Market Outlook | November 5, 2012

“Suspense is worse than disappointment.” (Robert Burns 1759-1896)

Improvement acknowledged

The political suspense lurks in the background for financial markets that are in equal limbo. The anticipated election results can easily stir short-term movements in macro indicators. Yet, guessing the potential priorities of policymakers is a daunting task that will keep many speculating and re-adjusting for months ahead. Nonetheless, the analysis of the current conditions presents more encouraging signs than highlighted in the day-to-day chatter. Perhaps, the early indicators like the silent bull market are now being vividly felt in the real economy.

Meanwhile, the improving economic data points match the bottoming business cycle. Stability in housing and turnaround in labor numbers paint a favorable picture in the post-meltdown era. The S&P homebuilders index (XHB) is up more than 238% from its lows of March 2009, showcasing the revival in housing – or at least, investors’ conviction on further recovery when taking account of the current trends and influence of policy makers. On a similar point, the Federal Reserve of Cleveland reminds us of the following:

“A direct link between housing markets and employment is found in the construction of new homes. When home prices are rising, more households will find new homes to be a viable alternative to existing homes. Starts of single-family homes have increased 27 percent over the previous year, and multifamily housing starts are up 35 percent.” (Stephan Whitaker, October 30, 2012).

Breathers and adjustments

For more than three years, the bullish stock market run looked ahead to a recovery. In that period, shareholders were rewarded for betting heavily on continued earning growth. Now broad indexes are pausing, as the S&P 500 index cooled by 4% from its annual highs (the index is up 12.5% in 2012). Collectively, we are entering a deliberation period in which participants are balancing the earnings growth slowdown versus the lack of alternatives in other liquid investments. Importantly, there are vital periods where there is a disconnect between the pace of economic recovery and stock market movement.

The relative edge of US markets remains noteworthy, while emerging markets attempt to play catch-up. In this setup, seeking investment ideas in emerging markets is appealing in areas that are undervalued or neglected. Encouraging signs of Chinese recovery enhance the near-term curiosity for risk-takers. The recent expansion in Chinese manufacturing serves as an ongoing hint of a new phase of a recovery, but confirmation is long awaited as skepticism grows.

The interconnected nature of markets is biased for a collectively working financial system. Currently, there is increased demand for corporate debt in Europe, and emerging markets demonstrate desperation for yields among global investors. The element of additional surprises in Eurozone resolutions is poised to trigger further enthusiasm away from trepidation that has escalated in recent years. Already, early risk takers are cashing in, as illustrated in this example:

“London-based hedge fund Adelante Asset Management has made a 70 percent gain on a sale of Greek bonds, showing the potential for big profits from betting on a recovery in the fortunes of a country effectively off-limits to investors a few months ago.” (Ekathimerini.com, November 2, 2012).

Big-picture calmness

The contentious discussion of quantitative easing in the US remains a heated debate at times but is generally accepted by the market. For now, the short story suggests: Inflation expectations remain low and economic recovery is not overheating; therefore, low interest rates remain in place for an extended period. Meanwhile, the CRB index reminds us that commodity prices (as a collective unit) are down for the year, and the overall message is that escalating prices are not to be feared.. In addition, volatility has remained low and “fear-mongering” messages are not sparking sensitive reactions. Perhaps, there is a macro stability brewing when considering low rates, contained commodity pricing and relatively low volatility. The suspense may turn to fear when these macro factors adjust more than expected.

Article Quotes:

“For all my value investor friends’ faith in physical assets and commodities producers, those are much more open to confiscatory taxation or seizure than shares in companies that have shown an ability to retain long-term franchise value. If you own a gold mine in South Africa or an oil concession in Argentina, you have a target painted on your money’s back. There are always politically compelling arguments for your having obtained a mineral concession through an unfair or even illegal process. You can’t move the mine or the oil well, and they get to take it back when they want. Sovereigns can take a long time to pay partial compensation. From an equity owner or corporate bondholder’s point of view, the best long-term source of income is a durable international brand, or a corporate design or technology team that has shown an ability to replicate itself over generations. Think Hermes, or Volkswagen, or Schneider Electric. None of them sell what they did in 1960, but they have shown the ability to develop and expand their product lines over time. They’re not based on confiscatable oil wells or gold mines, and the international debt they support isn’t documented by reversible Presidential decrees. The credit investor is always living in fear of inflation and devaluation. Better to own the debt of someone who has to worry about their access to markets, and who has been forced to meet customers’ needs over time.” (Financial Times, John Dizard, November 4, 2012).

“The fact that China watchers, as well as influential political insiders, still cannot say with certainty which leaders – or even how many – will comprise the new lineup is a testament to how opaque and anachronistic the selection process is for the rulers of a rapidly modernizing nation playing an increasingly important role in the global marketplace. In that sense, no matter who walks out onto the rostrum at the Great Hall of the People when the next Politburo Standing Committee (PBSC) is introduced to the world, attention will quickly shift from the identity of the new leaders to whether they can successfully manage the many challenges facing the regime. How severe are those challenges, and what is the likelihood that the new leadership will see bold action on reform as the best – and perhaps the only – means for addressing them? A first step in answering these questions is to put the issues confronting the CCP, as well as the ferment over how best to address them, in their proper context. Chinese elites, and especially the intelligentsia, have a storied tradition of trying to shape the thinking of an incoming administration. Against this backdrop, the effervescence of the debate in recent weeks over reform and the CCP’s future is consistent with the atmosphere that always precedes a leadership turnover.” (Center for Strategic & International Studies, November 1, 2012)

Levels:

S&P 500 Index [1414.20] – Staying above 1400 for a sustainable period is a tough feat considering the peaks in 2000 and 2007. Yet, the momentum remains positive for now, despite increasing odds for pullbacks.

Crude [$84.86] – After a 30% drop from March-June 2012, oil prices are attempting to stabilize around the $85 range.

Gold [$1685.00] – For the fourth time since last September, gold has not demonstrated the ability to stay above or reach $1800. Recent declines make a case for a trading range closer to $1600.

DXY – US Dollar Index [80.59] – In line with the 200-day moving average, while slightly above annual lows.

US 10 Year Treasury Yields [1.71%] – Eclipsing 1.80% will surprise most, while staying below 2% for months ahead appears to match the consensus view.


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