Market Outlook | July 2, 2012

“More important than the quest for certainty is the quest for clarity.” François Gautier (1959-present)

Perspective simplified

If one observer stated: Interest rates are extremely low, volatility remains low and oil prices are way off from previous highs, then it would have been sufficient to expect higher US stock prices. At least, that has been the thought process in the minds of active investors, especially in recent years. In any random year or cycle, this setup generates broadly accepted expectations of good returns.
To take a step back, last weekend, crude closed below $80, volatility index below 20 and US 10 year yield below 2%. So perhaps we should not be overly surprised that the S&P 500 Index gained 2.03% for the week and remains up 8.31% for 2012. All noise aside, the combination of these key barometers paints an actual positive year for stockholders. This is rewarding for those who favored some risk over safety in a period of increased fear mongering.

Search for clarity

Psychology, of course, finds a way to distort one’s view in looking back at last quarter. Thus, consider if the question was asked in the last few weeks: Why are US stocks not much higher? Perhaps, even the not-so avid-observer would loudly proclaim European worries are one key factor. Similarly, a global observer would add China is slowing and confidence in that market is dwindling faster. Of course, both points have some merits based on recent data that contribute to shaky sentiments.

Any interpretation of a Eurozone rally might attract doubters more quickly than believers. What have become tiresome acts of injections and “pain relief” actions from policymakers still leave some skeptics. That's the expected feel, especially over the weekend after a stunning up day to close the month. An ongoing lack of faith in “leaders” is a common jargon these days but doesn’t get much weight in long-term market performance. Converting non-believers to take risks has proven to be a daunting task thus far. Generally, to change minds requires drastic moves. At this junction, the bearish train is still relatively crowded. For example, the following indicator from last week offered this view:

“According to the American Association of Individual Investors (AAII), bullish sentiment dropped from 32.89% to 28.7% for a drop of 4.19 percentage points.” (Bespoke Investment, June 28, 2012)

Market participants have yelled and screamed about their dislike for potential returns due to global concerns. However, if Europe is not as bad as expected while China's true economic sustainability is a mystery (not overly grim), then things are not as bad as was thought. Then the element of an upside surprise lives on again for the second half of this year. Importantly, underestimating the prospects of a coordinated boost from policymakers in US, UK ECB and China is dangerous to ignore, even if these efforts produce short-lived results.

In the case of China, the FTSE China Index (FXI) peaked nearly five years ago and has remained sluggish. Therefore, the prospect of weakness is hardly a new element to Chinese stocks. Plus, the eight-month weakness of Chinese manufacturing showcases that bad news and worst-case scenarios are deeply factored in. However, the mystery of the outcome will drive further suspense and plenty of speculations.

Slow Revival

The lack of alternatives for liquid assets leads to piling on into known instruments. This increases the odds of collective asset price appreciation for global stocks. Of course, reward is not always a result of impressive fundamentals or an increase in innovative sectors. Uncertainly over pending regulatory climate creates some hesitancy in the near-term. Perhaps, the financial service dilemma is adjusting to new changes, new participants and inevitable new policies that are needed for several years.

For now, the message from the first half echoes a fragile revival in the post-2008 era. This transition phase divides the outlook between frustrated and forward-thinking investors. It’s these inflection points that shape valuable investments and timely entry points. Thus, ignoring the noise of fear has been fruitful this first half, despite few turbulent periods.

Article Quotes:

“Oil is not in short supply. From a purely physical point of view, there are huge volumes of conventional and unconventional oils still to be developed, with no ‘peak-oil’ in sight. The full deployment of the world’s oil potential depends only on price, technology, and political factors. More than 80 percent of the additional production under development globally appears to be profitable with a price of oil higher than $70 per barrel. The shale/tight oil boom in the United States is not a temporary bubble, but the most important revolution in the oil sector in decades. It will probably trigger worldwide emulation, although the U.S. boom is difficult to be replicated given the unique features of the U.S. oil (and gas) arena. Whatever the timing, emulation over the next decades might bear surprising results, given the fact that most shale/tight oil resources in the world are still unknown and untapped. China appears to be the first country to follow the U.S. example.” (Belfer Center for Science and International Affairs, Harvard University, June 2012)

“The black letter law that is taught in law schools is inevitably the codification of past views on finance and financial practices that may no longer be up to date at the time it is taught or practiced by recent law graduates. The high level of technical sophistication needed to master these areas of law tends to obscure the dis-connect between law on the books, the theories that may have informed this law, and the actual operation of the financial system. Lawyers do, however, play a critical role in the world of finance. They help structure new instruments, advise market participants on the legality of their actions and devise strategies for them to minimize the costs of regulatory restrictions. Lawyers also serve as expert witnesses to Congress and work in committees or at regulatory agencies that are charged with developing new legislation or regulations. This requires that lawyers know something about how markets operate in the real world. The most critical factors in these alternative theories are Imperfect Knowledge and the Liquidity Constraint, and the interaction between the two. They help explain why markets tend to destabilize even under assumptions of actor rationality and ready access to relevant information. These theories therefore hold important clues for rethinking not only the governance of finance but the organization of the financial system itself.” (Selected Works, Katharina Pistor, June 2012)

Levels:

S&P 500 Index [1362.16] – Signs of recovery from spring sell-offs and a strong bottoming statement made on June 4th at 126.74. Skeptics linger, but positive stability continues to emerge.

Crude [$79.76] – The one-day sharp rise slightly makes up for the recent decline from $105 to $77. The follow-through is awaited as the next main target is at $90.

Gold [$1598.50] – Several weeks of non-eventful but stabilizing movement closer to $1600.

DXY – US Dollar Index [82.25] – The multi-month strength in the dollar remains in place. Nearly a year since the index bottomed at 73.42.

US 10 Year Treasury Yields [1.64%] – Interestingly, the last trading days showcase a narrowing range between 1.55% and 1.65%. Trendless in some ways, but clearly the low end of the range is not a short-lived incident for now.

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