Market Outlook | October 22, 2012

“Power is so characteristically calm, that calmness in itself has the aspect of strength.” (Edward Bulwer-Lytton 1803-1873).

Composure required

Heading into this quarterly earning season, the ongoing question regarding corporate earnings’ sustainability was being asked with heightened curiosity. There already exists a jittery setup for stock prices, given an explosive multi-year upside run. At the same time, the debate over economic recovery resurfaces, given improving housing and consumer data. Yet, a slightly recovering economy might be easily confused with an extended stock market, but those assumptions are often costly and overly simplistic. Sustaining revenues for larger companies is surely a challenge, but that doesn’t ensure that the stock market appreciation is coming to a crisis mode, either.

Friday's stock market sell-offs captured recent disappointments in company earnings matching or exceeding expectations. Some earnings results reflected a cumulative impact of the slowdown in China and Europe that strongly influence multinational revenues. As anticipated, the inevitable slowdown from all-time highs in corporate earnings is more than reasonable. Similarly, the odds of pullbacks were much anticipated. As Bespoke Investment reminds us: “The Dow's 1.52% drop today [Friday October, 20] ended a streak of 81 trading days without a 1%+ decline. This was the longest streak without a 1%+ decline since the 94-trading day streak that occurred from July through November of 2006.”This was an amazing streak that showcases strength that’s been overlooked by most.

Lack of options

Plus, with interest rates this low, one has to wonder: What other alternatives present an attractive risk/reward? At this point, not many assets offer a liquid alterative. Thus, equities have not quite lost their relative luster despite ongoing fund outflows. Not to mention, even a 5-10% correction in broad indexes may not materially impact the current recovery mode. Sure, the growing list of bearish arguments of fragile markets is ready to unleash now. This paints the missed earnings targets as a clue for further doom. Yet, overreacting to these exhausted worries is as reckless as ignoring the earnings slowdown that has slowly persisted. Maintaining balance is the challenge for money managers for the next two or three quarters ahead.

Brewing suspense

Global growth and inflation are ongoing concerns that are pointed out by executives, investors and pundits. The recovery of emerging markets is not rapid but poised to resume. Thus, the recent correction was much needed and despite slower growth than last decade, there is strength in emerging markets that may be underappreciated. “Today, emerging market countries are the main driver of global growth. Emerging market economies will account for more than 70 per cent of the contribution to global growth in 2012 and are growing at a pace four times that of developed market economies.” (FundWeb, October 22, 2012). Inflation remains another debatable topic in terms of reported versus unofficial data. For now, inflation is not overly concerning. Growth is the bigger concern, as the economy is not close to “overheating.” Yet, passionate arguments and interpretation can shape investor mindsets.

In 2010 and 2011, volatility spiked to extreme levels (above 40s on VIX index). Perhaps, a similar pattern was anticipated this year, but in late October the calmness remains in place. Of course, there are market-moving events that can spark sudden turbulence – a thought circulating among financial professionals this weekend. Importantly, risk-aversion has been a dominant theme that has persisted during strong markets. Thus, claims that the rush to safety is a new phenomenon after weak earnings might be misleading. For now, emotional responses may play out, but overreacting to headlines is not a rewarding proposition.

Article Quotes:

“But there is a difference between expecting low returns due to reversion to long-term normal valuations and expecting low returns because something has fundamentally changed about the return-generating process for equities. Whether GDP growth in the U.S. and other developed economies is going to be slower in the future is not, in and of itself, a reason to expect a lower return to equities. Likewise, the fact that historic equity returns have been higher than GDP does not mean that the equity market has been some sort of long-term Ponzi scheme. Equities are an ugly asset class –one that is more likely than almost any other to lose investors a significant amount of money at those times when they can least afford it. That is, in a way, their charm. It is why equity is such an appealing form of capital for companies. It is the reason why equities have been priced to deliver good returns historically. And it is the reason why we believe equities are very likely to be priced to deliver strong returns into the indefinite future.” (GMO, White Paper August 2012)

“One possibility is that central banks are overestimating the scale of economic weakness, and keeping interest rates too low as a result. That might be good for corporate profits, but excessively loose monetary policy would also lead to higher inflation. So how are equity markets affected by inflation? In years when the annual inflation rate has been falling, the real return from American stocks has been 9.6%; in years when it has been rising, the real return has been minus 1.1%. So past experience suggests a sudden jump in inflation would not be great for the stock market. The other possibility is that central banks have not done enough: monetary policy is still too tight. In that case, the economy will be even weaker than is currently expected and profits will presumably be lower than forecast. It is hard to see how that scenario can be very bullish for equities either. Perhaps none of this would matter if the bad news was already reflected in share prices.” (The Economist, October 20, 2012)



Levels:

S&P 500 Index [1433.19] –Staying above 1400 seemed short-lived earlier this year (with a peak of 1422). Now, the 1420 level attracts some eager observers and any movement below 1400 can re-spark further sell-off potential. Nonetheless, the upside remains intact.

Crude [$90.05] – There has been a nearly $10 drop since peaking on September 14, 2012. We see strong evidence of bottoming around $90 over several weeks.

Gold [$1737.00] – In recent weeks, gold has held in a tight range between $1740-$1780. Interestingly, getting over the hurdle of $1750 remains a challenge for goldbugs.

DXY – US Dollar Index [79.62] – Mostly unchanged week over week. The index is 13% higher from all-time lows of March 2008.

US 10 Year Treasury Yields [1.76%] – The challenge is to surpass the 1.80% mark, as that range is tested for the third time in the last three months.



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