Market Outlook | January 28, 2013

“Courage is never to let your actions be influenced by your fears.” (Arthur Koestler, 1905-1938)

Undisrupted Rhythm

Ongoing discussions of low interest rates and a weak dollar have been used to explain various status quo trends, including a rising stock market. Yet, there is a perception that the relatively low rates and weak dollar will ultimately create growth. Perhaps that’s a simplistic view, as the first challenge for policymakers was restoring stability. These days, stability is a “sellable” point in US markets, given signs of progress in rising risk tolerance. At some point, growth in the real economy has to be easily noticeable beyond slight improvements in the monthly data. Reported data has pointed to growth in labor and housing, primarily. This week, more than 20 economic data points will set the tone for further clues. With volatility so low and stock markets at a multi-year high, the suspense is building to confirm the ongoing direction.

The macro climate has not been overly suspenseful in several months. Some wonder if participants are less prepared (in risk management) for rising rates and a strengthening US dollar. Although neither macro trend has shifted dramatically, the current setup of rising risk tolerance may serve as a catalyst. The US 10-year treasuries have fought back closer to the 2% range, while the dollar depreciation theme has slowed its deceleration. At the same time, the pace of gold price appreciation has paused, as well. Indicators of big-picture themes have been quite enough to create some complacency, and that has its sudden danger of turning faster than imagined. Thus, the surprise element rises despite the dormant-like performance thus far.


Euphoric responses

Recent chatter and observations quickly remind us of pre-crisis days. For example, hedge funds are back to using leverage, the ultimate symbol of subsiding fear and increased confidence. The Volatility Index (VIX) is not too far from its lows last witnessed in 2007. Lack of volatility has been witnessed for a while. Of course, the major comparison to five years ago is highlighted by the S&P 500 Index causing a buzz by reaching the 1500 level. Of course, a cheerful one-liner only deserves to be scrutinized for the skeptical crowd. Sure, earnings have being going up, but sustaining them is a doubtful matter, as Apple realized. And if earnings disappoint, the shrewdest crowds should not act overly surprised. Frankly, the lack of alternatives in investable assets also plays a part in driving markets higher, causing further disconnect between reality and fundamentals.


Investors’ dilemma

A three-year run-up in the S&P 500 index now finds a new wave of investors entering who may have awakened from accepting the fear-mongering messages. Yet, it is heavily documented that corporate earnings are at or near some peak, which is difficult to sustain. Similarly, the notion that saving is not rewarding in a low-rate environment has pumped more money into risky assets. Thus, some are begrudgingly forced to pile on risk even though the entry point is not overly attractive. In other words, it’s hard to claim that the stock market is at a bargain. Thus, with every upward move, the risk of a downside move is enhanced, both in domestic and emerging market areas. However, since staying neutral is vastly unappealing, the trend will favor further risk-taking until the next unforeseen shock.

Article Quotes:

“Canada is quietly trying to deflate its bubble without any eye-catching headlines. And that means keeping interest rates low while making mortgages harder to get. Now, raising rates to pop a bubble sounds like the kind of hard-hearted long view central bankers pride themselves on, but it's more hard-headed. Higher rates don't just make housing (or any other asset bought with borrowed money) less affordable for new buyers; they make them less affordable for old buyers with adjustable-rate loans too. That sends prices spiraling down and savings racing up, as heavily indebted households, which Canada has no shortage of, try to rebuild their net worths. Higher desired savings outpaces desired investment – in other words, the economy collapses – and subsequently cutting rates, even to zero, won't do much to reverse this, as houses and businesses are mostly indifferent to lower borrowing costs while they focus on paying down existing debts. It's what economist Richard Koo calls a ‘balance sheet recession,’ and it's a good description of how an economy can get stuck in a liquidity trap. But by keeping rates where they are and slowly tightening mortgage requirements, Canada hopes to engineer a more gradual price decline that won't set off a vicious circle.” (The Atlantic, January 25, 2013).


“Although many historians today focus on the Revolutionary War debt to foreign countries, the kind of debt that captivated the founders themselves, and served as one of the main prods to forming a nation, was domestic. It involved multiple tiers of bonds, issued by the wartime Congress and bought by wealthy American investors, who hoped to finance the war in return for tax-free interest payments of 6 percent. The first American financiers, in other words, were also the first American nationalists. Both the young Alexander Hamilton (savviest of the founders regarding finance) and his mentor Robert Morris (the wartime Congress’s superintendent of finance and America’s first central banker) believed that a domestic debt, supported by federal taxes collected from all the states, would unify the country. It would concentrate wealth, and yoke that wealth to a consolidated government. The goal was a nation capable of grand projects – ultimately an economic empire to compete with England’s. Other famous founders worked with Morris and Hamilton in building nationhood around the public debt. James Madison, who became Hamilton’s political enemy in the 1790s, was among his closest allies for nationalism in the 1780s. Madison’s famous ‘Federalist No. 10’ conveys a horror of default on the domestic debt as deep as anything ever expressed by Hamilton. In letters written before the Constitutional Convention to George Washington, another supporter of sustaining federal debt via taxes, Madison made clear the nationalists’ shared desire to shore up public credit by throwing out the Articles of Confederation and forming a nation. Edmund Randolph opened the convention by charging the delegates to redress the country’s failure to fund – not pay off, fund – the public debt by creating a national government with the power to do so.” (Bloomberg, January 25, 2013)

Levels:

S&P 500 Index [1502.96] – Closed above 2012 highs, reemphasizing the ongoing strength. Pending pullbacks will be monitored, especially if a new move develops below 1460. At this point, obvious bullishness is the signal, given the rapid upward move.

Crude (Spot) [$95.88] – A more than $10 jump since the lows of November 2012 awakens a new wave of buyers. Recent headlines in oil-influential countries may provide some short-term catalysts to an already explosive move. For now, the next key level is $100.42, which was last reached in mid-September 2012.

Gold [$1660.00] – Broke below the 50-day moving average of $1668.37. Gold observers remain unanimously positive on further price appreciation after a four-month sell-off period. However, this overly bullish scenario has yet to play out.

DXY – US Dollar Index [80.03] – Stability intact between 78-80. The overall message is that the “dollar weakening” theme has not decelerated.

US 10 Year Treasury Yields [1.94%] – In less than one month (Dec. 4, 2012-Jan. 4, 2013) a move from 1.56% to 1.97% materialized. Now, plenty of doubters line up to doubt the continuation of rising rates. Certainly, a resistance at 1.90% is eagerly watched for further clues.





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