Market Outlook | December 23, 2013

“The capacity to be puzzled is the premise of all creation, be it in art or in science.” (Erich Fromm, 1900-1980)

Wildcards accepted

Two less predictable market-moving mysteries ended up surprising observers while not dramatically shifting the narrative. First, despite the consensus view of not expecting the first taper announcement this December, the surprise unfolded with a mild tapering. For months, this event was labeled a major unknown to the status quo of low rates and higher asset prices. Simply, it was feared that the start of a taper would produce some mild shocks or a rise in volatility. The interesting element was the market response; it so far has not reacted in a fearful manner. Instead of concern, the market responded with an intra-day explosion, which matches the multi-year bullish response. That action propelled the S&P 500 index back to all-time highs, reiterating the ongoing and overly familiar trend of 2013.
Doubters of this rally remain even more puzzled. The taper was shrugged off quickly, similarly to prior earnings weakness. Plus, changes to QE policy and the arrival of a new chairperson have yet to rattle the thought processes of capital allocators or new, eager participants. Most likely, this joyful response is temporary, as the taper will be digested and refined with better clarity in the next three months. Patience is required here to digest the nuances and footnotes of the Fed’s messaging behind the taper decision.

Secondly, the economic growth recovery did not quite match the asset boom that’s noticeable. Labor numbers have been questioned despite a mild recovery, and GDP growth has been slow and not always a pleasant picture. Nonetheless, last week’s announcement of 4.1% third-quarter GDP restored further confidence and was a confirmation of economic “success” that was desperately awaited. This was certainly a headline that surprised many.

“[The] biggest contributor [to GDP] was what the government calls ‘gross private domestic investment.’ That includes construction, purchases of machinery and software, and accumulation of inventories that can be sold in future quarters.” (Bloomberg, December 20, 2013)

Again, this burst in GDP is only for one quarter. Most experts do not expect a further economic boom to sustain this recovery, but for the time being, the risk-takers have another data point to cheer and investors may rationalize this as the real economy playing catch-up to financial markets. Puzzling dynamics persist, as the light taper suggests that inflation is not a concern and economic growth is not quite robust. In addition, the labor and housing improvements remain skeptical. It’s unclear whether the pace is sustainable, and organic growth in the real economy remains very difficult to showcase openly. Nonetheless, the current atmosphere appears relieved to have a cheerful spin rather than skepticism, which has been out of favor for a long while.

Less imaginable

Consensus is hardly reliable based on recent examples which included expectations of high gold prices and inflation being a major factor. Gold is down, deflation is the concern and gloom and doomers are realizing the power of Fed-driven markets. Here we are at year-end, trying to dissect the status quo and speculate on potential surprises while relentlessly pursuing the attainable truth that’s interwoven with many messengers and events. Surely, the current levels of US stock indexes were unprecedented for most.

The level of stock market optimism has resurfaced, and there is no shortage of hubris when gauging basic investor sentiment. Yet, progress in tangible economic measures will provide the final say on the Fed’s QE efforts. One would be hard pressed to find many balanced forecasters calling for a stock market sell-off. In fact, with buybacks shrinking the supply of shares and momentum accelerating, it is harder to visualize a crisis-like feel. Yet, the question of slowing growth and the lack of further momentum needs to be asked rather than dismissed. A unanimous crowd of performance chasing is not a sufficient reason to take on further risk. Thus, winners are most likely the critical thinkers who challenge and grasp the status quo. Perhaps, the catalyst might revolve around a macro concern that’s low in the pecking order. Unlike common concerns of an earnings slowdown, Fed policies, a government budget deal, the potential risk of government shutdown, inflation, etc., maybe the less-discussed threat is the valuable catalyst worth understanding.

Seeking the undesirable

The decline in commodities and emerging markets has been well documented and a notable macro trend this year. In terms of emerging markets, since 2010, the US markets have outperformed emerging markets, as the relative argument for US markets has been a rewarding play for several years. Now, value seekers may consider finding a spot in unloved areas. Recently, bank analysts (like Goldman Sachs) have suggested reducing exposure in emerging markets for months ahead. Certainly, with globalization less vibrant and the continuation of a sluggish performance, being bearish is not a surprise. Not to mention, weakness in commodities is burdensome to developing country performance, too. Yet, if the lesson of going against the grain pays off, some may have to consider value bargains within emerging markets.

