Market Outlook | October 29, 2012

“Our dilemma is that we hate change and love it at the same time; what we really want is for things to remain the same but get better.” (Sydney Harris, 1917-1986).

Quandary confronted

If the earning slowdown was not a concern in previous months, it has now certainly awakened those who inquired about the sustainability of corporate earning growth. The actual versus expected quarterly announcements can find a way to “beat” estimates, but confidence in solid growth for two quarters ahead is not that high.
“Only 36% of companies have reported sales above estimates. This percentage is well below the average of 55% recorded over the past four quarters. If 36% is the final percentage, it will tie the Q1 2009 quarter (36%) as the quarter with the lowest percentage of companies reporting sales above estimates in the past four years.” (Factset Insights, October 26, 2012).

In addition, expecting further fuel from an already explosive stock market may be asking too much. Some chartists and others traders are loudly proclaiming the increased odds for pullbacks that have persisted over a few days. A more rational perspective would expect a 5-10% pullback, but that’s not quite dramatic enough to label it a prelude to a doomsday setup.

Yet, the struggle for money managers resides in distinguishing rapid micro noise from sustainable macro trends. Silently, in the background, two surprise elements may await: 1) A recovering emerging market led by China 2) a Eurozone solution better than the worst-case scenario. Both factors are poised to either lessen the pending sell-offs or fuel a renewed acceleration. Either way, the surprise element serves as a wildcard in influencing investors’ mindsets.

Grasping constraints

In taking a breath or two, one quickly realizes the intriguing dynamics of the fixed income market. First, money managers are demanding higher yields given the low treasury returns. Secondly, there is a lack of high-quality fixed-income products that can produce attractive yields without enhanced risk. Thus, owning “safe assets” sounds appealing in turbulent periods, but an obsession with safety comes with opportunity costs, as well. Perhaps this is frustrating for analysts who were accustomed to expecting reliable returns in previous decades. Similarly, this is frightening to those who cannot overcome or ignore the 2008 debacle and other equity market glitches, which led most participants to flee the risk exposure of US stocks. These patterns are well documented, but the money management world is forced to think sharply, to work harder and enhance one’s ability to deliver a balanced and accurate view of risk. The adjustment to slower growth and the higher price for safety changes market dynamics beyond the textbook definition of risk management.

Balancing mix

Conflicting forces of sluggish corporate fundamentals ahead are somewhat offset by the lack of trustworthy alternatives to liquid investments – not to mention the fact that the lack of evidence of a major “bubble” in this current run makes it difficult to envision more than a 15% drop in broad stock indexes. At the same time, improvements in economic numbers hint of a much-needed turnaround for confidence restoration. Yet, layers of puzzles create unease, which simply makes risk takers rather edgy. That unease is felt by moderates and expected rise in volatility. On that note, the upcoming week will provide further hints and data points to ponder. Pending announcements range from various job reports to construction spending to updates on the Chinese Purchasing Manager Index (PMI). Surely, digesting these points in the context of the big-picture concerns can spark noticeable reactions and overreactions.

Article Quotes:

“The [Chinese] economy’s strong performance at the end of the third quarter was in fact fuelled by a jump in investment, illustrating that consumption is still far from strong enough to power growth on its own. Retail sales, the best indicator of overall consumption, have been resilient, rising 14.2 per cent year-on-year in September. However, that has not made up for a deep slump in housing construction. Fearing that growth was on the verge of slowing too much, the government did what it does best: it cranked up investment. The approach has been two-pronged. The National Development and Reform Commission, a powerful planning agency, has approved a series of large infrastructure projects since May. Meanwhile, the central bank has loosened monetary policy by cutting interest rates twice and injecting liquidity in money markets to ensure that these projects could obtain financing. The fruits of these efforts began to be harvested in September. Investment in railways surged 78 per cent year-on-year and investment on roads climbed 38 per cent. This mini-boom in investment, not the resilience of consumption, was the reason that so many analysts concluded that China might be at the end of its nearly two-year-long downturn. If infrastructure spending continues to surge, it is entirely possible that the healthy trend of the first three quarters will reverse in the final three months of the year, and investment could once again overtake consumption as the biggest contributor to Chinese growth.” (Financial Times, October 18, 2012).

“From an economic growth perspective, it appears that fiscal policy has already been tightened too much and has been a vital factor behind the sub-par recovery. The bottom line make-up of GDP over in the three years of recovery shows that private sector demand is expanding at a reasonable pace, no doubt aided by the record low level of interest rates. The problem for bottom line GDP growth has been, quite extraordinarily, the fact that government demand has cut GDP for eight of the last 10 quarters. Attempts to cut the budget deficit at the federal level and balance the budget at the state level is hurting economic growth and constraining job creation. Ed Dolan from EconoMonitor points out that the September quarter GDP outcome was a rare example in recent times where government demand contributed to GDP growth. Indeed, government demand contributed a hefty 0.7 percentage points of the 2.0 per cent GDP growth rate, but at Dolan notes, that boost to GDP “turns out to be almost entirely due to a big jump in federal national defence consumption expenditures … the contribution to GDP growth from state and local government was a pathetic 0.01 per cent of GDP.” (Business Spectator, October 29, 2012).

Levels:

S&P 500 Index [1411.94] – Several signs of selling pressure at 1460. Buyers’ conviction will be examined at 1400 following a multi-week breather.

Crude [$86.28] – Recent downtrend in place after peaking at $100. No early sings of bottoming around $85 range at this point.

Gold [$1737.00] – Further evidence of sellers’ momentum at $1750, showcasing the run-up is pausing. However, the multi-year uptrend is not affected.

DXY – US Dollar Index [80.04] – Remains in a trading range over a two-month period. A long-awaited bottoming process may take place, but movements remain limited.

US 10 Year Treasury Yields [1.74%] – Trading closer to three-month highs of 1.82%. In mid-August and September, yields couldn’t surpass 1.90%. Increasing odds of that trend repeating this month, as well.

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