Market Outlook | May 20, 2013

“Nature cares nothing for logic, our human logic: she has her own, which we do not recognize and do not acknowledge until we are crushed under its wheel.” (Ivan Turgenev 1818-1883).

Digesting surprises

We are reaching a junction where fighting the status quo is wearing down those who did not accept the power of the Federal Reserve. The power of surprises plagues the consensus mindset and costs investors if they miss out. The surprises, of course, are in how the stock markets reached all-time highs, inflation is not a big threat and commodities are weakening despite an overall economic cooling period. Clearly, the Federal Reserve has engineered the stock market recovery and demonstrated its dominance and influence. Love it or hate it, those are the facts that confront those who placed their bets in the liquid markets. The commentary of Fed-bashing and gloomy opinions is mere noise now, as the bullish months passed by through all built-up concerns.

Similarly, gold bugs who kept proclaiming the “inevitable” gold price upside movement in a religious-like manner are learning that markets are not overly simplistic or logical. At the same time, this is a reminder that all trends must come to a pause even before a trend comes to a sudden shift. Two points made headlines this weekend:
“[1] Money managers, including hedge funds, pulled $1.4 billion from the U.S. gold futures market for the week ended May 14 by trimming their net long positions in the metal, according to Reuters calculations of data released by the Commodity Futures Trading Commission (CFTC) … [2] On [last] Friday, gold fell for a seventh straight session, its longest losing streak in four years, as the dollar rose to the highest since 2008.” (Reuters, May 17, 2013)

For those proclaiming the weak dollar path, it has been nearly deadly to claim a declining dollar in the last two years. Equally, the rise in inflation theory was proven wrong thus far and a spike in rates is hardly visible, as reaching 2% on the US 10 year Treasuries remained more of a struggle than a norm early this year. Unfortunately, grasping previous trends fails to create enough comfort for those looking ahead. Amazingly, it forces one to think of all surprise possibilities for months ahead and that the wisdom learned since the March 2009 recovery has reverted to a new normalcy.

Barometer

Is the stock market a barometer of confidence (wealth or wellbeing)? Or is the stock market a projection of earnings outlook? Or do these broad indexes provide clues to an economic recovery? Obviously, finding one answer that fits all these questions is plenty to ask. Thus, curiosity looms now with elevated markets, while pundits talk and managers wrestle with discovering the truth (for those who seek it, of course). Yet, in a competitive world judged by portfolio performance, the challenge of month-to-month money management is a brutally daunting task, especially if the status quo is misunderstood. In hindsight, the reward has been for the one that simply went bullish for the past three years or so and resisted piling into a “safe asset.” Obviously, the “truth” is nearly discovered by participants who fully noticed that after a crisis, it is more than convenient to sell/preach protection against the next crisis. But piling into safe assets to avoid unforeseen panic is not fruitful in practice. So weariness of fear-mongering stories is healthier. Now we collectively grasp the hint and message from the fluid market, which keeps welcoming risk and rejecting fear.

Many discuss the market “science,” logical arguments are thrown around constantly and salesmanship dominates forecasting as much as critical thinking. Yet, using science to prove points (future prediction) is one issue, but the art within markets is what differentiates and rewards those vested. Frankly, global economies are slowing; data after data have proven this point, not only in the Eurozone and US, but in emerging markets, as well. Nonetheless, the Eurozone troubles have not reached the overly dismal levels as expected. Thus, the better-than-expectations feel supersedes actual weak numbers. And that’s the lesson that keeps repeating itself on a global basis. Thus, the science alone is not enough without the art to complement it for taking a calculated risk.

Matching the art with logic

The sustainability of this market is bound to be questioned from chart observers and fundamental analysts. The glamour of calling tops will be enticing many in upcoming weeks with either the bad news brewing quietly or being less neglected than in prior months. Yet, the reason “bad news” was neglected is due to a lack of alternatives offered in markets and the acceptance of a low interest rate policy to resume in the foreseeable future. The puzzling issue remains whether the crowd will pile into stocks at a faster pace than the last four years. Perhaps, mildly using the term bubble might be more than justified beyond fear mongering. For now, a healthy pullback is not so newsworthy, especially in a period of overly tame volatility and restless crowd ahead of the summer months. Surely the stage appears set for some pause in this rally. Continuation of this upside run might even be more of a surprise than a global slowdown.
Article Quotes:

“The United States and China really are opponents – and they really do need each other to prosper. Accepting all this requires changing some of our assumptions about friends and enemies, allies and competitors. It means acknowledging that opposed forces and ideas do not always merge into a grand synthesis and that their struggle also need not issue in an epic battle to the finish. It would be uplifting to conclude that peace is logical, that rational people on all sides will avert conflict by acting sensibly. But such a conclusion simply betrays the facts – and possibilities – of this tense relationship. Instead I offer a more modest claim: Geostrategic conflict is inevitable, but mutual economic interdependence can help manage that conflict and keep it from spiraling out of control. We cannot project a winner in the Cool War. If violence can be avoided, human well-being improved, and human rights expanded, perhaps everybody could emerge as a winner. If, however, confrontation leads to violence, we will all lose.” (Foreign Policy, May 16, 2013).

“Low inflation has reassured investors that central banks can keep their feet on the monetary accelerator – and enabled share prices to increase faster than profits. But have prices risen too far? The valuation of stock markets can be gauged in two ways: relative and absolute. In relative terms, the convention is to compare the valuation of equities with that of government bonds or cash, and calculate the risk premium (the higher return investors demand for putting money into the more volatile stock market). A new paper by Fernando Duarte and Carlo Rosa, two researchers at the New York Fed, analyses 29 separate models used to calculate the expected premium over the past 50 years. A weighted average of those models suggests that the current premium is around 5.4 percentage points, about as high as it was after the bear market of the mid-1970s and close to the recent share-price bottom in early 2009. That makes equities look like a bargain. In contrast, the cyclically adjusted price-earnings ratio of the American stock market, which averages profits over ten years, is currently 23.2, as calculated by Robert Shiller of Yale University. That valuation is well above the historical average, suggesting lower, not higher, equity returns from here. Is it possible to square the absolute with the relative measures? Equities may perform much better than government bonds, but only because those bonds will provide dreadful returns.” (The Economist, May 18, 2013)

Levels: (Prices as of close May 18, 2013)

S&P 500 Index [1667.47] – Continuation of a higher market into record territory. The index is 5.4% above its 50-day moving average, which only begs the question of a pending breather.

Crude (Spot) [$96.02] – Once again attempting to top $96. With crude inventories at five-year highs, further pressure is building on prices to continue higher at the current range.

Gold [$1381.00] – After the short-lived rally, gold has confirmed its weakness, as the commodity stands one point above its April 17 lows. The debate between collapsing and bottoming will live on, but it’s hard to deny the multi-month downtrend that is persisting.

DXY – US Dollar Index [82.12] – Dollar strength is picking up the pace. The index is up nearly 7% since February 1 and has jumped 16% since May 2011 lows. This showcases a shift in the macro dynamics, in which the dollar is digging out of the three-decade downtrend.

US 10 Year Treasury Yields [1.95%] – Roaring back to the 2% mark after failing to demonstrate the rising rate theme. Annual highs of 2.08% set in March set the near-term benchmark. Yet, holding above 1.90% has not been an easy task recently and will be watched in the upcoming week.


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