Market Outlook | April 16, 2012

“Truth is confirmed by inspection and delay; falsehood by haste and uncertainty.” Publius Cornelius Tacitus

Awaiting Scrutiny

By all measures, sensitive market reactions were forming leading up to the start of a new quarter. Casually anticipated and eventually stimulating negative responses slowly outweighed the built-up momentum in recent days. A mild break is known to challenge the bulls’ conviction, while doubtful pundits reappear loudly by pointing out numerous fragilities. Of course, it comes to the forefront of discussion for investors, especially after a week where the S&P 500 Index fell 2%.

After an explosive first quarter for stocks, plenty of edginess is being or set to be released with increased curiosity around earnings results. Naturally, this has capital allocators reexamining the definition of risk in a market that’s mostly shaped by low interest rate policies and mostly upbeat sentiments. Recent downtrends are not earth shattering, when viewing the key catalysts such as rotating European concerns or a much talked about Chinese slowdown. Both are glaring issues that easily stir macro reactions and headlines while increasing the guesswork for speculators of all sorts for months ahead. Importantly, what is the impact of slowing China and Europe on US corporate earnings? That’s the question that should be asked and researched further.

Early spring clues

The well-known macro drivers, such as commodities, have not accelerated recently and are attempting to restore some positive momentum. For example, the run-up in crude price, a dominant theme for a decade, is not quite finding a new wave of buyers above $110 a barrel. Surely, there is a supply and demand argument that conveniently floats around to justify further upside moves. Yet, weekly oil inventory is signaling that supply is much higher than experts’ estimates. It’s too early to judge for some, but worth taking notes on whether soft demand in commodities serves as a barometer for a weakening global economy.

Similarly, gold aficionados are not vibrantly pounding the table these days. Sure, general fear has subsided since late fall and investor eagerness for “safe assets” (i.e. gold) eventually cooled off. Interestingly, the looming concerns with paper assets are assumed to benefit gold. Increased turbulence reawakens the commodity supporters – barring a synchronized asset decline in major assets. The explosive run witnessed last spring may be hard to replicate, but the stakes, along with expectations, are high.

Observing time

Profit-taking in risky assets by some managers after the end of the first quarter appears somewhat logical. Unlike fall 2011, it is not quite as easy to bargain hunt for seekers of higher-risk groups, such as banks, homebuilders or smaller technology-based companies. Thus, being an aggressive buyer at current price ranges may not be too enticing for now. Patience is needed for buyers and sellers alike until the new rhythm sets a noticeable tone. Buying should not be feared or dismissed, but the readjustment in the investor’s mindset needs to be understood. Further discovery of earnings feel and sentiment may end up providing a fruitful clue rather than overexerting capital along with the frenzied crowd.

Article Quotes:

“It should not be forgotten that the key institutions in China’s banking system remain more or less government owned. This changes the rules of the game considerably. Standard risk management variables, such as the capital adequacy ratio — which, incidentally, is extremely high among Chinese banks — and the non-performing loan ratio are only of marginal relevance because the integrity of the biggest banks is guaranteed by the government. China’s central government is willing and able to act on that guarantee. The level of outstanding public debt is modest and even when contingent liabilities are taken into account, such as local-government debt, the prospect of China falling victim to a European-style public debt crisis is remote. … Property prices in China may well be inflated; price-to-income ratios, particularly in the major cities, suggest that they are. But for high prices to constitute a bubble, they must be able to burst. In the case of China, it is not clear that they have, nor where a trigger might come from.” (East Asia Forum, April 14, 2012)

“Consider the first conundrum: the current relationship of Treasury yields to equity and dividend yields. In both the third and fourth quarters of 2011, the earnings yield on the Standard & Poor’s 500 Index was more than 2.5 times the composite long-term government bond yield, by far the biggest multiple in the past 50 years. And in the fourth quarter, the dividend yield on the S&P 500 (2.13 percent) was only barely below the composite long-term government bond yield (2.7 percent) — the narrowest gap in decades. These facts are cited as reasons that bonds have been overpriced. Yet the complete historical record shows that the current relationship of earnings yields to Treasury bond yields is hardly unprecedented. The ratio has been far higher in the past and has stayed above current levels for long periods. The comparison of bond yields to dividend yields over the past 130 years paints a similar picture, with today’s bond yields appearing not all that unusual. “ (Institutional Investor, April 12, 2012)

Levels:

S&P 500 Index [1370.26] – Waning buyers’ appetite in the near-term to drive the index above 1400. Visible consolidation between 1360-1400 suggests a cooling period from multi-week strength.

Crude [$102.83] – Late March peak setting the tone for price declines. Revisiting the ever-so-familiar $100 mark, where buyers’ will is facing a strong resilience test.

Gold [$1666.50] – Mounting multi-month evidence of a weakening trend. Last two attempts to surpass $1750 have been too difficult and have drawn some doubts in investors’ minds.

DXY – US Dollar Index [80.04] – After an explosive fourth-quarter 2011 run, the dollar is back to a dull trend of much of the same week after week.

US 10 Year Treasury Yields [1.98%] – An eventful 30 days, where rates round-tripped back to the 2.0% range.

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