Market Outlook | July 8, 2013

“Knowledge is proud that it knows so much; wisdom is humble that it knows no more.” (William Cowper 1731-1800)

Relative dominance

A few days after the July 4th holiday, there is a message echoing across financial markets. As stated so often on this weekly write up, the relative edge of the US Dollar and US equity is visible, as both are sought after globally. Neither is this cheerfulness driven by the positive headline labor numbers for June, which reinforces the prevailing bullish bias. Certainly this glorification of US markets is not breaking news for active and seasoned observers who’ve seen the silent bull market continue to build up for months. Equally, the Federal Reserve’s assessment of improvement is not an opinion that’s up for debate. The dollar reached a three-year high and rates are moving higher from deeply wounded levels, proclaiming economic strength. Surely, the change in QE is something that’s been too discussed and anticipated for one to act surprised.

So here we are in July, in which the Small Cap index (Russell 2000) is sporting all-time record numbers and the S&P 500 index is not far removed from all-time highs. For US homeowners and stockowners, the value of wealth broadly has not been destroyed over the last four years if one bought and held – thus proving how the post-crisis performance has virtually erased all the crisis-related damages. The debate now is more about future damages, for which no one has a clear-cut answer.

Seeking shelter

The increased demand for exposure to US equities does not suggest astronomical upside movement for years to come, either. Instead, the attractiveness of US stocks is bolstered by poor emerging market performance, the demise of commodity prices (with the exception of crude, of course) and shaky bond market confidence and actions. To grasp this loud statement in support of stocks, one needs to connect all macro dots and discard some of the misleading noise, which at times is very difficult. The BRIC nations have struggled immensely and investors are reacting viciously in their behavior. Here is one example of emerging market outflow:


“Global fund managers have yanked money out of Chinese stocks for sixteen of the last 18 weeks, including a net $834 million during a five-day period ending June 5. That was the largest outflow since January 2008, when the financial crisis was getting underway, according to data provider EPFR.” (Wall Street Journal, July 3, 2013)
The bottom line is that the lack of alternatives ends up driving rotation into the next-best assets. Equities may enjoy the pending inflow; however, earnings starting today will enable us to know if expectations match reality. For now, the known is the US attractiveness; the unknown is the fundamental shift and art of spin that await.


Reasonable unease

Before celebrating the positive momentum, one should ponder the macro occurrences that have been brewing in the last few weeks. 1) Interest rates have risen sharply as US 10 year treasury yields are above 2.50%. 2) Crude, unlike other commodities, refuses to decline below $85-90, finally breaking above $100. It continues to benefit from oil-related headline noise. 3) A strong dollar may not necessarily be beneficial for US companies dependent on overseas revenue. 4) European recovery is hardly visible and hopeful signs are not an easy find. Certainly, this is not quite a reason to declare an all-out collapse, but it is a justified list of worrisome topics that surely will persist even if bad news is completely ignored in the short term.

Higher interest rates and oil price appreciations are poised to be the vital macro indicators of collective interest. Financial circles view a rise in both as impeding economic and stock market growth. It is unclear whether the inverse relationship is theoretical or practical. Soon the answer will be discovered, but the discovery requires either patience or risky speculation, which is not comforting despite the cheerful bias.

Article quotes:

“Currently, more than half of China's industrial water usage is in coal-related sectors, including mining, preparation, power generation, coke production and coal-to-chemical factories, according to China Water Risk, a nonprofit initiative based in Hong Kong. That means that the water demand of the Chinese coal industry surpasses that of all other industries combined. A geographic mismatch worsens the water stress. Statistics from China Water Risk show that 85 percent of China's coal lies in the north, which has 23 percent of the country's water resources. As the majority of the Chinese coal industry is built where coal reserves are, those water-scarce regions are increasingly pressured to give more water. To answer China's rising appetite for power, Chinese policymakers have decided to establish 16 large-scale coal industrial hubs by 2015. If the plan materializes, those hubs are estimated to consume nearly 10 billion cubic meters of water annually, equivalent to more than one-quarter of the water the Yellow River supplies in a normal year, according to a report jointly issued last year by the environmental group Greenpeace and the Chinese Academy of Sciences. Researchers from the two groups say that China is now running into a tough choice: Should it adjust the national coal development plan that is set to fuel the economy, or should it go ahead and build up large-scale coal industrial hubs that could cause a serious water crisis?” (Scientific American, July 1, 2013)


“Unfortunately the euro resembles the flawed interwar version of the gold standard rather than the classical pre-war model. After the gold standard was restored in the 1920s, central banks in surplus states like France (which had rejoined it at an undervalued exchange rate) sterilised the monetary effects of gold inflows so that prices did not rise. That put all the pressure to adjust on countries like Britain, which rejoined the gold standard in 1925 at an overvalued rate. A similarly harsh deflationary process is now under way in peripheral euro-zone countries like Greece. Their adjustment would be much less draconian if the core states were prepared to tolerate considerably higher inflation than the euro-zone average. But Germany fiercely resists this. … When countries joined the gold standard, it bestowed a seal of approval that prompted a big influx of foreign money. That pumped up credit, driving an expansion of domestic banks that often ended in grief. Under the gold standard a strong state could support wobbly banks and investors; in pre-war Russia, for example, the central bank was called the ‘Red Cross of the bourse.’ But a weak state could easily forfeit investors’ confidence, as happened to Argentina in its 1890 debt-and-banking crisis. That same story has been repeated in the brief history of the euro. Money cascaded into peripheral Europe, causing banking booms and housing bubbles. In the bust that followed, the task of recapitalising banks has caused both the Irish and Spanish states to buckle.” (Economist, July 6, 2013)


Levels: (Prices as of close July 5, 2013)

S&P 500 Index [1573.09] – Between May 22, 2013 and June 24, 2013, the index fell 7.5%. Now, a bottoming process is setting up for a potential re-acceleration.

Crude (Spot) [$103.22] – After failing to hold above $98 on several occasions, oil has broken above key resistance. Momentum is building, given headline concerns. It is quite evident that $85 is a floor that was established both in April 2013 and December 2012.

Gold [$1251.75] – Recovering from recent lows of $1192.00. Deeply wounded from a heavy sell-off. Although the downside potential appears limited, the long-term downtrend is still intact.

DXY – US Dollar Index [83.23] – Since the May 2011 lows, the dollar has maintained its strength. It finished the week near the two-year highs. Certainly, the multi-decade trend of a weak dollar is not quite the case now, as the bottoming continues.

US 10 Year Treasury Yields [2.73%] – Explosive move remains in place, with the jump from 1.61% to 2.73% in nearly two months. This is a macro game changer that’s been long awaited. Stabilization is anticipated, but this trend is not fragile




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