Market Outlook | September 29, 2014

“Nature has always had more power than education.” (Voltaire, 1694-1778)

Selective Hearing

Bulls and bears continue to hear the message that they want to hear. The bullish spin is well documented. Simply put, optimism has been driven by the recent historical performance of low rates and higher stocks. More stock buybacks and less turbulence have summed up the trends for years. Lower yields and lower collective fears are the consequences of policies and sentiment. At this point all of these factors are so evident for market observers that little argument is needed to promote and glorify this multi-year market run. The scoreboard tells the story: Market bulls are more hubristic due to the several record highs and price appreciations. A period where no one wants to miss out the rally combined with high profile IPO’s surely creates the buzz of a bull market even to a casual observer.

For bears, many naysayers have overused "crisis" or “gloom and doom” outcomes dating back a few years. Some over-bet on commodities as a safe haven, particularly Gold; while others underestimated the Fed's power (as trickery or magic by some interpretations). Other cynics incorrectly screamed "top" or "bubble" to no avail. In the past some felt inflation was a critical issue for the economy. Meanwhile, others likely focused more on the rising rates as the catalyst. Another bearish argument centers on the slowing or not so vibrant real economy in Western nations. The lack of stock market correlation with fragile and weak economies was puzzling of course. Low wage growth combined with a lack of growth in small to mid-business is another matter. Bears have criticized this unhealthy set-up by stressing this climate is overly favorable to super large companies. With weak economies comes further sentiment changes, which has been long awaited by the highly bearish crowd, who were silenced in recent months.

A market breather now seems both overdue and needed if there is a natural flow to this market cycle. Amazingly, with each record high the bears' momentum appears crushed, but more than ever prior arguments are still worth keeping on the radar. Presumably, a natural response is looming.

Reconciling

As October approaches, the bullish argument faces more difficult questions in preserving the status-quo's dynamics. Certainly, the Fed-led rally has been battle tested, so far surviving the “crisis” or “panic” like reaction by global investors. Not only have low interest rates and low volatility benefited from this market, but so have other technical issues.
First, the supply-demand of outstanding shares suggests that corporate buyback has played even a bigger role in accelerating share prices. As many ponder past events and implications, a potential shift in the reduction of an overall supply of shares shows that:

“Second-quarter S&P 500 buybacks decreased 27.1% compared to the prior quarter, and fell 1.6% vs. to the second quarter of 2013, S&P Dow Jones Indices” (Pension & Investments, September 23 ,2014).

Secondly, if investors look beyond the surface, small cap indexes (non-S&P 500 stocks) have shown to be weaker relative to larger names. The Russell 2000 index, a small cap barometer, has declined by nearly 8% since peaking on July 1st 2014. Unlike the Dow Jones and S&P 500 indexes, which trigger plenty of day to day attention, the smaller cap areas have not preformed in the same manner, and the ongoing weakness signals another warning sign. Perhaps this is similar to Emerging Markets' struggles of 2013, which provide investors with another perspective in which valuations are stretched and a reset is deeply needed.

Timing is everything, but timing the market is a daunting task. Nonetheless, tracking the buybacks and small cap trends can serve as catalysts that contribute to shift in the status-quo. One may argue that instead of looking for an external catalyst, it is better to track the shift in factors that contributed to this run. As all eyes are focused on interest rate policies, other indicators become even more vital.

Bigger Picture

Investor sentiment has not dramatically reacted to the unfolding global events and historical matters. There is a sense of immunity by the equity markets, which did not respond to Ukraine or extremist group threats or even other political deadlocks. Interestingly, these events did not overly sway participants to react in a negative manner. Most notably the Eurozone crisis came and went and most appear numb to the known troubles. ECB’s attempt to lower rates is not a convincing prospect especially given the Fed’s inability in the US to create a robust economy during a low rate period. Instead, we’re in a political and leadership crisis amongst the Eastern nations (Russia, China) who oppose the interest of traditional Western nations.
Many are asking the status and value of globalization at this junction. Emerging Markets had their moment, but trouble loomed. China’s growth is highly questionable, and Russia is at the forefront of reexamining relations with Western nations. Surely, corporate interest and foreign policy matters are not aligned, and markets are focused on earnings rather than the 10-20 year implications for now. However at some point, the status-quo of a higher global stock market will have to confront pragmatic realities and not only perception.

