Market Outlook | February 18, 2013

“Chaos often breeds life, when order breeds habit.” Henry Brooks Adams (1838-1918)

Habitual pattern

The established and prevailing low rates, weak dollar and calmer volatility shape the current trend. This habitual pattern of risk taking is accepted as the rewarding norm. Perhaps, rash or optimistic decisions are made by fear of “missing out” rather than calculating unforeseen fears. Surely, this pile-on attitude will turn into complacency or numbness. The volatility index is at its lowest point since the 2008 crisis. There are plenty of explanations for this, but the real numbness to bad news and better-than-expected results has reshaped a bull market that’s in the fourth year of formation.

Demand and deployment in risky assets are visible in the S&P 500 Index, which is up for the seventh week in a row. Sustainability of this cheerful headline is being pondered and questioned around the holiday weekend, especially by a few passionate market followers – and rightfully so, as believers and new bulls may be overly eager to continue this rally. Not to mention, most are too intimidated to go against the grain, especially when this status quo is generated by the Federal Reserve game plan.

Early tone shifts

Monitoring potential shifts in this well-documented and highly followed low interest rate policy showcases that a macro catalyst is silently brewing. Looking ahead, some are dissecting the clues that may serve as a catalyst and eventually disrupt the Fed-induced rally. Interestingly, the tone of the Fed is poised to gradually change for two reasons: 1) Economic improvements (by reported data) can send a message supporting a mild move in rising interest rates and changes of Fed’s purchasing plans. 2) The low-rate environment has created a new wave of increased risk appetite, given the lack of attractive yielding assets.

In this regard, the comments of Federal Reserve Governor Jeremy Stein delivered the following message:

“Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit. … One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability” (Speech, Federalreserve.com, February 7, 2013).

Overheating acknowledged

Perhaps, the warning signs are not too mysterious for a casual observer and the Federal Reserve’s plans are not as clear as most would like to think. For now, the sensitive data point revolves around improvement in the US labor market – which is collectively used as a barometer of a healthy economy. Meanwhile, those relying on the stock market for sentiment can easily (misleadingly) conclude optimism is in full gear. We’re in a period where the US economy and global economies attempt to play catch-up to the stock market. The disconnect between a heating equity and credit market versus a mixed to not-so-good global economy is a risk that’s worth studying. That art in deciphering the next macro move is beyond quantitative models, political talk or headline watching.

In the same light, Eurozone weakness is not so easy to ignore these days, even though the recent mantra alludes to a ‘great escape’ from further crisis. Being skeptical in the Eurozone has not been a profitable bet, but in due time the real economy must reflect the forward-looking market behaviors. Clearly, even if the markets decide to look ahead (for surprises), the present conditions are bluntly muddy:

“Gross domestic product fell 0.6 percent in the fourth quarter from the previous three months, the European Union’s statistics office in Luxembourg said today. That’s the most since the first quarter of 2009 in the aftermath of the collapse of Lehman Brothers Holdings Inc. and exceeded the 0.4 percent median forecast of economists in a Bloomberg survey.” (Bloomberg, February 14, 2013).

Popular but pausing

During the bullish market, the owners of gold had mixed feelings, especially in the last six months. Two challenges have resurfaced for the commodity. First, rising investor confidence may stir less demand for “safe assets” – which negatively impacts gold. Second, the momentum-driven gold appreciation, witnessed for so many years, has changed its course, as well. Therefore, regardless of how general risk is perceived, the gold price movement seems mysterious, but the trend is negative by any measurable indicators.

Surely there is no denying that gold serves as a hedging instrument for those seeking to diversify their currency holdings. That primarily applies to Central Banks and larger hedge funds. Nonetheless, the decade-old gold rush is facing a turbulent and existing downtrend that’s in limbo. Early cyclical messages of a pause in gold prices have been restated a few times, even though aficionados and staunch bullish participants are too nostalgic to change their views. The drivers of gold prices must be understood beyond typical supply-demand analysis. This is a dreadful task for those only analyzing the traditional valuations of known assets. Yet, this invites further speculation on the next price movement, and the less rosy behavior only adds further suspense.

