Market Outlook | November 4, 2013

“Pleasure may come from illusion, but happiness can come only of reality.” Chamfort (1741-1794)

Unanswered questions

Illusion versus reality appears more difficult to distinguish. It is overly confusing to put market observers, economic data gatherers and policymakers in one room to gauge overall wellness. On one end, asset prices are rising in developing markets while economic strength is not at comforting levels. On the other hand, global growth is not overly promising. Essentially, the usual questions persist despite the feel-good headlines of rising markets. At this junction, even the most seasoned experts are forced to ask the same old questions to seek some clarity.

Why do asset (stock) prices rise? Is it because the value is understood or perceived to be massively amazing? What’s the connection between a robust economy and increasing asset prices – if there is any strong connection at all? What is the effectiveness of QE and GDP – if any? Are these two factors unrelated, potentially overblown or possibly misunderstood? Are recent US macro concerns of dysfunctional government and Fed “taper” discussions still a concern or less concerning than imagined? Have markets lost their creditability as a barometer of economic strength, or has having a disconnect been normal in other, prior periods? What’s the connection between fading confidence in government and optimism toward stocks? Is there any wisdom to take away from the recent shutdown decision to defer issues? After all, markets did not bother to panic; therefore, what signals a peak in confidence?

Recent inflow into US equities has been quite massive; who is left to pour more money to US stocks? “Investors poured some $54.2 billion into all equity mutual funds and exchange-traded funds in October, the third-largest inflow on record, data from TrimTabs Investment Research showed on Sunday. All three of the largest monthly inflows into all equity funds have occurred this year, and this year's inflow of $286 billion into all equity funds is the biggest since 2000, TrimTabs added.” (Reuters, November 3, 2013).

Answering all these questions in one page is not an easy task, but to unglue the illusions, one would have to start by asking these questions that are washed away in brief mainstream summaries. Certainly, these answers are not found by looking at a chart of the S&P 500 index or tracking varying earnings results.

Uncertainty deemphasized

In any area, there are misconceptions, trickery and illusionary forces that end up driving the collective thinking. Explanations of these types of behaviors are best left to behavioral finance experts and other psychological experts. However, at this junction, these market dynamics are mysterious to some but rather dangerously familiar to others. Of course, claiming a bubble is not quite the simple explanation. Denying the bubble-like symptoms isn’t overly wise, either. Thus, this limbo will persist until a major shock or newsworthy discovery. For example, the elevated ranges of Chinese property values is one matter unfolding. As many times as “bubble” is thrown around, it is only taken seriously after the fact. Naturally, it’s fair to say some are fatigued from hearing “bubbles” discussed. Yet those on the ground level of risk management are either admitting confusion or denying tough choices in categorizing the current reality. What’s convenient for those proclaiming the Fed’s success is to loudly declare the ongoing euphoria as indexes make all-time highs. Is that run justified? That’s a question that’s debated hourly by traders and has gone unanswered for weeks. Justified or not, the reality is felt on actual returns, which is the bottom line sought after. Mapping out a five-year investment plan is shaky for any risk manager or analyst. Soft job numbers combined with a mixed to weak economic outlook enhance the suspense of trends and pending policies. This week, US labor numbers will provide further clarity, at least for shorter-term participants. The lack of yield-generating assets leaves few investment options for asset managers. Perhaps, the inflow into stocks is not surprising given the scarcity of worthwhile and liquid investments.

