Market Outlook | February 11, 2013

“Many complain of their memory, few of their judgment.” Benjamin Franklin (1706-1790)

Recovery vs. wildness?

With each upside stock market move that comes closer to revisiting the 2007 highs, the S&P 500 Index attempts to remind us that the post-bubble era may quickly erase the undesired recent memories. Digesting the current climate requires an open but critical mind.

On one end, old tricks and familiar habits persist: Leverage is back as it’s applied by larger risk-taking institutions , sub-prime mortgage deals are vitalizing and perceived “risk” is more favored than not. On the other end, the post-mortem analysis of the 2008 credit crisis is making some noise. This is highlighted by the federal suit against one credit rating agency in regards to mortgage-related investments. In addition, more chatter and pending legislation is taking hold in the discussions related to banking regulations. By now, the macro-focused worries have dissipated, at least by noticing that the Bank Index (BKX) is up nearly 70% since October 2011. Unresolved regulatory matters and pending fallouts have not stopped shareholders from partaking in the heavily scrutinized financial sector.

Beyond the visible

Beyond the cheerfully trending stock and real-estate markets, there lies a murky, hard-to-decipher economic status. The prognosis of the current economy is mixed, and digging deeper may lead to further ambiguity rather than clear-cut answers. In terms of housing and student loans, which drive the consumer market, there is a fact that’s hard to ignore for an active or casual observer: “The Chicago-based credit bureau found that 33% of the almost $900 billion in outstanding student loans was held by subprime, or the riskiest, borrowers as of March 2012, up from 31% in 2007.” (Wall Street Journal, January 30, 2013). Perhaps, the gloomy climate for questionable borrowers reminds us of the desperate need for growth and reinforces the daunting shape of credit markets. This is a discussion that’s at the center for social and financial pundits. Yet, it’s becoming overly difficult to find experts or lawmakers with conviction and ideas for job growth or problem solving.

It appears the marketplace feels that unrecoverable problems are not worth worrying about. Certainly, this mindset is developing to the liking of the Federal Reserve. Glancing at the very calm volatility index (VIX), the barometer reinforces that turbulence is not overly priced-in for the pending weeks. Simplistically, bad news is overly exhausted and numbness to the bullish bias is in place. The same nearly applies in the Euro-zone, where the crisis-like mindset rapidly evaporated. In fall 2011, being overly worried was costly at a critical inflection point. Today on a global scale, “fear” is not trading at a steep premium as the non-fearful pay up to own risky assets. In this case, risky assets not only include mortgage-related securities but also Euro-zone based sovereign debt.

“A combination of complacency and a strong appetite for risk is relieving pressure on Spain and Italy, causing investors to underprice the risks in both countries. … (The) wake-up call to pay more attention to the risks in Spain and Italy has not been heeded by investors. Yet the stakes are rising, increasing the scope for a more severe correction in asset prices.” (International Financing Review, February 5, 2013)

Chess match

For investors and fund managers, the option of missing out on the market rally is too costly from a performance standpoint. Thus, further herding inevitably takes place and sentiment rises not by independent thinking but by collective bias. A typical asset manager is faced with weighing the required mandate of profitability versus the inevitable irrational market behavior. Certainly, profits and losses can be measured on paper more easily than psychological measures. For now, marching with the favorable themes brings some comfort in the near-term. Thus, the self-fulfilling prophecy of a recovery is a hard battle to fight, until the clues turn into shocks. It’s healthy to leave some room for surprises and unknowns. In that respect, two indicators worth tracking (not necessarily acting on) for early clues include a strengthening US dollar and interest rates. Although neither is endorsed by the Federal Reserve, at some point the tune is bound to change.

Article Quotes:

“Quantitative easing by major economies to support financial asset prices is driving demand for gold in the emerging world, said Marcus Grubb, head of investment research at the World Gold Council. Before the crisis, central banks were net sellers of 400 to 500 tons a year. Now, led by Russia and China, they’re net buyers by about 450 tons, Grubb said by phone from London, where his industry group is based. While Putin is leading the gold rush in emerging markets, developed nations are liquidating. Switzerland unloaded the most in the past decade, 877 tons, an amount now worth about $48 billion, according to International Monetary Fund data through November. France was second with 589 tons, while Spain, the Netherlands and Portugal each sold more than 200 tons. Even after Putin’s binge, though, Russia’s total cache of about 958 tons is only the eighth-largest, the World Gold Council said in a Feb. 8 report. The U.S. is No. 1 with about 8,134 tons, followed by Germany with 3,391 tons and the Washington-based IMF with 2,814 tons. Italy, France, China and Switzerland are fourth through seventh. While gold accounts for 9.5 percent of Russia’s total reserves, it accounts for more than 70 percent in the U.S., Germany, Italy and France.” (Bloomberg, February 10, 2013)


“We can now discern more or less when the catch-up growth miracle will sputter out. Another seven years or so – enough to buoy global coal, crude, and copper prices for a while – but then it will all be over. China’s demographic dividend will be exhausted. Beijing revealed last week that the country’s working age population has already begun to shrink, sooner than expected. It will soon go into ‘precipitous decline,’ according to the International Monetary Fund. Japan hit this inflexion point fourteen years ago, but by then it was already rich, with $3 trillion of net savings overseas. China has hit the wall a quarter century earlier in its development path. The ageing crisis is well-known. It is already six years since a Chinese demographer shocked Davos with a warning that his country might have to resort to mass suicide in the end, shoving pensioners onto the ice. Less known is the parallel – and linked – labour drain in the countryside. A new IMF paper – ‘Chronicle of a Decline Foretold: Has China Reached the Lewis Turning Point?’ – says the reserve army of peasants looking for work peaked in 2010 at around 150 million. The numbers are now collapsing. The surplus will disappear soon after 2020. A decade after that China will face a labour shortage of almost 140m workers, surely the greatest jobs crunch ever seen. ‘This will have far-reaching implications for both China and the rest of the world,’ said the IMF.” (The Telegraph, February 3, 2013)

Levels: (Prices as of close February 8, 2013)

S&P 500 Index [1513.17] – Continues to make multi-year highs, closing near intra-day highs set on Friday, February 8. Notably, a breakout above 1460 triggered an accelerated run. The index is approaching 2007 highs of 1576, which has a symbolic meaning to participants.

Crude (Spot) [$95.72] – As witnessed in September 2012, crude has failed to go above $98. In the near-term, observers’ wait for deceleration continues.

Gold [$1668.00] – Barely moved week over week. This simply reiterates the non-trending pattern that has persisted for several weeks. The 200-day moving average stands at $1663.15, which serves as a benchmark to pending movements.

DXY – US Dollar Index [80.24] – In the last six days, a mild spike in the US dollar versus other currencies. This is a theme that’s been developing since the start of the month, as the EUR/USD dropped from 1.36 to 1.33. Yet, this mild dollar strength is hardly impactful enough to claim a major trend shift.

US 10 Year Treasury Yields [1.94%] – Flirting near the 2% range after a surge that began in early December. Now, the two-month run is stalling. No evidence of a major breakout in rising rates.



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