Market Outlook | June 17, 2013

“What has puzzled us before seems less mysterious, and the crooked paths look straighter as we approach the end.” Jean Paul Richter (1763-1825)

The plot thickens

In the past month, a few events have unfolded, heightening hints of a potential sell-off. It started with sharp sell-offs in emerging markets, along with currency volatility and certainly the ongoing debate about the status of Quantitative Easing (QE). In addition, US participants in the past month witnessed a run-up in interest rates and minor pullbacks in broader markets. In what has been a smooth-sailing ride (year-to-date: S&P 500 up 14.1% and NASDAQ 100 above 10%), now this begs a few questions about asset prices. Are we poised for a slowdown triggering a prolonged selling period? Is the status quo at risk of changing its tune? These are natural and key questions to ask among the financial circles.

Before building the pending downside thesis, one should realize a few reasons that favor further upside moves in US markets. Here are key influential points to consider:

1. Limited participation. This thus-far unloved rally does not feel like a broad participation to set up a bubble-like collapse in the US. A few pundit comparisons to the 2008 or 2000 bubbles are not quite relevant yet. Perhaps, the lack of enthusiasm thus far may require more cheerleading to even reach a more dangerous level.

2. Lack of alternative markets. When considering European woes and the recent emerging market sell-off, US equities end up benefiting from capital rotation. Plus, given the low interest rate environment, there are limited options in sound bond investments, which again bodes well for equities

3. Power of intervention. Stabilizing the market remains a priority for central bankers as conductors of the financial market orchestra – stimulus efforts can prolong the rally and attempt to postpone potential demise or loss of confidence.

Big-picture assessment

Surely, the reason for upside moves is now being understood. However, there is a potential setup of a lose-lose situation facing the Federal Reserve, which risks the hopes of those falling deeply in love with this market. In the summer of 2011, the panic served as a buy signal. However, in summer 2013, having market confidence is not such a rare trait or outlook.

First, if QE as we know it ceases, there is a natural investor withdrawal or shift from the status quo that can cause justified and unjustified concerns. Participants have been trained not to doubt the status quo, and when that's taken away, then fear easily brews.

Secondly, if QE continues for long, then the mystery of QE’s end date would trigger additional skepticism and worry beyond the Fed’s messaging control. Not to mention, if the economy is considered okay, then more will ask: Why more stimulus? The last thing central banks desire is to admit that ongoing stimulus efforts were a failure. So one should brace for government intervention and confusing messaging. So far, it's quite clear that US homeowners and stock owners benefited in price appreciation. Thus, the Fed can flex some muscles to re-emphasize the old saying: "Don't fight the Fed.” Yet, the economy is mysterious to grasp, when sorting through revisions and debatable sample sizes and other tricks in calculation that confuse rather than refute potential doubts.

Unlocking confusion:

It’s fair to say that the trend for recent months is known. The upcoming trend is less clear, which can cause some near-term disturbance. Perhaps, some market overreaction should not be surprising and is the healthy approach. Corporate earnings ahead will dictate some responses related to investor confidence. If emerging markets are slowing, then odds are multi-national corporations will feel the pinch, too. So earnings may set the tone in the US. Each trading day can confirm the clues of jittery macro reactions. For now, cleverly observing is wiser than boldly relying on old trends or speculating on new, unproven movements.

Article quotes:

“After three years, Greece’s experience is telling. As a new IMF report acknowledges, structural reforms there have failed to produce the intended effects, partly because they ran up against political and implementation difficulties, and partly because their potential to increase growth in the short run was overstated. Nor have Spain’s labor-market reforms worked as expected. None of this should come as a surprise. Structural reform increases productivity in practice through two complementary channels. First, low-productivity sectors shed labor. Second, high-productivity sectors expand and hire more labor. Both processes are needed if the reforms are to increase economy-wide productivity. But, when aggregate demand is depressed – as it is in Europe’s periphery – the second mechanism operates weakly, if at all. It is easy to see why: making it easier to fire labor or start new businesses has little effect on hiring when firms already have excess capacity and have difficulty finding consumers. So all we get is the first effect, and thus an increase in unemployment. There is little new in the European Commission’s approach, and few reasons to be optimistic that its “new” strategy will work better than the old one. Structural reform – however desirable it may be for the longer term – simply is not a remedy for these countries’ short-term growth conundrum.” (Project Syndicate, June 17, 2013)

“Emerging markets from Brazil to India took steps to stem an outflow of capital as concern mounts that developed nations are approaching the beginning of the end of an era pumping unprecedented liquidity. India’s central bank sold dollars the past two days to stem the rupee’s slide, two people familiar with the matter said, while Indonesia unexpectedly raised its benchmark interest rate today. Brazil said yesterday it would unwind some of the capital controls it began putting in place in 2010 – when the Federal Reserve was embarking on its second round of quantitative easing, known as QE2. Thailand said it sold dollars in the past week. Foreign selling of Thai, Indonesian and Philippine stocks has reached record levels as the threat of reduced Fed monetary stimulus spurs the biggest equity declines since 2011. Overseas investors unloaded a net $2.7 billion from the three stock markets so far this month, the biggest eight-day outflow since Bloomberg began compiling the data in March 1999. Three years after emerging-market policy makers from Brazil to South Korea warned about destabilization from record Fed stimulus, they are now coping with the prospect of the spigot being tightened. Fed actions have pumped more than $2.5 trillion into the financial system since 2008.” (Bloomberg, June 13, 2013).

Levels: (Prices as of close June 14, 2013)

S&P 500 Index [1626.73] – After peaking on May 22, the index appears to stabilize around 1620. Buyers with conviction are offered an entry point, while sellers debate the magnitude and potential of this downtrend.

Crude (Spot) [$97.85] – Very early signs of a breakout above $96. There is technically some significance in that move, yet some wonder if this is a short-lived run.

Gold [$1385.00] – A nine-month decline leading to a more than 20% depreciation reemphasizes the cycle pause. Although there has been chatter of buying the last few quarters, gold prices have not rejuvenated.

DXY – US Dollar Index [81.66] – Since late May, the dollar has declined in value, giving up some of the gains that began in February 2013.

US 10 Year Treasury Yields [2.12%] – After an explosive run since May 3, yields have risen at a faster pace. Sustainability remains questionable and suspenseful.


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