Market Outlook | March 10, 2014

“Do not quench your inspiration and your imagination; do not become the slave of your model.” Vincent van Gogh (1853-1890)

Strength established

Analysts these days are torn between pointing out worrying factors for the next market movement versus praising the already known powerful bull market. Typically, when indexes reach all-time highs, the technical/chart observers will point out that the bullish run faces no resistance ahead. Junctions like this invite the common thought of “unlimited” upside potential and reawaken the sideline capital that’s been overly skeptical. Capital inflow into US markets is quite evident:

“The inflows into stock funds in the week ended March 5 marked the fourth straight week of new cash into the funds. Funds that specialize in U.S. stocks attracted $8.9 billion of the net inflows, marking their biggest inflows since late December.” (Reuters. March 6, 2014)

Equally, this sentiment comforts those adding on to further risk and participating in the upside momentum of this five-year bullish run. Importantly, in 2013, the S&P 500 index registered all-time highs on numerous occasions. Therefore, the mention of record highs at this point is hardly news or alarming for observers. This is dangerous in some ways, when price appreciation has a numbing effect as markets again march to their own rhythm. Even the Eurozone is viewed as recovering or calming down, yet the banks’ exposure to debt is worth tracking:

“Banks in the region [Eurozone] now hold about €1.75trn in government debt, equivalent to 5.7% of their assets and the highest relative exposure since 2006, according to European Central Bank data. In Italy and Spain, roughly one in every 10 euros in the entire banking system is now on loan to governments.” now on loan to governments.” (IFR, March 8, 2014).

Surely, bargain hunters in undervalued European assets might seek select investments, but overall, the crisis concerns have not fully evaporated. At least, risk reduction is not an overnight exercise as risk-takers test their luck.

Since September 2010, developed markets have performed very well versus emerging markets, and this has been highly discussed in recent periods. A massive investor exit from emerging markets is more profound given multiple weeks of consecutive capital outflow. Forward-thinking observers are facing a dilemma, asking: Does one buy emerging markets that are out of favor and relatively cheap? Or does one chase the momentum of what’s been proving to work – US equities? Both are equally challenging to answer, but it’s fair to say that EM is more of a bargain these days, and the risk-reward appropriately reflects that.

Misaligned perspectives

The dollar is now reaching a five-month low, which is a noteworthy macro theme. A weak dollar has helped US exporters further, as seen in prior years. Ongoing cost-cutting methods by corporations have led to some adjustments, which in turn leads to softening economic growth. The interest of shareholders (maximizing stockholders’ value) is naturally not always quite aligned with those seeking economic growth. Thus, the further demise of the real economy is not a topic that’s endearing to capital allocators and risk managers.

Unemployment data has its own trickery, interest rate policy comes with its own self-serving messaging purpose and the stock market reflects shareholders’ perceived value. Thus, finding the truth amidst conflicting events and trends is mind numbing to those not looking to deeply speculate on unfolding events. Settling for the simple and clear explanation of low rates and higher risk tolerance continues to convince plenty.

Basics examined

Investors continue to examine: a) Are prices relatively cheap enough? b) Does the upside offer promising returns? Investors in equities in the US contemplate this as we head into another week. As basic as this sounds, answers to these questions remain the fundamental driver in a market that is rational. In other words, if one is seeking value at bargain prices, then not too many ideas are available outside of stock-specific investments. Similarly, if one is looking for distressed assets, then the best bet appears to be waiting for the next crisis (or heavy price adjustment). Patience is required here, as assets have collectively risen in the post-2008 period. Surely, there is scarcity of ideas, especially for investors looking to deploy large capital. Equally, as the markets have long realized, there are limited safe and liquid assets that can produce yields. A game of limited options for big capital forces creates a point where capital is invested based on relative options rather than stellar fundamentals. That being said, shocks have been averted, as “safer” assets are being redefined. Importantly, signs of irrational behaviors are seeping through and markets are creating their own realities. At some point, the basic questions will be asked, but for now, some realities are conveniently deferred.

Article Quotes:

“This year Western firms’ giant bet on the emerging world will come under more scrutiny. Most multinationals are far more profitable in emerging markets than Vodafone. American firms made a 12% return on equity in 2012, roughly in line with their global average. But having grown fast, profits are now falling in dollar terms. There has been a long bout of share-price underperformance as investors have lost their euphoria. An index run by Stoxx, a data firm, of Western firms with high emerging-market exposures has lagged the broader S&P 500 index by about 40% over three years. And the recovery in the rich world will mean there will be more competition for resources within firms. All this will bring strategic questions into sharp relief. Divisional chiefs from Brazil or Asia will no longer get a blank cheque from their boards. Although the average company has prospered, there have been disasters; plenty of firms and some whole industries need a rethink. The emerging-market rush may end up like a giant version of the first internet boom 15 years ago. The broad thrust was right but some big mistakes were made. The companies suffering a slowdown in profits come in three buckets. Consumer firms including Coca-Cola, Nestlé, Unilever and Procter & Gamble have suffered a gentle weakening in demand and a currency drag.” (The Economist, March 8, 2014)

“On March 5, during an annual meeting of its legislature, Beijing announced that it is increasing its military budget by 12.2 percent, to a total of $131.6 billion in 2014. While still less than a third of the $496 billion that Defense Secretary Chuck Hagel proposed in February for the U.S. military in 2015, it still represents a significant expansion, even after two decades of double-digit growth in the PLA's [People’s Liberation Army] official budget. But few doubt that the grand total allocated to China's military is yet higher, and many in the U.S. government wish they had more insight into the method to the darkness surrounding the PLA. There is general consensus that China, like many nations, spends more on its military than it reports: In February, the U.S. Defense Intelligence Agency said that China's military budget reached $240 billion in 2013, according to Bloomberg. As the most salient data point of China's military, Beijing's official budget gets a lot of attention. And that's largely because there's little other information that comes with it. ‘The single number, without any accompanying detail, represents the sum total of public transparency by the world's second-largest defence spender and the fastest rising military power, pored over by intelligence agencies and military experts from around the world in an effort to glean any clues about China's future strategic intentions,’ reported the Financial Times.” (Foreign Policy, March 7, 2014)

Levels: (Prices as of close March 7, 2014)

S&P 500 Index [1878.04] – Reached all-time intra-day highs of 1883.47, which will serve as a very near-term barometer. The bullish run has been confirmed, especially in the recent move above 1840.

Crude (Spot) [$102.58] – Barely moved relative to prior week. Prices seem stuck in the $100-105 range. Buyers and sellers are reconsidering the recent moves and reassessing whether prices are justified, given supply output in recent months.

Gold [$1345.25] –Nearly a 13% rise since the lows late last year. The first wave of a recovery bounce is materializing. The second wave of recovery is being questioned in terms of further momentum to get near or past $1400.

DXY – US Dollar Index [79.69] – Most of February witnessed a decline in the dollar. This is a common trend, but a move below 80 triggers some questions about a pending trend in the near-term.

US 10 Year Treasury Yields [2.78%] – Impressive move back to the 50-day moving average (2.78%). Showcases signs of recovery in economic data. Reaching 3% is the ultimate test that can set the tone for the first half of 2014.



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