Market Outlook | September 30, 2013

“Good teaching is one-forth preparation and three-fourths theater.” – Gail Godwin (1937-present)

Theatrical

Beyond the theatrical discussions that range from QE debates to a government shutdown to murmurs of economic growth, there is a looming theme worth observing. In the weeks ahead, observers will watch the pace of the depreciating dollar; lower US 10 year yields and a bottoming in gold prices remind us of the tumultuous summer of 2011. That was around the last debt ceiling debate, which triggered a downgrade of the US sovereign rating. Of course, it was then when volatility rose and stocks were sold off hard before it eventually led to a buy opportunity for stock market risk takers. It was then, when the “safe assets,” such as treasuries and gold, were highly sought after, that uncertainty reached a new, confusing and unsettling place.

As this autumn approached, casual fear (not panic) was lurking in the background despite elevated US market indexes. Consistently, a few sentiment-driven discoveries repeat themselves. For example, growth is slowing, the government is viewed as dysfunctional and consumer confidence is not quite robust. In addition, talks of a new Fed Chairman combined with deferred “taper” talk add layers of uncertainty. The theatrics are plenty for noisemakers, stretching from Italian leadership to Chinese growth estimates. Money managers would need to apply shrewdness in re-assessing risk at this junction.

Cycles and moods

What is relatively certain is the mood of global uneasiness as Eurozone concerns persist. The fragile nature of confidence restoration is a very daunting task from developed to emerging markets. We’re in an era when the word “bubble” is easily thrown around and dangers are outlined consistently (and sometimes overblown). Perhaps, that’s understandable given recent memories of the 2008 breakdowns and short-lived panic of 2011. Neither event can be masked or quickly erased in the investor’s mindset today, even when a bullish market is highly celebrated and risk-taking has panned out better than sideline observing. Interestingly, most of 2013 is known for rewarding bold moves in risky assets, with some signs of credit returning. Ironically, looking at the housing surge, one may easily argue that memories are short-lived, and credit bubbles are merely a cycle of boom and bust. Timing the cycles is the inevitable mystery as housing experts contemplate these issues.

Mind-boggling or not, the disconnect between QE and the real economy is so obvious that it’s only a matter of time until this reality is confronted. Reasons for a sell-off are plenty and known, but a market that’s shrugged off complex and practical matters awaits another test. Simply, the power of QE has driven the upside momentum and continues to drive the mindset. The natural human ambition of chasing returns remains too powerful, considering the recent equity inflow data. More capital is rotating back to European stocks, as well as emerging markets.

“Investors fed a record-breaking $25.94 billion into equity funds for the week ending Sept. 18, eclipsing the old mark set during the third quarter of 2007, according to EPFR Global.” (Barrons, September 20, 2013).

Critical assessment

So far this year, the S&P 500 index is up 18%, sporting a pretty number on a historic basis. Similarly, the Nasdaq 100 is up more than 20%, creating an all-out confidence and performance chasing. Thus, even a slight danger is imminent, considering a healthy correction has been mostly averted and earnings confidence is not quite subdued. Odds that we made annual highs for the year are being questioned and are soon to be resolved.

Surely, the gloom-and-doom theories have been mocked and disproved, which creates comfort and hubris. Whether an overconfidence level has been reached is debatable, but catalysts are less predictable. At times, figuring out key macro catalysts is even more difficult than guessing market direction. Yet, the frantic symptoms are already embedded in this market. Government shutdown or political crisis in Italy only adds to an existing list of concerns, which includes the sustainability of corporate earnings. Being washed away by some of the latest news is misleading at times, since the fundamentals of corporate and economic growth have been muddy. Complacency has swept away investors and, in due time, comfort will face unmet realities. Perhaps then, the volatility index may reawaken from its deep two-year sleep.

Article quotes:

“To put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus. The projections implied by the Fed’s macro-econometric model concerning the timing and effects of the 2008 economic stimulus on unemployment, which have been notoriously wide of the mark, are a case in point. Yet the mainstream of the economics profession insists that such mechanistic models retain validity. Nobel laureate economist Paul Krugman, for example, claims that ‘a back-of-the-envelope calculation’ on the basis of ‘textbook macroeconomics’ indicates that the $800 billion US fiscal stimulus in 2009 should have been three times bigger. Clearly, we need a new textbook. The question is not whether fiscal stimulus helped, or whether a larger stimulus would have helped more, but whether policymakers should rely on any model that assumes that the future follows mechanically from the past. For example, the housing-market collapse that left millions of US homeowners underwater is not part of textbook models, but it made precise calculations of fiscal stimulus based on them impossible. The public should be highly suspicious of claims that such models provide any scientific basis for economic policy.” (Project Syndicate, Frydman, Goldberg, September 13, 2013).

“China has opened the Shanghai Pilot Free Trade Zone today, the first free trade zone (FTZ) on the mainland. State-run news outlet Global Times reports that the FTZ will be ‘an important step in China’s economic reform and the internationalization of the yuan.Details as to exactly what will be allowed remain somewhat murky, but the Financial Times reports a surge in interest in both houses neighboring the 28 square-kilometer zone, which is located in Shanghai’s Pudong district, and in stocks of companies expected to benefit. Initially believed to entail primarily a reduction of tariffs, the FTZ recently appears to have been positioned as a symbol of China’s commitment to economic reform. Now, according to plans issued on Friday by China’s State Council, it will be a test ground for financial liberalization. Specifically, interest rates in the zone will be market driven, and firms will have greater freedom in converting yuan and shifting money offshore. Foreign companies will ‘gradually’ be able to participate in a commodities future exchange. The Wall Street Journal says that Citigroup has received approval from Chinese authorities to set up a branch in the FTZ, making it the first foreign bank to part in the new development. Other banks have expressed interest in following suit. Meanwhile, a number of foreign hedge funds are apparently set to be allowed to raise money from domestic Chinese institutions. It appears now that the Chinese government is using the FTZ in Shanghai as a test-bed for tricky reforms, in much the same way that Deng Xiaoping used Shenzhen in 1980 to experiment with capitalism. Those reforms are seen as marking the start of China’s extraordinary economic rise over the past three decades. Apart from the financial sector deregulation, the reforms being trialed in Pudong include a ‘negative list’ approach to foreign investment, which would mean that outside certain prohibited sectors, foreign companies would get the same treatment as domestic firms.” (The Diplomat, September 29, 2013).

Levels: (Prices as of close September 27, 2013)

S&P 500 Index [1691.75] – Struggling to hold above 1700 yet again, as seen in August. Despite the highly cheered “no taper” announcement, the S&P 500 index is facing some resistance when viewing the chart.

Crude (Spot) [$102.82] – Noticeable downtrend as crude has declined nearly $10 per barrel in less than a month. There are growing odds that the next familiar target is closer to $96 as the supply data continues to expand.

Gold [$1328.00] – Risk-reward evaluators notice that above $1300, there are signs of revival. Upside potential ranges from recent highs of $1419.50 to the 200-day moving average ($1470).

DXY – US Dollar Index [80.53] – The last three months have showcased a near 6% decline. Dollar weakness re-emerges to a nearly eight-month low.

US 10 Year Treasury Yields [2.62%] – There has been further evidence that surpassing 3% is a legitimate hurdle in the recent cycle. The multi-month bond sell-off (yield appreciation) is pausing. Staying above 2.50% (around the 200-day moving average) looks to serve as a key near-term barometer.


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