Market Outlook | January 16, 2012

“Clear thinking requires courage rather than intelligence.” - Thomas Szasz (1920-present)

Accepting the Expected

Much of the weekend’s discussion revisits the belabored concerns related to European downgrades. For the most part, there have been no surprises as some wonder if Germany’s outlook upgrade actually stirs up a positive reaction, versus the negative responses to the inevitable downgrade of France and other nations. Of course, further chatter hovers around the magnitude of potential damages to fragile markets. The debate in the Eurozone will live on and the political twist will take its own course. As for participants, there are a few things to digest and balance amidst the flurry of fearful headlines. As witnessed before, downgrades and downturns do grab headlines, but the overall implications can be easily misunderstood.

Short-term traders will focus on bank exposure to toxic debt and clues from earnings reports, while weighing the potential reawakening of extreme volatility levels. These key discussion points can trigger memories back to the summer of 2011, a period of explosive volatility mixed with sensitive responses to unpleasant debt realities. However, this time around, the shock element does not appear on the same frenzied scale, yet we are approaching a period that will strongly test buyers’ conviction.

Meanwhile, the puzzle of slowing growth in Asia will keep money managers in suspense. The rapidly emerging Chinese economy is poised to slow down a little, while the developed Japanese economy has been struggling. Both cases reaffirm the existing relative strength argument of the US market, given lack of alternatives. Yet, the impact of slowing global growth on earnings of multi-national US companies is a major puzzle for those invested in US equities.

Sentiment Clarity

Longer-term investors are trying to grasp the true and confusing sentiment of recent months, while seeking to identify buy points. One side argues sentiment is picking up steam and pointing toward some confidence restoration. When combining the improving labor numbers and stock market rally, there is a case to be made for a minor reawakening of buyers’ faith. Perhaps, much of the attention toward this improvement is attributed to the AAII Investor Sentiment data, which has stayed to be positive (49% bullish and 17.2% bearish). Similarly, the Volatility Index is much lower than previous months as well. This points to the calmness of the US stock market in recent months

On the other hand, European worries are still closer to the higher end of the range when looking at credit spreads, demonstrating extreme fear in investors’ expectations. Similarly, in the US many analysts and hedge fund managers expect a lot of weakness in their targets. Common examples for weak forecasts include those centering around: a slowing global economy, weak earnings, declines in home prices, and hard-landing in China. These are some of the many lists of concerns crafted by strategists and so-called financial experts in opinion pieces.

As a follow up one should ask, if there are more reasons to sell than buy, then why wouldn't everyone bet on a collapse? This is especially a question that should be asked when the reasons to buy appear to be more akin to wishful thinking than a trend. For now, the glaring reasons to purchase assets are either to bet on surprises in improving numbers or to speculate the global angst is overblown. In any case, the roaring guesswork of the quantitative easing 3 announcement is a wildcard that’s gearing up to spark mixed reactions. Not to mention, the election year plays a bigger role in the timing of stimulus announcements. As the perceived risk continues to escalate there is a reward to capture in specific areas for patient participants.

Currency Feel

Last year, a run up in Gold prices confirmed a vote against most currencies and a form of showcasing displeasure in the action of central banks. This year, investors are expressing a similar opinion by betting against the Euro. Interestingly enough, the CFTC showcased total shorts of $25.9 billion for the Euro. Simply, this highlights the migration toward a strengthening US Dollar. This points to risk-aversion that is looming in nearly all financial markets. Perhaps in due time a collective recognition of excessive risk-aversion can retrace financial markets to a normal patterns.

Article Quotes:

“Mistakes directly leading to the deaths of 200 passengers are a very different beast than mistaken economic forecasts, which (as part of a group of culprits including Wall Street greed, regulator incompetence, and home-buyers' ignorance) indirectly led to a great and devastating recession. But like the pilots, the Fed's failure was not a matter of education or training. These were among our greatest economic thinkers. Quite like the pilots, they trusted the mechanics of a complex system they did not fully understand, especially the connection between the housing and financial markets. Amazingly, in retrospect, they often emphasized inflation concerns over housing concerns and the health of Wall Street. (‘Markets are now so much more developed and sophisticated that maybe it's different this time,’ Dino Kos told Greenspan.)…. It was total systemic failure, from 2006 into 2008, to diagnose a crisis and act to stop it, based partly on overconfidence that, in the economy, we had built an unstallable machine -- that the plane could, quite certainly, fly itself.” (The Atlantic, January 13, 2012).

“Fakery is not dead, of course. In 2009, roughly 30% of mobile phones in the country [China] were thought to be shanzhai—a popular term for clever fakes. The Business Software Alliance, a trade group, claims that nearly four-fifths of the software sold in China in 2010 was pirated. In December the US Trade Representative issued its annual report on the world’s most “notorious” counterfeit markets. Of the 30-odd markets identified, eight were in China. Some, such as Beijing’s Silk Street market, are well-known. The report also points the finger at Taobao, an online marketplace owned by Alibaba, China’s biggest e-commerce firm. That may be unfair. Taobao has clamped down so hard recently that it is enduring protests by angry vendors. Still, as China grows richer, life is growing harder for fakers. A recent study of China’s luxury market by Bain, a consultancy, concludes that “demand for counterfeit products is decreasing fast.” McKinsey, another consultancy, found that the proportion of consumers who said they were willing to buy fake jewellery dropped from 31% in 2008 to 12% last year.” (The Economist, January 14, 2012).

Levels:

S&P 500 Index [1277.81] – Slightly above the fragile state of 1280. Overall, short-term momentum is positive, but bound for a further test from buyers.

Crude [$98.70] – Narrow trading arrange forming between $95-100; a range last seen in the summer months, but a near-term deadlock for buyers and sellers.

Gold [$1635.50] – A four-month decline is attempting to settle around the $1600-1650 range. Recovery attempts will be revisited this week.

DXY – US Dollar Index [81.51] – Multi-month appreciation in the dollar confirms the global strength. Positive momentum has built since the frenzy mode in summer 2011.

US 10 Year Treasury Yields [1.86%] – Continues to head lower near all-time lows, with a further reiteration of risk-aversion. September 2011 lows of 1.67% are a key level to watch in weeks ahead.

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