Market Outlook | March 11, 2013

“Make not your thoughts your prisons.” William Shakespeare (1564-1616)

Reflective comparison

Not long ago, in September 2011, the markets were overcoming the US sovereign downgrade, weak employment numbers and a dysfunctional perception of lawmakers in the US and Europe. Those factors served as the backdrop for escalating worries resulting in a crisis-like madness. History will remember those months for the aftermath of the debt ceiling drama, but there are a few takeaways that are helpful, especially to grasp the nature of today’s bull market.

On September 9, 2011, gold reached an all-time high of $1895.00. Gold, touted as the safe-haven asset as well as the anti-currency bet, attracted momentum chasers, which eventually drove prices higher. During that same period, the S&P 500 index was attempting to stop the “severe bleeding” after a multi-month decline. Investors were seeking a breather of sorts following the heightened frenzy. Back then, the fragile state of the post-2009 recovery was being questioned, especially as QE 2 ended at the end of June 2011.

Today, with the luxury of hindsight, one notices that since September 9, 2011, gold prices have declined by 16% while the S&P 500 Index rose by 37%. Interestingly, back in autumn 2011, the volatility index (VIX) was around 40, versus last Fridays’ calm finish of 12.59. Stocks, gold and volatility have dramatically changed in less than two years. How has the setting changed between then and now? A few explanations are floating around, such as a rise in investor demand for risky assets driven by the Federal Reserve or the temporary problem-solving of kicking problems down the road. Another possibility is that the perception of Eurozone conditions has improved, temporarily. Either way, the scoreboard is giving observers some noticeable clues.

Digesting some lessons

Sentiment in gold prices continues to change its tone. In its twelfth year of a bullish run, gold supporters may appear confident that the prices will stay higher. Yet, it is hard to ignore the recent downtrend and $5 billion outflow in the main gold fund (GLD) this year. Sure, a near-term recovery looms around the corner, but the investor base is less patient and eager for big moves. However, after a decade, one should adjust expectations and grasp the nuances of an asset that’s often confused between being a commodity or a currency. It is also confused between a momentum play and a value investment. Frankly, the distinctions are not as clear as some would like to claim. Thus, further discovery awaits, as the verdict for gold is murky. Similarly, the commodity index (CRB) peaked in September 2012, suggesting the waning momentum that stretches beyond gold.

As the S&P 500 Index nears 2007 highs, the investment crowd cheers with hopes of participating in a fruitful experience. The habitual low interest rate environment continues to make a strong pitch that supports stocks and other risky assets. Improving economic trends broadly continue to make headlines, while the unemployment numbers are slowly improving. At some point, if the economy improves at the desired pace, then questions will surface as to altering plans by the Federal Reserve to end its stimulus efforts.

Thinking ahead

Entering the fourth year of a bullish stock market has shocked some while intriguing others. But for money managers, critical decisions await between the casual joining-the-crowd path versus the difficult task of planning. Now it takes guts to think ahead beyond just this status quo of low rates, a weak dollar and higher stock market. Slowly, a new trend is silently forming. The US dollar is strengthening by showcasing eight weeks of rally. Meanwhile, Treasury yields continue to rise so far this year. Today, it seems a little wild to think that the rates will rise, but the landscape is shaping that setup, given the perceived economic growth. The lesson of sudden shifts is hardly surprising in the last five years. Yet, bracing for changes requires more skills and guts. Perhaps, flexibility is the biggest asset heading into a suspenseful spring.

Article Quotes:

“In the face of slowing exports, the [Chinese] government wants to raise domestic consumption's share in the economy to close one of the world's widest gaps between rich and poor and quell discontent among those Chinese who feel they missed out on blistering economic growth of the past three decades. The economy picked up in the fourth quarter as a spurt of infrastructure spending orchestrated by Beijing broke seven straight quarters of a slowdown. Consumption’s contribution to growth, however, fell in the fourth quarter for the third straight quarter. About 13 percent of China's population still live on less than $1.25 per day, the United Nations Development Programme says. Average urban disposable income is just 21,810 yuan ($3,500) a year. Meanwhile, China has 2.7 million millionaires in dollar terms and 251 billionaires, according to the Hurun Report, known for its annual China Rich List. Urbanization could cure China's economic imbalances, a study by consultants at McKinsey showed last November, putting it on a path to domestic consumption-led growth within five years to replace three decades of investment and export-driven development that stoked global trade tensions. The government hopes 60 percent of its population of almost 1.4 billion will be urban residents by 2020, from about half now, and will build homes, roads, hospitals and schools for them.” (Reuters, February 28, 2013).

“According to Morningstar, a research firm, the average monthly inflow into American bond mutual funds over the past three years has been $18.5 billion; US equity funds have seen average outflows of $7.2 billion. In January, despite much talk of a “great rotation” out of bonds and into equities, bond funds received inflows of $38.1 billion and equity funds (domestic and international) had inflows of $37.8 billion. There are a few signs that investors are demanding higher yields from corporate issuers in 2013 but nothing that indicates panic. As long as the return on cash is so low, it is unlikely that bond funds will see massive outflows. To the extent that investors are moving into equities, they are probably shifting out of cash and money-market funds, not bonds. So for a collapse in the corporate-bond market to happen there will either have to be a sudden reversal of central-bank policy or a wave of defaults. The former looks highly unlikely this year. The latter is most likely to occur if companies suddenly go on a wild spending spree with borrowed money. A recent pickup in mergers and acquisitions may eventually lead to the kind of excesses that have been seen in the past. But these are early days. If this is a bubble, it probably has a bit more inflating to do.” (The Economist, March 9, 2013).

Levels: (Prices as of close March 8, 2013)

S&P 500 Index [1551.18] – Approaching all-time highs of 2007; the bullish run is intact. Nearly a 16% rally from mid-November 2012. The breakout above 1460 triggered the current forceful upside momentum.

Crude (Spot) [$91.95] – Trading in line with the 10-month average. Over the past two years, buyers’ appetites have slowed down at $98, and selling pressure wanes at $84. Within this trading range, several up-and-down patterns persist. For now, the ability to stay above $90 can shape the collective mindset.

Gold [$1579.40] – Over the last year and a half, gold prices have established a range between $1600-1800. Now the slight break below $1600 creates a charged-up environment between buyers and sellers. Odds favor a slight price increase in the near-term. However, since September 2011, gold prices have declined 16% - a slight hint that’s worth noting.

DXY – US Dollar Index [82.69] – After the bottoming process over the last five months, the dollar is strengthening. Since the lows of May 6, 2011, the DXY is up by more than 13%.

US 10 Year Treasury Yields [2.04%] – As the last three months showcase, rising yields as the short-term trend suggest not only a move above 2%, but a changing dynamic according to the technical picture. Climbing back to 2% has been a gradual task. Yet, sustaining above 2% remains a major macro puzzle with attentive eyes watching.

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