Market Outlook | June 25, 2012

“Simplicity is the ultimate sophistication.” Leonardo da Vinci (1452-1519)

Familiar actions

Major assets have appeared fairly synchronized in the past few months, highlighted by sharp commodity declines. As usual, higher and reliable returns with low turbulence are hard to find. Instead, we’re in a discovery period where lofty expectations have not been fully met. Through this familiar puzzle, another round of stimulus efforts was announced last week to a less-than-enthusiastic audience. The Federal Reserve’s statements reiterated the need for milder stimulus while projecting an uncertain tone for pending recoveries. Of course, for economists tuned in to the central bank’s nuances, a lot of the substance is not earth shattering. Unfortunately, bold actions or empathic messaging by central bank officials ahead of elections is not too common. Yet, the fund manager remains challenged in a world of limited liquid assets and scarce investable instruments, given low interest rates.

Uncommonly Common

An inverse relationship between oil and stocks is discussed too often, at least in the past, but is yet to materialize in that manner in recent months. Crude prices coming down sharply have not guaranteed a rising stock market. Amazingly, around the increasing Iran turbulence in mid-spring, some observers were buying into explosive runs in crude prices. This has not been the case thus far, but the year is only halfway finished. Surely, sensational stories rarely end up driving the fundamentals over time. Perhaps, this is a valuable lesson to remember as it resurfaces in various trends where the newsworthy item is confused with prevailing drivers.

Behavior in crude markets in many ways reflects the global economy weakness – a not-so-pleasant barometer but a realistic awakening. Crude prices mirror the downturn of emerging markets. That's clearly visible in emerging market indexes (EEM), which paints a more powerful picture. Since March 2012, the emerging market index has declined by nearly 16%. In that same period, crude prices declined by 28%, where weakness in China served as a key catalyst to many of the subsequent sell-offs. Of course, the Eurozone background further fuels the threat of a slowdown and at some point this trend is overdone. If crude serves as a sentiment indicator, then confidence for commodity-related areas presents an inflection point.

Naturally, the next question relates to gold prices’ ability to live up to hype of protecting against so-called fear. Gold’s price appreciation did not signal the death of “paper assets” but surely left its mark since the early 2000s. The strong and growing belief in gold prices extends from central banks to hedge fund managers to the individual investor. However, the popularity of gold increases with every perceived troublesome piece of Eurozone news or slowing growth in emerging markets. It’s important to note that this spring, when unpleasant general news resurfaced, gold trading patterns did not make a big splash as a safe haven. Instead, prices retreated modestly. Now those disliking the Federal Reserves statements greatly await a resurgence in gold prices. This thesis is suspenseful but never easy as it looks at first glance.

Risk Misunderstood

A simplistic observation may point to glaringly shaky confidence across assets globally. Interestingly, moments such as these occur one or two times a year – in which buying unfavorable assets may lead to a rewarding result due to misunderstanding of bad news. A cliché perhaps to hear, “buy when everyone sells,” but how often is this applied? It’s a question for researchers to decipher, but in recent memory, risk-taking at periods of low confidence has proven fruitful. With so much institutional capital chasing reliable (liquid) returns, the opportunity to bet big in lesser-known areas has its virtues. Buying selectively in a period of loathing usually provides an opportunity, but the window tends to close faster than desired.

Figuring out if demand for safety is trading at a premium is severely challenging. Based on the volatility index, turbulence is contained, at least in US stocks. And that’s not so clear, especially when the Volatility Index (VIX) is closer to annual lows rather than highs. In a period of confusion, risk-taking is not such a bad idea if executed in a timely manner with conviction. Importantly, when well-known pundits/fund managers begin to dislike stocks, that may be positive for smaller investors willing to take a chance in neglected themes.

Article Quotes:

“It used to be that homeownership signaled and led to economic growth. But that relationship was tied to the industrial era, when building and buying more homes primed the pump of America’s great assembly-lines, increasing demand for cars, appliances, televisions, and all manner of consumer durables. Those days are gone. The United States is a now knowledge and service economy; less than ten percent of Americans work in some form of manufacturing and just 6.5 percent are engaged in actually producing things. The stuff Americans buy is largely made offshore. Instead of leading to economic development, higher rates of homeownership today are associated with lower levels of it. Homeownership is either not correlated or negatively correlated with the big drivers of economic development. Writing recently in the Wall Street Journal, Dan Gross notes the shift in this country toward a ‘rentership society.’ But this is not to say that the U.S. is destined to become a ‘nation of renters.’ The issue is one of balance. The rate of homeownership in America hit an all-time high of near 70 percent right before the crisis and has since dropped back to roughly 65 percent today.” (The Atlantic, June 20, 2012)


“As part of its diplomatic pressure on Tokyo, Beijing appeared to halt exports of so-called rare earth metals – a resource vital to many of Japan’s high-tech industries – prompting alarm among some of the many other countries that rely on China for the actually not-so-rare metals. At the time, China claimed that it hadn’t directed exports to be halted, suggesting that it was a spontaneous decision by all its exporters. Few were convinced, and the Chinese move was followed by a round of deals among other nations and much media speculation about a possible Chinese stranglehold on other nations’ economies and even national security. To be fair to China, there had already been warnings over the environmental toll that illegal mining of rare earth metals was taking, and the government warned that it was tightening up on such activity, adding that it was this crackdown, and not exploitation of its virtual monopoly, that was driving its cuts in export quotas. … But will an announcement by China this week change things up again? In a policy paper, Chinese officials warned a decline in its rare earth reserves in some mining areas was ‘accelerating.’ ‘The Chinese government exercises strict control over the total volume of rare earth smelting and separation, and will not approve any new rare earth smelting and separation projects except for those state-sanctioned projects of merger and reorganization and for distribution optimum. Existing rare earth smelting and separation projects are prohibited from expanding their scale of production.’” (The Diplomat, June 20, 2012)

Levels:

S&P 500 Index [1335.02] – Buyers showed plenty of interest around 1300, but near-term pressure is building to stay above 1350.

Crude [$79.76] – A four-month sharp decline continues. Dramatic drop, considering March 1, 2012 highs of $110. Attempting to bottom closer to the $80 range.

Gold [$1565.50] – Recent weeks demonstrate a back-and-forth movement between 1550 and 1600.

DXY – US Dollar Index [82.25] – The dollar-strengthening theme continues since last May. Closely approaching annual highs in the near-term.

US 10 Year Treasury Yields [1.67%] – Last few trading session suggestions point to a tight range between 1.56% and 1.68%. Filtering with annual and all-time low levels, yet some signs of stabilization.

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