Perhaps, the dollar strength is one indicator that screams of a trend shift, or at least is sounding an alarm of sorts. Essentially, the strong dollar is changing the landscape not only for other currencies (Euro) and commodities (i.e. Gold and Crude), but soon this may impact corporate earnings. Perhaps, this may play-out in day to day stock movements. As many speculate the next catalyst or turmoil in global events, the Dollar is loudly making a wake-up call to collective assets. However, the stock-market and volatility are the indicators of a broader interest, and the numb responses to concerns have been stunning. How long can stocks live in a world of their own? How long can investors tolerate the calmness directed by the Fed? The biggest puzzle of all: how long can the status-quo drive these stocks higher based on perception rather than reality? A new season and a new month look to tackle these unanswered questions.

Article Quotes:

“Russia’s state-run OAO Rosneft said a well drilled in the Kara Sea region of the Arctic Ocean with Exxon Mobil Corp. struck oil, showing the region has the potential to become one of the world’s most important crude-producing areas. The announcement was made by Igor Sechin, Rosneft’s chief executive officer, who spent two days sailing on a Russian research ship to the drilling rig where the find was unveiled today. The well found about 1 billion barrels of oil and similar geology nearby means the surrounding area may hold more than the U.S. part of the Gulf or Mexico, he said… The discovery sharpens the dispute between Russia and the U.S. over President Vladimir Putin’s actions in Ukraine. The well was drilled before the Oct. 10 deadline Exxon was granted by the U.S. government under sanctions barring American companies from working in Russia’s Arctic offshore. Rosneft and Exxon won’t be able to do more drilling, putting the exploration and development of the area on hold despite the find announced today… The development of Arctic oil reserves, an undertaking that will cost hundreds of billions of dollars and take decades, is one of Putin’s grandest ambitions. As Russia’s existing fields in Siberia run dry, the country needs to develop new reserves as it vies with the U.S. to be the world’s largest oil and gas producer… The importance of Arctic drilling was one reason that offshore oil exploration was included in the most recent round of U.S. sanctions. Exxon and Rosneft have a venture to explore millions of acres of the Arctic Ocean.” (Bloomberg, September 27, 2014)

“China is likely to delay its financial reform agenda in favor of stabilizing growth, economists and investors say, in a move that could hinder efforts to correct distortions in the economy. Deregulation of interest rates was a key plank in the ambitious reform agenda that top Communist party leaders approved last November, which promised to give market forces a “decisive” role in capital allocation… China has taken steps in recent months to impose market discipline on state borrowers. In May, the cabinet approved a pilot plan to allow local governments to sell bonds directly, rather than borrowing through opaque financing vehicles. The agency that manages SOEs also announced its own pilot aimed at raising the efficiency of state groups. But it could take years to transform SOEs and local governments into entities able to withstand a rise in borrowing costs.” (Financial Times, September 28, 2014)

Levels: (Prices as of close September 26, 2014)

S&P 500 Index [1,982.85] –For several weeks the 2,000 mark served as a critical psychological point. For now the September 19th number of 2,019 serve as a record high. Recent wobbly action and slowing momentum begs further questions about sustainability.

Crude (Spot) [$93.54] – Since 2011 the commodity has struggled to stay above the $105-110 range. On three occasions since 2012, selling pressure mounted from $105 to $90. The current sell-off is attempting to bottom yet again as $90.43 (Sept. 11) serves as a key low.

Gold [$1,213.75] – The demise in gold prices since October 2012 ($1,791) is visible. As a two year anniversary awaits from the Gold “topping” period, observers wonder if the $1,192 from July 2013 is the ultimate bottom which will satisfy sellers. $1,200 is a fragile and critical point in the weeks ahead.

DXY – US Dollar Index [85.64] – Continuation of an explosive run. Since May 2014 the index has gained over 8%, making a key macro statement by making multi-year highs. Resounding statements given the index remained in a well established trading range for a long while. A break above $84 is a big statement to solidify the dollar’s strength for eleven weeks in a row.

US 10 Year Treasury Yields [2.52%] – Once again Yields failed to stay above 2.60ish percent and in the recent past did not dip too much below 2.40%. Again, critical inflection points await as the summer lows of 2.30% from August are on the radar for observers.

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