“Thanks to productivity improvements, the U.S. also remains the world’s largest value-add manufacturer, at 24%, versus 15.1% for second-place China and 14.8% for third-place Japan. In a recent and widely disseminated report, Boston Consulting Group argues that with Chinese wage rates continuing to rise, the U.S. will start to see a significant amount of manufacturing activity shifting back to these shores by 2015, as the U.S.-China labor-cost differential narrows. The shift will be especially pronounced, the consulting firm predicts, in seven manufacturing sectors: transportation, electrical equipment and appliances, furniture, plastics and rubber products, machinery, fabricated metal products, and computers/electronics. As companies in those sectors “reshore” manufacturing operations, BCG says, they could create 2 million to 3 million jobs in the U.S. To be sure, many manufacturers will continue to produce goods globally, too, whether to comply with local-content laws, to enable speedy access to global markets, or, where labor costs remain a big component of total costs, to continue to take advantage of low-wage environments. (CFO Magazine, December 1, 2011)

“Since the financial crisis, black swans have been all the rage. Rare is the pundit discussion about the financial order which leaves this rare bird un-cited, or for that matter unsighted. Now everyone is seeing black swans everywhere, suggesting that the cognitive bias might have shifted. Are we on the verge of denying the existence of white swans? Are we in danger of denying the possibility of the existence of normalness? Martin Wolf, of the Financial Times, has coined the term ‘Taleb Distribution’ to describe the fact that the world, as well as the shape of the bell curve distributions we use to graphically represent it, may be wider than we thought. Perhaps, Wolf suggests, the two tails of the alleged bell curve are fatter than we thought. Perhaps there are probability distributions which give the appearance of being normal distributions, but in fact are not. In such a case, treating financial crises as once-in-a-century black swans may not quite capture the whole of the picture. Perhaps swan sightings will occur more often than a random distribution around a mean would suggest. Perhaps problems big enough to shake the entire system are not once-a-century events, but once-a-decade events.” (Forbes, January 5, 2012)

Levels:

S&P 500 Index [1277.81] – Since October 4 lows, the index has appreciated by nearly 19% as the extension of a fourth quarter is visible in the early part of this year. Index is now trading above 200 day moving average, yet buyers and sellers will debate the merits of the index.

Crude [$101.56] – Like stocks, crude has risen since early October. Above $100 is a theme that’s picking up momentum. Meanwhile in the near-term, Crude’s ability to stay above $105 will be watched with heightened curiosity.

Gold [$1616.50] – Several month of decline creates a set up around $1600, where buyers seek to reenter, while sellers point out the declining momentum. Yet the recent message states that investors are not rushing to buy Gold and questions if an appreciating Dollar is inversely impacting the alternative currency.

DXY – US Dollar Index [81.24] – Strengthening Dollar remains a key macro theme. The 11% rise since spring 2011 is not to be taken lightly for trend followers.

US 10 Year Treasury Yields [1.95%] – The five month average stands at 1.98%, which illustrates the ongoing low rate patterns. In addition, an average below 2% is slowly becoming a norm these days.

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