Market Outlook | December 9, 2013

“An era can be said to end when its basic illusions are exhausted.” (Arthur Miller, 1915-2005)

The known story

Signs of improvement in last month’s labor numbers are an additional factor that contributes to the existing story of strength and confidence. Surely, the decline in unemployment headline is not quite an obvious statement of reviving economic growth, but it’s possibly a “selling point” for confidence restoration. Deflation is visible, but not quite addressed, and global growth is attempting to make a case for recovery. Yet, assets are blossoming and participants are chasing returns.

Then there is the US 10 year Treasury yield that’s rising as bonds continue to sell off. Clearly, there is an outcry of demand for stocks rather than bonds for eager risk-takers and skeptical observers. With this brewing, there is ongoing speculation as to how these market-moving factors are viewed by the Fed. It’s no surprise that the central bank more or less remains the conductor of the market narrative as well as the self-anointed data interpreter, holding several press conferences. The mighty Fed's perception at times remains more vital than collective investor perception. Thus, in taking risks, one has to view facts, understand participants’ mindsets and engage in getting into the heads of central banks to make their next move.

Back to basics

Perhaps, this bull market is flirting with and reaching some plateau where few items are unexplainable with the exception of the following: Limited investment options are driving up stock market demand and a lack of shares is available in liquid and highly sought-after company stocks.

“Corporations have been on a buyback binge in recent years. S&P 500 companies purchased $118 billion of their stock in the second quarter of this year, up 18 percent from the first quarter, according to S&P Dow Jones Indices.” (Reuters, December 2, 2013).

Supply-demand explains plenty and maybe that's the factor that counts in this stock market run-up. Investor demand is not met by market supply (available shares and /or risky assets with high return potential), leading to higher and higher prices.

At that point, any speculation or artful explanation may go far beyond what's needed. The end-date to this status quo has been and will be suspenseful to risk allocation. Therefore, changes in sentiment most likely are set up by changing dynamics in investor demand. That's where the taper discussion fits within the context of what has happened – all-time highs and low volatility that's lingered for a long while. Perhaps, this explains the lack of meaningful sell-off that occurred this year. Demand for liquidity and 20%+ returns make US stocks overly attractive for traditional yield seekers. Expecting the same explosive returns next year might be asking too much, but is hardly an uncommon thought surfacing in folks’ minds here at year-end.

Sorting out noise

Underneath the investor demand versus market supply relationship, there is noise that's polluting, entertaining and plainly distracting. All-time highs create invincibility, which is proven to end in an ugly manner. Yet, the peak is hard to time and remains costly for mistiming. Pile on winners is the message from advisors, and the gloom-and-doomers have quietly evaporated. In fact, the housing market is seeing similar excess demand and remains an asset that continues to rise from low rates policies as well. Yes – a global theme indeed, where returns are a top priority and risk is not as overly feared as in prior years. Asset managers sense that producing returns is more an issue of survival and some naysayers are ignored too quickly. Sure, there has been an overdose of “bubble” studies produced in this multi-year run.

“Many economists have struggled to accept that bubbles exist, as that is difficult to square with the idea of efficient markets. If assets are obviously overpriced, why don’t smart investors take advantage and sell? Edward Chancellor of GMO argues that investors can find it hard to arbitrage away a bubble. Manias can last much longer than investors think, as many contrarians discovered to their cost during the dotcom boom of the late 1990s. Nor do investors know whether a bubble will be resolved through a sharp fall in prices or a long period of stasis, in which inflation erodes prices in real terms.” (The Economist, December 7, 2013).

At the end of reading thoughts, concrete studies and expert comments, one is left to admit that timing the market is tricky and the real economy is not as rosy as presented. Clearly, that’s the humbling answer. In terms of financial markets, turbulence is predictable to some extent, but the catalyst for early shock is not quite easy to target. Plus, the status quo of an all-time high market sounds appealing and the easy path is to preserve the ongoing trend and not doubt the Fed. Clichés and trader sayings aside, there is a point where the market narrative becomes tiresome and exhausting. Have we reached that boiling point? Fair question yet again. It should be noted that emerging markets did suffer heavy sell-offs in the first half of this year. It is not clear if collective hubris is reaching extreme ranges, but the dynamics of interest rates are the last resort for clue seekers. The not-so-pleasant real economy serves a purpose to remind us that the glitter and glamor of headline numbers is not a reliable source for comfort, even in a year where stocks have been glorious.

