Market Outlook | July 16, 2012

“It is far better to foresee even without certainty than not to foresee at all.” Henri Poincare (1854-1912)

Never Certain

Like last summer, talk of uncertainty is abundant, but when it comes to making investments, one should ask, when was it ever certain? The answer is usually never. Risk aversion may be overly discussed and in higher demand (for comfort seekers) even with low volatility and near-historic low interest rates for yield seekers.
This low-rate environment is too well established by now and is a global phenomenon. Generally, these efforts are believed to push investors into taking more risks than saving. However, the end goal of quantitative easing (QE) is to raise inflation expectations with the hope of forming some sort of stability. Stimulus efforts of all kinds globally are debatable as to whether they are successful or not. At times, the disconnect between the real economy and “fed speak” certainly can sap the excitement out of an observer.

Dependence

Meanwhile, the Federal Reserve of New York reminded us that without stimulus efforts, the S&P 500 Index would be 50% lower – an attention-grabbing finding indeed. This study illustrates the heavy influence of Federal Reserve policies on market responses. Bravado or not, the stimulus efforts do shape minds and move markets in an environment where most look for guidance from central banks. Certainly, betting against the central bankers has not been a wise or brave move for a fund manager. As for the future, the verdict remains unknown, with increased distrust and questioning of central banks’ leadership (some driven by politics, of course). Importantly, recent chatter mildly hints at increasing odds of further quantitative easing to come, despite ferocious and growing opposition. Yet, the real economy has a key role to play and probably will have final say in shaping further policies.

Growth Dilemma

After a decade of growth in emerging markets (particularly China) and commodities, pundits and risk-takers alike are confused as to the next wave of growth. We keep learning that growth is scarce for now and anticipating growth appears too hopeful in some ways. Thus, we’re in a deadlock, in terms of price movements where risk-averse participants are not convinced of good growth stories.
Clearly, last week the losses announced by a financial company combined with a US city filing for bankruptcy added a dent to an already beaten-up sentiment. Plus, with each event we discover the complexities of financial markets and how so-called experts may not fully grasp the intertwined or opaque practices. However, on the bright side, it’s safe to say present ugly realities are confronted politically and financially more than at the peak of 2007 summer highs. Lessons learned are valuable for those looking beyond the intermediate-term suspense of an election year.

Participation

Casual participants appear fed up with the guessing game, especially when the day-to-day pounding news of uncertainty causes more confusion than conviction. Stock market observers have noticed declining volume as part of a slowing demand:
“Its [New York Stock Exchange] volume has dropped 40% in the past two years. In June 2011, average daily volume was 2.2 billion shares. In June 2010, 3.0 billion. That number came in a volatile period after the Flash Crash of May 6, 2010. But was itself down 6.9% from June 2009, a year earlier.” (Securities Technology Monitor, July 11, 2012).

This decline in stock market volume is not to be confused with increased volatility or decline in value. It primarily showcases the individual investor’s lack of appetite for participation in stocks in the post-crisis era. Now, a lack of popularity can invite opportunities that are less crowded for patient but more diligent investors. Bargain hunting is underway in some sectors, while further discounts are awaited in others. That said, the rest of the earnings season could set the tone for the new expectations to stir some new participants.

Article Quotes:

“To get a sense of magnitude, consider this: If Libor was understated by an average of only 0.1 percentage point for a year, the discrepancy on the roughly $300 trillion in interest- rate swaps outstanding at the time would add up to $300 billion. That’s about a fifth of the aggregate capital of the 16 banks whose reports were used to calculate Libor in 2008. Much of that amount would not be actionable, but it also doesn’t account for other types of financial contracts or potential punitive damages. It’s in no one’s interest if the prospect of decades of litigation, and prolonged uncertainty about the ultimate cost, cripples the banking system. It’s certainly the last thing a struggling global economy needs. Bank executives, regulators and prosecutors should be thinking now about how to come clean quickly, compensate the victims and move on. The fund set up by BP Plc to pay claims related to the 2010 Deepwater Horizon oil spill offers one possible template. Banks could pool their resources into a global Libor victims’ compensation fund, appoint an independent administrator and create a transparent formula to calculate damages. Doing so might persuade angry clients to settle rather than pursue litigation that would serve mainly to enrich armies of lawyers.” (The Editors, Bloomberg, July 12, 2012)

"Understanding this dynamic, it follows that QE will have its greatest impact on financial markets when interest rates and risk-premiums have spiked higher. If interest rates are low already, and risky assets are already priced to achieve weak long-term returns (we estimate that the S&P 500 is likely to achieve total returns of less than 4.8% over the coming decade), there is not nearly as much room for QE to produce a speculative run. Leave aside the question of why this is considered an appropriate policy objective in the first place, given the extraordinarily weak sensitivity of GDP growth to market fluctuations. The key point is this – QE is effective in supporting stock prices and driving risk-premiums down, but only once they are already elevated. As a result, when we look around the globe, we find that the impact of QE is rarely much greater than the market decline that preceded it. … In short, the effect of quantitative easing has diminished substantially since 2009, when risk-premiums were elevated and amenable to being pressed significantly lower. At present, risk-premiums are thin, and the S&P 500 has retreated very little from its April 2012 peak. My impression is that QE3 would (will) be unable to pluck the U.S. out of an unfolding global recession, and that even the ability to provoke a speculative advance in risky assets will be dependent on those assets first declining substantially in value." (John Hussman, July 9, 2012)

Levels:

S&P 500 Index [1356.78] – At a healthy range above both the 200- and 50-day moving averages. Showing a revival after a dismal April and May, yet strength remains unconfirmed.

Crude [$87.10] – Trading between $80-$100, which has become a familiar place in the post-2008 era. Trend-following in this volatile commodity remains tricky, especially with unfolding events. It’s fair to say that buyers and sellers lack conviction for now.

Gold [$1595.00] – No major change from the last weeks or months. After a four-month decline, anxious buyers are seeing momentum develop to break through the $1600 range.

DXY – US Dollar Index [83.34] – Flirting with new highs yet again. The strengthening dollar theme is alive and well for over a year – mostly as a function of relative gain as others devalue their currency.

US 10 Year Treasury Yields [1.48%] – Demand for safety via Treasuries is too visible as yields approach all-time lows, as witnessed on June 1st, 2012 (1.43%).

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