Digesting recent moves

The commodity markets remain fragile – a theme that’s hardly debatable. The CRB (Commodity index) is down more than 7% since late August. Obviously, gold struggled to maintain its strength and peaked about a year ago. It was October 5, 2012 when gold bugs were too confident and the price of an ounce of gold stood at $1791.75. Today it is barely above $1300, and price stability is unclear. The same applies for crude, which has failed again to stay above $110, then struggled to hold $100 and is now in the mid-$90s. Basically, the commodity decade run is slowing and, as witnessed earlier this spring, the waning global growth plays a part in this. In fact, emerging markets sold off earlier this spring with similar concerns. The EEM (emerging market fund) is 24% below its all-time highs reached in October 2007. Again, this reinforces that commodities and emerging markets are not quite as explosive as US equities. Although emerging markets are recovering, commodities are facing several pressures after an impressive multi-year run. Changes in commodity prices can impact consumer behavior as well as key foreign relations. Perhaps, these developments are macro events with powerful catalysts that are worth tracking for upcoming months.

Article quotes:

“It has become something of a cliché to predict that Asia will dominate the twenty-first century. It is a safe prediction, given that Asia is already home to nearly 60% of the world’s population and accounts for roughly 25% of global economic output. Asia is also the region where many of this century’s most influential countries – including China, India, Japan, Russia, South Korea, Indonesia, and the United States – interact. One future is an Asia that is relatively familiar: a region whose economies continue to enjoy robust levels of growth and manage to avoid conflict with one another. The second future could hardly be more different: an Asia of increased tensions, rising military budgets, and slower economic growth. Such tensions could spill over and impede trade, tourism, and investment, especially if incidents occur between rival air or naval forces operating in close proximity over or around disputed waters and territories. Cyberspace is another domain in which competition could get out of hand. … In fact, the regional security climate has worsened in recent years. One reason is the continued division of the Korean Peninsula and the threat that a nuclear-armed North Korea poses to its own people and its neighbors. China has added to regional tensions with a foreign policy – including advancing territorial claims in the East and South China Seas – that would be described diplomatically as ‘assertive’ and more bluntly as ‘bullying.’”(Richard Haass, Project Syndicate, November 4, 2013).

“Just beyond the mainstream, though, there's a growing view that QE could continue at its current rate for even longer – until, say June 2014. That would bring the QE total, including the subsequent taper, to some $5,000bn, equivalent to more than 30pc of America's annual GDP. Last Wednesday, at its monthly meeting, the Fed's monetary committee voted to keep QE going – ordering the purchase of another $40bn of mortgage-backed securities and another $45bn of Treasuries, so $85bn in total. While the wording of its statement was very close to that of the month before, one key sentence was removed. In its September statement, the Fed had said that ‘the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labour market.’ In the October minutes, that sentence was gone – causing some to argue that tapering is now more likely, because the economy is improving. Yet, the only reason that ‘tightening of financial conditions’ has gone is because, since early September, when it lost its nerve, the US central bank has stopped talking about tapering. This illustrates the Fed's Catch-22. If Bernanke starts preparing the world for tapering again, yields will start to spiral, choking off recovery and robbing the Fed of its resolve to taper. So US policymakers are caught in a trap – a seemingly inescapable dilemma that stems directly from the massive scale of QE.” (The Telegraph, November 2, 2013).

Levels: (Prices as of close November 1, 2013)

S&P 500 Index [1761.64] – Slightly up for the week which was enough make another all-time highs. Since March 2009, the index has risen more than 1.6 times. Prior all-time highs of 2000 and 2007 remain in some investors’ minds as unchartered territory continues to be explored.

Crude (Spot) [$94.61] – Substantial drop since September, in which crude has fallen by nearly $18 a barrel. Normalizing to ranges seen in the spring between $88-$96. Downside momentum continues to build.

Gold [$1324.00] – Clearly, this year has marked a significant breakdown in prices. Between October 4, 2012 and July 1, 2013, gold declined by more than 33%. Overcoming that sell-off has led to range-bound trading. Momentum is tilted to negative, with oversold recoveries being a possibility for risk-takers.

DXY – US Dollar Index [80.71] – After hitting the lowest point of the year, the dollar index has slightly recovered back to the 80 range.

US 10 Year Treasury Yields [2.62%] – Attempting to bottom around 2.60%. Glimpse of signs for rising rates in the last few weeks, as the 50-day moving average is at 2.70%.


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