Market Outlook | December 10, 2012

“Ninety-nine percent of the failures come from people who have the habit of making excuses.” George Washington Carver (1864-1943)

Mixed labor results combined with a slightly convincing housing recovery linger in this recovery process. Another week has passed where US labor numbers can be interpreted as not so ugly. Others might conclude the economic health results were not that amazing, either, with the truth residing somewhere in between. Meanwhile, the discussion of market meltdown or complete collapse appears less viable despite occasional fear-driven moments, while the positively trending market is slightly more visible and the bullish stock market run is now more acknowledged than denied by casual observers. Those who made excuses for not participating in the stock market are now realizing the S&P 500 Index is up more than 12% in 2012.

Like several months before, the investor’s search for clarity centers around the following:

1. Assessing trends and hints from economic data
2. Grasping impact of low interest rates
3. Speculating on big-picture sentiment and catalysts

 Economic recovery

The trick of digesting data creates a danger for those who lump various data points into one headline story. Even the nature of stimulus impact on housing and labor is mysterious, for the most part. As the end of Operation Twist looms around year-end, there are brewing questions on Federal Reserve policy. Whether Quantitative Easing 3 was “overkill” or much needed is to be determined – a macro call of high significance. In fact, the extension of stimulus efforts from the Federal Reserve is not off the table, either. All that said, long-term investors who are looking to deploy capital for three to five years face a quandary given the shaky grasp of the current business cycle.

Digging out of lows

Global interest rates remain around historic lows. The pattern of trading at or around all-time lows has become a norm in this era. In fact, the contemplation of negative yields is not a bizarre thought these days, as hinted by the European Central Bank. Plus, the same story is evident in 30-year mortgages, which remained near all-time lows last week by dropping below 3.40%. Interestingly, many have attempted to call the rates in the past few years and have not been accurate. Thus, this mega global coordinated effort is not bound to change in one quarter, but any clue will be overly dissected.

Forecasting sentiment

Favoring gold against owning other instruments, including cash, has its appeal mainly for those seeking diversification. Yet, there is more risk to gold that’s loudly publicized besides the directional debates. Perhaps, this historical reference is worth noting for commodity risk assessors: “In 1933 President Roosevelt issued Executive Order 6102, prohibiting the private holding of gold and requiring U.S. citizens to turn over their gold bullion or face a $10,000 fine (equivalent around $170,000 today) or 10 years imprisonment. In response, opportunistic coin dealers encourage investors to buy expensive “numismatic” or “collectible” coins, taking advantage of an exemption in the 1933 order which protected these assets from government seizure.” (Naked Capitalism, Satyajit Das, December 6, 2012).

Collectively, soft and hard commodities have showcased underperformance for more than a year. Specifically, the CRB – or commodity index – has declined by nearly 20% since peaking in early May 2011. The commodity optimist sees further price increases as part of the ongoing decade-long run, while others suggest that further easing from risk-aversion may make the gold story less appealing. Right now, both views are deadlocked without any trend shift to make a splash.

Speculators may find it worthwhile to guess investors’ response toward risk in upcoming months. The script of risk-aversion is typically associated with increasing US dollar demand, less trust in Federal Reserve policy and ongoing credit downgrades in European nations. This bearish script is wearing down, along with upside expectations that are coming down. However, unknown risks associated with tax implications and pending regulatory changes continue to cause a natural pause. Not to mention overly sensationalized fiscal worries that are lumped into many forward-looking dialogue.

The desperate search for growth is a common theme that stretches from the GDP to corporate earnings and emerging markets growth. Revival of the Chinese market in recent weeks is fulfilling the demand of risky asset investors. Other developing countries like Turkey and Mexico offer renewed momentum for those searching for a sustainable but profitable run. Similarly, in recent weeks, the Chinese recovery is showing positive signs despite skepticism. This is demonstrated by a 20% run in the Chinese index since September 5, 2012. Perhaps, the investor’s dilemma of lack of growth combined with limited options will force more risk-taking than imagined.

Article Quotes:

“As evidenced by the tire case, China often does retaliate (China also recently initiated investigations on US polysilicon in retaliation for the punitive US duties on Chinese solar cells). In fact, the US may stand to lose more in such tit-for-tat exchanges because most of China's exports have little added value. For example, Chinese inputs account for less than 2% of the value of each iPhone imported to the US from China, while Apple's profits amount to 60% of that value. Sadly, the misguided US effort to ‘get tough on China’ does not stop with trade but extends to investment. Countries with a substantial trade surplus like China tend to invest heavily overseas, and such investments create jobs in other countries. However, the US government has been cool towards Chinese investment. Unlike companies from most other countries, Chinese companies wishing to invest in the US are often singled out for a heightened national security review by the federal inter-agency Committee on Foreign Investment in the United States (CFIUS). The extent of US hostility towards China in trade and investment is puzzling given the co-dependence of the two economies. The benefit to the US from its economic relationship with China is real – and contrary to what many claim, such benefit does not come at the cost of US jobs. Chinese investment has an even greater potential for creating US jobs. A cash-flush China would be happy to invest in the United States if it is allowed to do so, and many Chinese companies would be happy to comply with whatever security requirements the US government has in store (if it tells them what these are).” (Asian Times, December 8, 2012)


“Private equity firms and hedge funds have stepped into the morass that is the US housing market by scooping up single-family homes at discounted prices and renting them out to disenfranchised masses. Their goal is to generate returns from a combination of rental income and appreciation in housing prices. Silver Bay Realty Trust, a joint venture of RMBS specialist Two Harbors Investment with private-capital management firms Pine River Capital Management and Provident Real Estate Advisors, is seeking to put a public face on the booming trend through its forthcoming initial public offering. Credit Suisse, Bank of America Merrill Lynch and JP Morgan plan to price 13.25m shares at an indicative price of US$18–$20 each on December 13. The vehicle, which is seeking to be structured as a REIT, is initially targeting a net annual yield of 6%–8% after factoring in vacancies and operating costs. Higher returns are expected in future years as occupancies rise and the value of owned homes appreciates. Silver Bay gets its revenue from an underlying portfolio of 3,100 homes. The vehicle is structured as an up-REIT, whereby the joint-venture partners will control a 64% equity stake and public shareholders the remainder.” (International Financing Review, December 8, 2012)

Levels:

S&P 500 Index [1418.07] – New challenges facing the current momentum as the index nears 1420.

Crude [$85.93] – Ongoing pause continues following a peak since $100 in mid September. So far, resilience is witnessed at $85. At same time, buyers’ appetite above $90 is less visible.

Gold [$1701.50] – For the second time in a month, attempting to climb above $1700. Enthusiasm of the commodity anticipates a rally, while recent history shows that Quantitative Easing 3 has yet to have a big influence on pricing.

DXY – US Dollar Index [80.15] – No major decline since the fall. Yet, the catalyst for a noteworthy upside move remains a mystery at this point.

US 10 Year Treasury Yields [1.61%] – Stability in place between 1.55-1.82% which is a theme that continues to repeat. A step back reinforces an era of historic lows that continues to resurface.

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