Market Outlook | January 3, 2012

“No river can return to its source, yet all rivers must have a beginning.” - Native American Proverb

Digesting Twelve Months

Taking a directional stock market view was rough given various swings throughout the year. Most sellers found plenty of reasons to sell when uncertainty triggered thoughts and sparked interlinked reactions of a rush to safety. Some buyers tried to pick bottoms here and there, but after all simply holding positions turned out to be as good as trading in and out. 2011 presented a clutter of events that are historical in nature and with glimpse of overreaction in between.

For writers and financial reporters who romanticized the collapse of empires, it certainly created exuberance, or at least a vindication of sorts for long-time bears. For policymakers flooded with endless pressure, the unfolding events simply accelerated the aging process with grief and misleading solutions. Truth seekers were glorified by eventual discoveries and unpleased by politics as usual, while the real truth was more confusing than glaring. For financial students, a few terms such as risk analysis, volatility and money management seemed theoretical in some instances yet too basic at times.

These were challenging and interesting times indeed. When considering the gloomy facts that we confronted in the past six month, the possibility of pent up demand is quietly brewing. Yet upsides moves are not always a declaration of comfort, but a fragile gauge of improving moods.

No Endings and Unclear Beginnings

In any cycle, it is safe to assume that greed and fear will persist as fundamental human traits. An age old discussion continues as these patterns get tiresome but their real merits live on. These days, more than greed, deciphering the justified fears is the challenge. Generally, the attitude toward business, and the government roles in stimulus matters have not been comforting. Plus, heated attitudes create a stalemate for moving ahead in most western countries. Ongoing deadlocks were not quite imaginable at times, but once the label “crisis” is thrown around then it surely turns into politics as usual.

Meanwhile, those evaluating assets, as they did for the last 30 years, will have to make adjustments or face consequences in this era. If we’ve reached an “end of financial services as we knew it” before 2008, then we are in the early innings of a new cycle of a cloudy outlook. At least in the near term, pending US elections, Eurozone resolution, chatter of bubble reform and emerging market momentum is in the minds of participants. While the changing landscape of the labor environment combined with rising commodities rapidly converts financial data into social unrest and further mass awakening.


Gearing Ahead

Yearly predictions are thought provoking, entertaining or noisy for some, but present a new spark of energy, whether good or bad. As stated by few, predictions usually end up being mostly wrong and even surprises turnout to be realities. Lots of time is spent by strategists deciphering the biggest themes and surprises. Clearly, the obvious event of high interest is the day to day coverage and speculation surrounding the US election. 2012 might finally suggest there is a fatigued crowd ready to march on after the electric 2011, which highlighted chatter of policymaking risks and crisis management banter.

In any given year, value seekers buy value like stocks, momentum chasers chase momentum, new money goes wild in new areas and short-sellers seek dismal setups. This largely remains business as usual for the most part. Yet, if politics and financial markets remain closely tied to day to day events, long-term holders will not be fully comforted. And now, in early 2012, the question to ask more than the big year-to-year themes is how to grasp the mindset of longer-term players.

Long-term Clarity

Based on escalating volatility some may argue markets are too short-term natured than usual, especially when policymakers think, or are forced to think, in narrow timeframes. Although this point seems glaringly obvious in certain conditions let us not forget that serious and influential capital finds a way to evaluate ideas from a 3-5 year outlook before deploying capital. That said, for long-term players, taking a few steps back may be as appropriate as making big bets. Examining, tracking and following these three areas can spearhead a framework for 2012:

1. Understanding the traits of the current and dynamic currency markets
2. Grasping the global landscape of capital inflow and outflow, while covering the less know mainstream facts
3. Clarity of the two points above can lead to selective buying in discounted assets or a bet against overvalued areas

Currency Shifts

For over a decade, observers have witnessed a depreciating dollar that peaked in mid 2001. Of course, decline in currency value is not to be confused with a loss of leadership as the dominant currency. Frankly, panicky moments demonstrated the global rush to hold US dollars. Now, a trend reversal is setting up, in which the dollar appreciates versus other major currencies. Any strength in the greenback does not erase the competing alternatives that range from Gold to the Euro to another emerging currency. On the other hand, the gap to overtake the dollar is not narrow; however, this year may jumpstart an era where the dollar strengthens while its dominance is tested from various angles. In addition, the Euro remains in an unsettled condition, but assuming a currency collapse might be premature at this stage.

