Market Outlook | August 27, 2012

“Quarrels would not last long if the fault were only on one side.” (François de la Rochefoucauld 1613-1680)

Disagreements:

A series of divided views remains visible in the actions of the Federal Reserve, congress, Euro-zone leaders and investors alike – a theme that continues to resurface among those credited with setting market tones. Surely, the contentious and passionate differences today have led to the following:

1) Increased difficulty in deciphering the “believable” data about the economy and stock market, given increasingly biased views.

2) Ongoing public and private disagreement among policy makers in a rebuilding era creates unneeded uncertainty, if not further confusion.

3) Confidence restoration is not easily achieved when adding more layers of difficulties in heated debates.

4) Unconvincing messages of longer-term sustainability and undesired results of increased risk aversion.

In a puzzling manner, the desire for collective success (of the global economy) seems less noticeable than imagined. Specifically in the case of the Federal Reserve, the debate over the need for stimulus has played out for a while in FOMC meetings. Thus far, the plan to ease has prevailed, but its results are under scrutiny, as usual. A new wave of uncertainty looms over the leadership of the central bank, driven by election chatter and speculative banter on the next quantitative easing. The question of further easing is debatable itself, which only confirms a genuinely confusing state of affairs rather than providing any answers.
Perspective mystified

It’s hard to tell if market success is feared more than fear itself. So far this year, investment success, when measured by continuing equity market appreciation, appears more acceptable than not. However, it has failed to drive away all legitimate and illegitimate fear mongering by pundits. Perhaps that’s business as usual, but it stands out in an unusual time.

For example, the view of the market today varies depending on whom you ask during a random stroll. The year-to-date numbers show 12% return for the S&P 500 index and 22% appreciation for the Nasdaq. For an outsider removed from the day-to-day noise, these numbers may reflect normal times. Even weak economic numbers did not fully destroy the market’s spirit, but revealed the disconnect between the real economy and stock prices – frustrating for the too-logical-minded participant and tricky for those with a gambler’s mindset. Nonetheless, the end result increases the challenge for prudent managers in charge of selecting profitable ideas.
Gold’s glory?

Euphoric supporters of gold appear to be reawakened, as sentiment is overwhelmingly positive. The following discovery was summarized on Bloomberg:

“Twenty-nine of 35 analysts surveyed by Bloomberg expect prices to rise next week and three were bearish. A further three were neutral, making the proportion of bulls the highest since Nov. 11. Investors bought 51.7 metric tons valued at $2.78 billion through gold-backed exchange-traded products this month, the most since November, overtaking France as the world’s fourth-largest hoard when compared with national reserves.” (Bloomberg August 23, 2012)

In digesting the fact above, one should not have a knee-jerk reaction on the bullish or contrarian side. Instead, understanding the landscape may tell the story better. Chart observers will point out increasing odds for price appreciation given a bottoming process that’s unfolded around $1550 (per ounce) for several months. At the same time, macro observers with a gloomier outlook for “everything else” are known to confidentially cling to a relatively mainstream view of buying gold ahead of further chaos. Sure, that point has its merits when considering uncertainty and inflation. Interestingly, the lack of chaotic market events and calming volatility levels this year may easily convince plenty to think that the worst is ahead in the second half. Yet, it is glaringly dangerous or at least intriguing that the consensus is overly optimistic in embracing gold as the investment solution.

Article Quotes:

“In 1962, one newspaper pushed that ‘it's about time you stopped worrying about layoffs and start thinking about security and the future.’ In 1983, another wrote about a rise in consumer confidence: ‘The nuclear threat still looms. Reports come in every week of further destruction of forests by acid rain. Unemployment is at a record high. But people seem to be tired of worrying.’ Then again in 1992: ‘People are saying, “I'm tired of this recession,” and they are spending again,’ wrote the Dallas Morning News.

It turns out there's more to this than anecdotes. There's a theory in behavioral psychology called the fading affect bias. In simple terms, it states that negative emotions leave our memories much faster than positive ones – a sort of natural aversion to unpleasant thoughts. In 1948, psychologist Sam Waldfogel gave a group of participants 85 minutes to write down every event they could remember from the first eight years of their life, and rank them as pleasant, unpleasant, or neutral. Logically, events should have been spread evenly between the three. But they weren't. Pleasant memories outweighed negative ones by almost twofold. People had a distinct positive bias when recalling their past.” (Morgan Housel, August 24, 2012 The Motley Fool)

“Despite cheaper labor abroad, currency manipulation, intellectual property theft, and subsidies to foreign competitors, these American manufacturers are winning. Many of them are small or medium-sized businesses that are family owned. Some are large corporations led by executives who still believe that America is the best place to set up a factory. … These manufacturers help explain why, against all odds, our nation held the global lead over China in manufacturing output until 2009. What's extraordinary is that our aggregate output remains competitive with China's, even though the sector constitutes only 10 percent of our economy compared to nearly 40 percent of theirs. We are a global leader, in part, because our labor productivity (the value that a worker produces annually) is more than six times as large as China's or India's and significantly larger than Japan's or Germany's. Strong productivity has enabled the United States to increase its manufacturing output over the past 30 years to a greater extent than any other developed nation, more than doubling in size. American manufacturers often have an advantage over their competitors in more authoritarian or bureaucratic nations because participatory governance is preferable to top-down governance, even in the business world.” (Ro Khanna, Reuters, August 21, 2012)

Levels:

S&P 500 Index [1411.13] – After reaching annual highs of 1426 on August 21, there is a growing anticipation for a correction toward 1350. Despite these changing sentiments, in the near term, the uptrend remains in place.

Crude [$96.15] – Staying above $100 has been challenging in the last two years. In the springs of 2011 and 2012, the commodity peaked, then normalized to a sideways pattern.

Gold [$1618.50] – Odds for a bottoming process here appear high. The consensus is overwhelmingly positive here; however, a run above $1895 seems mysterious for now.

DXY – US Dollar Index [82.59] – Dollar strength has been slowing since late July. This pause does not trigger a significant move to reach a cycle conclusion.

US 10 Year Treasury Yields [1.68%] – A struggle to climb above 1.80% while not too far removed from the lows of 1.37%. Event-driven movements should make moves in yields rather sensitive.


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