Tangible takeaways

Speculation aside, markets are known to rally beyond the scope of what the consensus believes to be rational. In fact, the irrational element of market behavior is what keeps investors, speculators and observers eagerly awake. Yet, mean-reversion is inescapable in any cycle or asset, for that matter. Surely, the last year and a half produced an improving economic environment, a roaring stock market and desperate search for higher-yielding assets. To think that the status quo remains in place is becoming a much riskier proposition than a daring or safe outlook. Prudent and forward-thinking observers are stuck in a balance between the Fed-induced rally versus a pending inflection point that requires corrections to calm the bubble-like nerves. Understanding these conflicting dilemmas is what most likely rewards the next few months.


Article Quotes:

“(The) Federal Reserve’s balance sheet is not as big as shrill critics of QE3 would lead you to believe. True, $3 trillion is serious money. It represents a tripling in the size of the Fed’s balance sheet since 2008, before the U.S. central bank unleashed the first round of its aggressive campaign of so-called quantitative easing. It is now on round three, and has committed to keep buying bonds until it spies a substantial improvement in the outlook for the labor market. But as a percentage of GDP (gross domestic product), the Fed’s balance sheet is still smaller than those of the Bank of Japan, European Central Bank, and Bank of England, notching under 20 percent of GDP compared with over 30 percent of GDP for both the BOJ and ECB. Jim Bullard, president of the St. Louis Federal Reserve, made this point during a presentation at Mississippi State University on Wednesday. Bullard was more cagey on whether it mattered that the Fed’s balance sheet was smaller than several other major central banks. He said the size of the balance sheet could still hinder a “graceful exit” from the Fed’s extraordinary efforts to spur growth, while the value of the assets on its books would fall as interest rates rise.” (Reuters, Macroscope, February 15, 2013).

“Economists have conducted hundreds of studies of the employment impact of the minimum wage. Summarizing those studies is a daunting task, but two recent meta-studies analyzing the research conducted since the early 1990s concludes that the minimum wage has little or no discernible effect on the employment prospects of low-wage workers. The most likely reason for this outcome is that the cost shock of the minimum wage is small relative to most firms' overall costs and only modest relative to the wages paid to low-wage workers. In the traditional discussion of the minimum wage, economists have focused on how these costs affect employment outcomes, but employers have many other channels of adjustment. Employers can reduce hours, non-wage benefits, or training. Employers can also shift the composition toward higher skilled workers, cut pay to more highly paid workers, take action to increase worker productivity (from reorganizing production to increasing training), increase prices to consumers, or simply accept a smaller profit margin. Workers may also respond to the higher wage by working harder on the job. But, probably the most important channel of adjustment is through reductions in labor turnover, which yield significant cost savings to employers.” (Center of Economic and Policy Research, John Schmitt, February 2013).




Levels:

(Prices as of market close February 15, 2013)

S&P 500 Index [1519.79] – Nearly 8% above its 200-day moving average. Clearly, the uptrend is in place, but technical signals argue for pending pullbacks.

Crude (Spot) [$95.72] – Pausing from a recent multi-month rally. The $98 range marks a hurdle rate and vital point for buyers.

Gold [$1668.00] – The commodity is down 10% since peaking in October 2012. There is various evidence of slowing enthusiasm. The recent break below the 200-day moving average signals concern for gold bugs. Behavior between $1600-$1620 can signal the next shift in trend.

DXY – US Dollar Index [80.58] – Few points removed from 200-day moving average. In the last six month, a bottoming shape is visible. It’s worth remembering that the Dollar Index is up 11% since May 2011.

US 10 Year Treasury Yields [2.00%] – The struggle to stay above 2% will be tested in the weeks ahead. July 2012 may have marked a bottom for interest rates and remains a vital trend indicator for macro observers. Entering a new inflection point, yet again.


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