Market Outlook | June 3, 2013

“Every calamity is a spur and valuable hint.” Ralph Waldo Emerson (1803-1882)

Concerns building

The status quo of higher markets, lower interest rates and stable economic growth is not as sustainable as in previous years. There are several unfolding events that point to a potential for increased uncertainty and analysts, journalists and participants alike misunderstand plenty of uncertainties. A few big-picture themes to consider:

1. The end date for quantitative easing is being debated as interest rates show signs of rising (increased bond market nervousness).

2. Drivers of sharp selling in the Japanese stock market are being understood as the sell-off spreads to other emerging market indices.

3. The lack of compelling and sustainable fundamental strength in corporate earnings suggests limited upside potential.

4. May ended with a stretched stock market that needs a breather from an explosive recent month and a well-defined four-year bull market.

5. Weak economic data in key nations (led by China) signal lack of expansion and growth. This is further supported by the decline in commodity prices, which respond to the softening global demand.

All this adds up to suggest that a pending calamity is in the not-so-distant future, as the collective run-up has long ignored the brewing issues. Of course, the right move in the past few years has favored risk-taking, and pessimists were wrong in their views and missed out. Now in a new setting, the environment is quite different than March 2009, when the S&P 500 bottomed after the crumbling of the bubble top. Back then, it was an opportune time to purchase; these days, it’s not ideal to double down on risk.

Deceiving calmness

The comfort of the status quo leads to calmness, which is common before bigger sell-offs, as witnessed in August 2007 – right before the major sell-off. Certainly, the magnitude of any pending sell-off should not be automatically compared to the 2008 crisis. Perhaps, the magnitude is not the same here, but the concept of ebb and flow is important. Not long ago, the all-time highs in the S&P 500 index we cheered as other global indexes rejoiced in the collective bull market. Yet, even the most bullish and rational speculator would admit some sell-off or price readjustment is necessary. At least, the disconnect between the real economy and elevated stock market is harder and harder to justify. Thus, as the summer months approach, there is plenty to ponder, as central banks will have to find a coherent explanation of pending developments while investor near-term overreactions seem inevitable in either direction. When viewing turbulence (Volatility Index), it has been quiet since summer 2011, and keeping that calmness may not be as successful as the last two years.

Bracing and accepting

With all the uncertainties, it is fair to say participants – investors and analysts alike – are facing shaky confidence and limited conviction. If market uncertainty is brewing while lack of conviction is playing out, then ongoing rosy forecasts for risk-taking omit the recent clues that suggest corrections in asset values. The S&P trading at all-time highs versus weakening real economic data is a highly noticeable reality that illustrates this disconnect. Full questions await on earnings and sustainability.
“Of the 106 companies that have issued EPS guidance for the second quarter, 86 have issued projections below the mean EPS estimate and 20 have issued projections above the mean EPS estimate. Thus, 81% (86 out of 106) of the companies that have issued EPS guidance to date for Q2 2013 have issued negative guidance. This percentage is well above the five-year average of 62%.” (Factset, May 31, 2013).

It is one thing to beat already lowered analyst expectations; it is another to showcase natural growth. Overwhelming evidence is building, from technical chart pattern spotting to simple economic trend following. There is the usual denial or attempts to keep the uptrend going. Even commodities such as gold are in a decline, rather than serving as a reliable shelter during risk aversion. The safe asset is not quite safe, either, as there is a lack of escape in the short term. Thus, accepting the inevitable correction is healthier than fighting it. Keeping an open and observant mind appears to be the trick for the week ahead, as tension accumulates.

Article quotes:

“The list of major emerging-markets countries either currently cutting rates or very likely to do so in the near term consists of just five: Hungary, Poland, Turkey, Korea, and India. The first two of these are suffering the consequences of the extended euro area recession. On top of that effect, the National Bank of Hungary is carrying out a “structural” easing associated with a regime change at the central bank, with doves now holding a majority on the board. Turkey is also feeling the euro area chill, though to a lesser extent. Its easing additionally reflects the upgrading of the role played by real exchange rate management in determining the overall policy stance. Gradual currency appreciation (in real, trade-weighted terms) is triggering compensatory interest rate reductions. In Korea’s case, global cyclical weakness is combining with the yen’s depreciation — a negative competitiveness shock to Korea — to bolster the case for additional cuts, on top of the 50 basis points in easing during 2012. Finally, India has been cutting gradually since last year but has brought the policy rate down a modest 75 basis points during that period. The statement following the most recent move suggested that the cycle is drawing to a close or perhaps has already done so.” (Institutional Investor, May 15, 2013).

“I believe this to be a crucial point of distinction and I think that many Western central bankers – including some of our own Bank of England members – have misled themselves, as well as others, about measuring the effectiveness of so-called quantitative easing (QE). Some policymakers, especially in the early days, tried to judge the success of QE by the impact it had on whether long-term bond yields were lower than they would otherwise have been. It always struck me that this was hardly a high hurdle, nor an appropriate one. In fact, it could be a potentially troublesome criterion once markets believe the economy is starting to do better – as some might now think about Japan – because eventually, if economies return to normal, it would seem quite sensible that bond yields might return to normal. Most economists would argue normal 10-year bond yields should equate closely to the trend growth rate, plus the inflation performance or underlying inflation expectation, plus some kind of risk premia.” (The Telegraph, May 31, 2013)



Levels: (Prices as of close May 31, 2013)

S&P 500 Index [1630.74] – The last seven trading days have started a near-term correction after reaching record highs. The magnitude of the sell-off is being questioned.

Crude (Spot) [$91.97] – Once again holding in not far from $92, but failed to hold above $96 – confirming the weakness in global demand.

Gold [$1413.50] – After a multi-month sell-off, a bottoming process appears to form around $1400. Yet, the intermediate-term trend remains fragile and confirms a prevailing weakness.

DXY – US Dollar Index [83.37] – A few points removed from its multi-year high. The dollar strength story remains alive.

US 10 Year Treasury Yields [2.12%] – Within the month of May, treasury yields went from annual lows (1.60% - May 1) to reaching yearly highs (2.23% - May 29). This was an impressive reversal, raising all types of questions on faith of interest rate policies and movements.


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