Here is one point to consider for contrarian thinkers:

“The economic growth in emerging markets is about four times faster than in developed countries, the fact that all exchange reserves are very high in these countries and the debt to GDP (gross domestic product) levels of these EM (emerging market) countries are much lower. The combination of these factors means that we are very much into a sweet patch going into 2014. So, we believe that emerging market equities will do quite well going forward.” (Mark Mobius Interview, Live Mint / WSJ, December, 23, 2013)

Perhaps, the theme of fathoming the unfathomable, as once coined by a money manager, continues to apply in the year ahead as it did in the year past.


Article quotes:

“Much of the euro’s design reflects the neoliberal economic doctrines that prevailed when the single currency was conceived. It was thought that keeping inflation low was necessary and almost sufficient for growth and stability; that making central banks independent was the only way to ensure confidence in the monetary system; that low debt and deficits would ensure economic convergence among member countries; and that a single market, with money and people flowing freely, would ensure efficiency and stability. Each of these doctrines has proved to be wrong. The independent US and European central banks performed much more poorly in the run-up to the crisis than less independent banks in some leading emerging markets, because their focus on inflation distracted attention from the far more important problem of financial fragility. Likewise, Spain and Ireland had fiscal surpluses and low debt/GDP ratios before the crisis. The crisis caused the deficits and high debt, not the other way around, and the fiscal constraints that Europe has agreed will neither facilitate rapid recovery from this crisis nor prevent the next one. Finally, the free flow of people, like the free flow of money, seemed to make sense; factors of production would go to where their returns were highest. But migration from crisis-hit countries, partly to avoid repaying legacy debts (some of which were forced on these countries by the European Central Bank, which insisted that private losses be socialized), has been hollowing out the weaker economies. It can also result in a misallocation of labor.” (Project Syndicate, Joseph Stiglitz, December 4, 2013).

“How fearful should we be of deflation? It depends on why prices are falling. Bad deflations stems from a ‘demand shock’ in a highly indebted economy, say, a housing market implosion or collapsed banking system (the story of the Great Depression and Great Recession). The downward spiral of debt deflation is potentially ominous. The greater the deflation rate, the higher the real interest rate, the more difficult it is for borrowers to service debts, raising the risk of widespread bankruptcies. The big risk at the moment, especially in Europe, is for the onset of a debt-deflation downward spiral. Deflation isn’t always bad, however. Sometimes, mild deflation can signal a vigorous, creative, healthy economy. Good deflation stems from a positive supply shock, e.g., a string of major innovations that combine to push down costs and prices while opening up new markets and opportunities. Productivity-driven deflation was common during the last part of the 19th century. For instance, the wholesale price level fell about 1.5 percent annually from 1870 to 1900, yet living standards improved as real incomes rose 85 percent, or about 5 percent a year. The U.S. economy grew threefold, and by 1900 America was the world’s leading industrial power. …. The commonplace assumption is that the zero-bound, quantitative easing and other extraordinary measures taken by the Federal Reserve and, more recently the European Central Bank, are aberrations from the normal ways of central banking business. The belief is misplaced. The unusual will become normal, with deflation the main price trend in a hypercompetitive global economy and quicksilver technological change.” (Bloomberg, December 19, 2013).

Levels: (Prices as of close December 20, 2013)

S&P 500 Index [1818.32] – Breaking above 1800 again and reaching intra-day highs of 1823.75. Buyers demonstrated confidence at 1780 on three occasions in the last few weeks.

Crude (Spot) [$99.32] – Showing signs of recovery around $95. Buyers’ conviction should be tested around $100-105.

Gold [$1196.00] – Prices are barely clinging on and are a few points removed from annual lows of $1192.00 set on July 5, 2013. The debate is set for bargain hunters who may re-enter versus optimists losing confidence if prices below $1200 turn into the new norm.

DXY – US Dollar Index [80.57] – Since December 11, the index has risen more than 1%, suggesting some strengthening in the dollar. Not quite a noteworthy move, but it raises the question of whether the dollar strength is a new trend.

US 10 Year Treasury Yields [2.88%] – Yields have moved higher this month, from 2.76% to 2.88%, showcasing a combination of strength in economic numbers and a recent resurgence to revisit the annual highs of 3% set on September 6, 2013.

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