Emerging Puzzle

The ongoing and heated debate circulates around the sustainability of emerging markets. China’s market is not quite understood and the mystery keeps many on the edge for now. Bubble-like traits in China have persisted since 2007, while by most accounts economic strength is visible, despite questionable reporting. The China 25 Index (FXI) is down 52% from its peak in 2007. Perhaps, those expecting demise should note that a slowdown is not a new trend but a potential continuation of an existing trend. Coming into last year, the inflation and housing worries in China were issues not only for pundits to address, but pointed out by government members as well.

Emerging market growth rates have attracted plenty of capital inflow last decade equaling $70 billion in investments to BRIC countries. (EPFR Global Data) At the same time, finding enthusiastic investors these days is not as easy as before, given the fragile nature of interconnected markets and increasing skepticism. On one hand, the US showcases a relative attractiveness, but that’s mainly for safety. Therefore, growth seekers will eventually continue looking into developing and frontier markets for higher returns. Eventually, the competition within the BRIC countries is bound to increase as much as the ongoing debate of developed versus emerging markets. In the long-term reward awaits for nations with the ability to engineer soft landing while maintain relative stability.

Selective Purchase

For larger money managers, buying “cheap” has been a theme in recent years. Distressed assets especially in Europe are trading at a discount as European banks continue to sell assets. Clearly, there are plenty of desperate sellers forced to meet liquidity needs. Simply, unfolding macro events have created an appealing marketplace for patient and aggressive buyers in a period where risk is less favorable. Buying at current levels may not be too appealing by consensus measures, but opportunistic players are taking note. Similarly, declining valuation in select sectors are known and expected to spark further merger & acquisitions. In fact, these trends are visible in technology and new media space.

Article Quotes:

“If the eurozone does not want to embrace capital controls, it has only two alternatives: make the local printing of money more difficult, or offer investment guarantees in countries that markets view as insecure. The first option is the American way, which also demands that the buyers bear the risks inherent in public or private securities. The taxpayer is not called upon, even in extreme cases, and states can go bankrupt. The second option is the socialist way. Investment guarantees will lead, via issuance of Eurobonds, to socialization of the risks inherent in public debt. Because all the member states provide one another with free credit guarantees, interest rates for government securities can no longer differ in accordance with creditworthiness or likelihood of repayment. The less sound a country is, the lower its effective expected interest rate. The socialist way follows necessarily from the free access to the printing press that has so far characterized the eurozone. As long as banks – and thus governments, which sell their debt to the banks – can draw cheap credit up to any amount from the European System of Central Banks, Europe will remain volatile. The exodus of capital will continue, and enormous compensation claims of the European core’s central banks, particularly the German Bundesbank and the Dutch central bank, will pile up.” (Project Syndicate, December 29, 2011)

“If Chinese perfidy should shut down the route through the South China Sea, Japanese crude carriers from the Middle East could simply swing south of Sumatra, cross the Lombok Strait, and sail up the east coast of the Philippines. Studies have concluded that the detour would add three days to sailing times and perhaps 13.5% to shipping costs; an annoying inconvenience, perhaps, but also not an energy or economic Armageddon. The bloviating about the vulnerability and critical importance of the South China Sea maritime route can probably be traced to the fact that it is an international waterway and therefore a suitable arena for the United States to flex its "freedom of the seas" muscle. Smaller nations bordering the South China Sea welcome the US as a counterweight to China in their sometimes bloody but low level conflicts over fishing and energy development issues. Any US attempt to lord it over the Lombok Strait in a similar fashion would presumably not be welcomed by Indonesia, which exercises full, unquestioned sovereignty over the waterway.” (Asian Times, December 22, 2011)

Levels:

S&P 500 Index [1257.60] – Staying above 1250 has proved to be difficult for a sustainable period. Near-term is hovering around a 200 day moving average.

Crude [$98.83] – An explosive fourth quarter rally showcases a resurgence in buyers’ demand.

Gold [$1531] – Cooling off from a multi-year run. Early September marked a turning point as the commodity enters a multi-week downtrend.

DXY – US Dollar Index [80.29] – The second half of 2011 saw the dollar bottom and strengthen while setting the stage as a key macro theme for months ahead.

US 10 Year Treasury Yields [1.87%] – Trading at the low end of a three decade decline. The next noticeable range stands at the intra-day lows of September 23rd at 1.67%.

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