Article quotes:

“But there is also another kind [of deflation]. This is where falling costs and increasing efficiency of production create a glut of consumer goods and services. In other words, supply persistently exceeds demand. Some people regard this sort of deflation as benign. After all, consumer prices are falling, people need less money in order to live well … what’s not to like? Well, it depends on your perspective. In this world, if you are fortunate to have a well-paid job, you can indeed live well. But this sort of deflation causes unemployment. Or if it doesn’t, it pushes down wages in lower-skill jobs. After all, for production costs to fall, either there must be fewer people earning wages, or wages must be lower. So we end up with a bifurcated labour market – those in high-skill, well-paid jobs, who enjoy a rising standard of living, and those who are either unemployed or in poorly-paid low-skill jobs, who become increasingly dependent on state support. Government welfare expenditure therefore rises. However, the well-off don’t like paying taxes to support the unemployed and the low-paid, so they use their electoral muscle to pressure governments to cut welfare bills. As welfare bills are cut, poverty rises among the unemployed and poorly paid. Governments may adopt draconian measures to force the unemployed into work, even at starvation wages, and to quash civil unrest.” (Pieria, Frances Coppola, December 8, 2013)

“American investors who make decisions by weighing sell side research or listening to cable news are underestimating the risks of the fragmentation of the euro area’s economies and banking systems. Europeans are far more aware of the degree to which banking systems and government bond markets have become renationalised, with proportionately much thinner cross border capital flows. The combination of fiscal austerity and private sector depression in peripheral Europe – the so-called ‘adjustment’ – has if anything increased the risk of capital controls, even, in some cases, outright exit from the euro area. For example, Greece is now on track to have a primary surplus, and is marking its self-sufficiency on a cash basis by refusing to submit its budget for approval by EU authorities. There was an implicit agreement by the Greek government and the Europeans to postpone ‘Official Sector Involvement’ until after the September German elections and the formation of a new government. That is now past, and you can expect Greek OSI next year. Fully discounted, you say? What happens when there are then popular demands in Portugal for similar treatment for that country’s official debt? Where does the process of successive losses imposed on creditor-country taxpayers stop? It might be difficult under these circumstances for, say, a French government to succeed in persuading the German electorate to agree on ‘more Europe’ in the form of a common fiscal policy.” (Financial Times, December 6, 2013).


Levels: (Prices as of close December 6, 2013)

S&P 500 Index [1805.09] – Although slightly down for the week, the index is not far removed from all-time highs.

Crude (Spot) [$97.65] – After a multi-month downtrend that saw prices down as much as $91.77, the last few trading days produced a spike. Prices to stabilize once there is a clear grasp of inventory.

Gold [$1222.50] – The annual commodity demise continues nearing the 1200s. In upcoming trading days, the question lingers whether gold will flirt with annual lows of $1192. About a year ago, prices were around the $1680 range, as the annual decimation of commodities continues.

DXY – US Dollar Index [80.68] – Appears stuck for weeks. The 50-day moving average is 80.34, which is hardly far from current levels. The dollar has remained subdued even tough yields have been rising recently.

US 10 Year Treasury Yields [2.85%] – Since October 23, 2013, yields have made a strong move from 2.46% to above 2.80%. This trend of higher yields mirrors action witnessed late spring to early fall. Perhaps, the perception of a rising economy along with the potential revisit of 3% reignites this momentum of bond sell-offs.

Dear Readers:

The positions and strategies discussed on MarketTakers are offered for entertainment purposes only, and they are in no way intended to serve as personal investing advice. Readers should not make any investment decisions without first conducting their own, thorough due diligence. Readers should assume that the editor holds a position in any securities discussed, recommended, or panned. While the information provided is obtained from sources believed to be reliable, its accuracy or completeness cannot be guaranteed, nor can this publication be, in any Publish Post, considered liable for the future investment performance of any securities or strategies discussed.