Market Outlook | October 8, 2012

“Vision is the art of seeing what is invisible to others.” (Jonathan Swift 1667-1745)

Re-confirming strength

The existing bull market continues its run while the US economy appears to reaffirm its slow recovery. Central banks’ implementation of stimulus plans may have accumulated enough doubters, but the success of raising inflation expectations is still questionable, so the tone has led to assets seeing a collective boost. Housing improvement has been long underestimated and its contribution to the GDP can create surprises in the quarters ahead. Confirmation of construction and manufacturing growth will be watched attentively to see if there is an actual broad-based recovery. At this point, as in prior decades, the US manufacturing sector is sluggish, but even minor improvement can contribute to further evidence of new cycle recovery.

The desired pace of the current recovery is debated in many ways, but the clues of a housing healing should not be easily ignored. A recent status update on homeowners’ condition provided some early clues:

“According to the scorecard homeowner equity has risen to its highest level since the third quarter of 2008 and 1.3 million borrowers have been lifted above water, largely due to rising home prices. Equity jumped $406 billion or 5.9 percent to $7,275 billion in the second quarter of 2012.” (Mortgage News Daily, October 5, 2012)

Not too foggy:

These days, convincing the gloom-and-doom crowd with endless data of improving or cheery messages is not an overnight task. The same way, turning risk-averse observers into optimistic risk-takers ends up taking significant time. Yet, markets move faster than economic factors and select entry points are offered in a narrow period. The increasing confusion in data digestion, political messaging and residues of the 2008 crisis have puzzled many minds. Simply, casual and seasoned observers have been challenged by and at times missed this relentless “silent bull market.” Glancing at the scoreboard today (year to date: S&P 500 +16.2%, Nasdaq 100 +23.5%, German DAX Equities +25.4% and US Bank Index +30.5%) shows healthy return numbers by any equity-based historic standards. Perhaps, this reality is aggregating the trailing fund managers who failed to bet enough on US stocks.

Obviously, if the message of economic strength is not fully transmitted to wider audiences, then confidence restoration remains a lengthy process. Anticipation of Washington’s policy and elections outcomes further confuse many to stay stagnant:
“Almost 79 percent of respondents cited uncertainties related to the political environment as their number-one challenge.” (National Association of Manufactures, September 13, 2012).

Adjusting vision:

Similarly, the lack of stock market participation is hard to dismiss. Highly intensified and politically charged opinions on the economy are less relevant for markets. This year revealed the slowness of emerging markets, improvements in US labor and redefinition and restoration of a fragile global financial system. Interestingly, hedge funds are buying debt of risky European nations. According to Bloomberg, last month witnessed the $104 billion purchase of Spanish bonds by foreign investors (October 7, 2012). Perhaps, this shows risk-taking by few in anticipation of improving Eurozone solutions. This is a though reality to envision given what’s transpired in the last five years. Whether this is right or wrong is one issue, but acting on courage is what keeps the spirit of financial markets alive. Frankly, betting on upside surprises is out of favor and partially neglected.

As the mild race to own stocks piles up, then the grim question asked will be whether a strong economic recovery ends up slowing the stock market’s upside potential. Although economic strength is not fully evident, the trend is slightly positive. Yet the laundry list of worries has grown if not stayed the same from the start of the year. That includes: further discovery on Eurozone crisis, magnitude of China slowdown and escalating regional tensions leading to potential spike in commodities. The so-called “inventory” for worrisome matters continues to appear excessive more than was imaginable. For example, when it comes to buying downside insurance, last month presented heightened fear of all sorts:

“In September, average daily volume (ADV) in VIX futures reached a new all-time high of 126,345 contracts, which surpassed the previous record ADV of 102,587 contracts during June 2012.” (HedgeWeek, October 2, 2012).

Thus far, high trading activity in volatility-related products has not translated to increased volatility. Rather, the opposite result has been seen, in which volatility is not quite as high as expected.

That said, to claim a blind-sided collapse that may loom around the corner is not a shock (yet again). Rampant attempts to avoid or minimize misunderstood risk remain a theme, but riskless instruments are unattainable – reinforcing the importance of emphasizing relative attractiveness. For now, a slowing US economic recovery attempting to catch up with the explosive stock market only demonstrates a new cycle formation and a new definition of “normal.” The search for a “new normal” remains unknown to all.

Article Quotes:

“June or July is usually the peak month for both total and full time employment. This year the numbers broke last July’s level in April. The economy was a couple months ahead of schedule in affirming the uptrend in jobs. That uptrend is still firmly entrenched, even in the full time jobs including the September decline. The gains have clearly accelerated in 2012 versus 2011. The idea that the economy slowed in 2012 is hogwash. With QE3, the Fed is adding more fuel to a fire that was already beginning to burn hot. … The withholding tax data shown below also suggested that something in the labor picture is still undergoing consistent gains, regardless of what the SA [seasonally adjusted] data says. Increasing withholding tax collections of 2% in real terms are growing at double the rate of population growth. … Economic pundits must face the fact that the 10 million fake jobs spawned by the bubble are not coming back. The 7.8% unemployment rate is probably ‘normal.’ The bubble unemployment rate of 5.5% was abnormal.” (The Wall Street Examiner, October 5, 2012)

“Chinese leaders have plenty of cash, so they can easily funnel resources into new industries. They are already directing funding toward strategic emerging industries such as green technology products and next-generation information technology equipment and software. Where they run into trouble, however, is in actually getting those new industries off the ground. That requires turning off the spigots of government support flowing toward the older and more inefficient industries and state-owned enterprises, a tough task when local government officials are fighting hard to keep them alive. In green energy, for example, Chinese leaders have directed substantial resources toward wind and solar. That has paid off in clean energy manufacturing: Chinese companies are using cost innovations to manufacture cheaper versions of wind and solar technologies developed abroad, and they are exporting those products all over the world. What Chinese leaders really want, however, is to develop their own technologies and sell more of them at home, and that is not going so well. Chinese leaders are doling out funds for clean energy R&D, but they distribute them through government channels, and government officials direct the money toward old friends instead of new prospects. Resources go to the well-connected instead of to the entrepreneurial. Many private enterprises cannot get financing, and private enterprises are more likely to generate the new ideas China needs.” (Center for American Progress, October 2012).

Levels:

S&P 500 Index [1460.93] – Closed last week a few points away from September 14 highs of 1474.51. The current strong recovery began in early June as the odds for near-term correction increase.

Crude [$89.88] – Interestingly, after making annual highs along with stocks in mid-September, the momentum for oil has slowed sharply. A notable move below $90 is worth watching and deciphering between a trend and a temporary pause.

Gold [$1784.00] – Continues to trade near annual highs. Surpassing $1800 remains a suspenseful event for some buyers and a mere test of strength for most observers.

DXY – US Dollar Index [79.32] – In line with its four-year and two-points below its ten-year moving averages. Both demonstrate the lack of noteworthy movements and the relative stability of a strong currency.

US 10 Year Treasury Yields [1.74%] – It was September 30, 1981 when rates peaked, and ever since, the downside has persisted over three decades. Now, attempting to dig out off all-time lows set in July at 1.37%. Over a 10-week period, stability is forming between 1.60%-1.80%.


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