Market Outlook | September 24, 2012

"Silence is a source of great strength." Lao Tzu, (600 B.C. – 531 B.C.)

A silent bull market

The much-anticipated announcement of further easing came and went mostly as expected. With this Quantitative Easing (QE3) announcement, the theme of synchronized uplift in all assets reminds us of 2007, or pre-crisis mode. It is fair to say that this summer, key markets were not quite caught up in the grim conditions of market hopelessness as experienced in late 2008. Neither did the Federal Reserve’s recent action feel like a desperate shock to get out of "intensive care" like the dull late winter of 2009. Yet, through all this repair and these confidence restoration attempts, it simply feels like a silent but powerful bull market. Amazingly enough, even the German stock market (DAX) is already up 26% in 2012. Not many openly glorify the recent market success. Perhaps, many are hesitant to fully relinquish the fearful mindset that’s commonly driven by too many unknowns. That said, de-leveraging is not so pleasant and restoring employment in the current landscape is not easy, but in many ways the market has explored and examined doomsday scenarios.

Growth in private sector jobs has been increasing slowly, corporate earnings are closer to all-time high levels and housing appears to be digging out of a deep ditch. All three fundamental points have backed this strong equity market that is looking ahead or at least for signs that indicate the stopping of the ongoing bleeding. For example, “A lack of inventory in the low-price segment of the market meant the average price of a home was up just because there were fewer low-priced homes in the mix. Adjusting for price, existing home sales were up a more impressive 16%, which is more in line with the growth we are seeing in new home sales.” (Morningstar, Robert Johnson, September 22, 2012). The expectation for continuously improving numbers is slowly building, which only enhances further sensitive responses.

Underestimated

Surely, when the thought of the S&P 500 index revisiting 2007 highs while Nasdaq hovers near its 12-year highs occurs, then it naturally stirs a knee-jerk reaction of a market that’s accelerating too quickly. It is understandable, but not necessarily wise, to take “overbought” statements at face value. Investment managers and participants are set to quarrel between the “gut feel” of day-to-day observation versus a mechanical but familiar set of circumstances that supports higher stock indexes

Through this upside move, there are instances of reality check that lead to a blurry vision when dissecting the testy social and foreign policy environment ahead of election season. Excessive diversion into these not-so-pretty but contentious social dynamics may have led some professionals to lose focus on trends and macro catalysts. Plus, the lack of clarity in regulatory policies and banks’ new revenue models enhance the list of uncertain items. Nonetheless, that’s not enough to depress a dynamic and evolving financial market.

First, it has become too common for politicians or pundits to bash the Federal Reserve’s actions these days. Secondly, there has been a growing fear movement that has led investors to purchase downside protection (insurance) in portfolio holdings. This is exhibited in various ways, as this summary showcases: “The CBOE saw more than 600,000 VIX contracts traded on Friday [September 14, 2012] for open interest of 7.66m, of which more than two-thirds represented calls, indicating that investors are positioning for volatility to increase in the near term.” (IFR Asia, September 23, 2012). Thirdly, the lack of retail investor participation is noteworthy and not needed to produce a solid year-to-date return. Interestingly, the majority of hedge fund managers did not participate or show strong convictions in the rally. At the end of August, when the S&P 500 index returned nearly 12%, hedge funds only produced 3.8% (Hennessey Group LLC). This is not overly alarming for longtime mutual fund observers who’re accustomed to underperformance by overhyped or larger managers. Similarly, few money managers may increase overall risk tolerance to chasing returns by accumulating winning stocks. That response potentially fuels further market upside movement (fairly or unfairly), especially if the real economy improves at least psychologically. Sure, pending pullbacks resurface here, but the positive momentum is hard to debate or ignore.
Suspenseful questions

Now that the anticipation of further central bank easing is nearly off the table, then what’s the next upside catalyst? It’s a question that’s being asked and an answer that will not be clear in the near-term. Are expectations going to escalate too high? And if the stimulus fails to produce growth, then what are the options and consequences?

These are all valid questions that will play out. Certainty, the Federal Reserve plan is now quite evident to decrease the suspense. The results of US elections and pending results from Eurzone solutions clearly will set the stage. Not to be missed in all headline-sensitive items is the potential resurgence of emerging markets, which contribute significantly to sales of larger multi-national firms. If the interconnected market operates in a coordinated recovery, then a collective strength may re-emerge. Any movement of collective strength can spark a much louder bull market as the odds for this are still underestimated.

Article Quotes:

“Americans have profited from China’s meteoric rise: China holds $1.15 trillion of the roughly $16 trillion total in federal debt, enabling deficit-popping tax cuts and government expenditures on social programs and the military. Nearly 160,000 Chinese students attended American universities last year, a 398 percent increase over the past 15 years, according to the Institute of International Education. Chinese firms invested more than $4.5 billion directly into the United States in each of the previous two years, through either mergers or opening new factories, according to the Rhodium Group. More than 1 million Chinese tourists came to the United States last year – each spending an average of about $6,500. The Commerce Department estimates 3.25 million Chinese will visit in 2016.” (The Fiscal Times, September 21, 2012)

“Much that could have gone wrong in the euro zone suddenly seems to be going right. Germany’s constitutional court in Karlsruhe has given the go-ahead for a new rescue fund. A banking union is taking shape. The ever-awkward Dutch have swung back to pro-EU mainstream parties in this week’s election. This builds on a recent pledge from the European Central Bank (ECB) to act to stop the break-up of the currency. Even angry talk of expelling the Greeks from the euro has died down. But don’t rejoice quite yet. The fine print of the Karlsruhe judgment may yet cause problems. Even Dutch centrists are wary of handing over cash and sovereignty. Nobody yet knows how to defuse the ticking bomb of Greece. The ECB’s commitment is untested. And nobody yet knows whether and when Spain will accept the offer of ECB help. Then there is the danger of complacency: debtor states might slow down reforms; creditors may lose the will to repair the euro’s fatal flaws.” (The Economist, September 15, 2012)

Levels:

S&P 500 Index [1465.77] – Trading at annual and multi-year highs while 7% above its 200-day moving average. Recent break above 1420 showcases some buyers’ appetite despite pending pullbacks.

Crude [$92.89] – Sharp near-term decline triggered after reaching the $100 level on September 14, 2012. Set to hold steady around $92 as participants decipher the reasons for recent declines.

Gold [$1784.50] – On one end, a break above $1750 demonstrates ongoing strength that aims to reach all-time highs of $1895 set last September. However, staying above $1750 for a considerable time has been challenging. In November 2011 gold peaked at $1795 and on March 2, 2012 the commodity stalled at $1781.

DXY – US Dollar Index [79.32] – Since late July, the dollar strength run has taken its familiar course of depreciation. In recent weeks, the dollar has been attempting to stabilize, but appears to trade around its multi-year average.

US 10 Year Treasury Yields [1.75%] – The last two months are establishing a new tight range between 1.60% and 1.80% as more clues are awaited for a noteworthy move.

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