Market Outlook | November 24, 2014

“Worry is a cycle of inefficient thoughts whirling around a center of fear.” (Corrie Ten Boom 1892-1983)
The “Simple” Tale

As 2014 draws to a close, the theme of easing from ECB to Japan to China is the key market driver— following the footsteps of US policies, of course. After all it is simple to understand: lower rates lead to higher stock prices and that's the slogan being presented and perceived by most market participants. The last few years serve as stark evidence of this slogan, and now that trend has turned into a quasi-marketing pitch masterminded by Central Banks.

The continued demise of volatility after a brief awakening this fall further confirms the strength of this resilient US stock market. Close observers will point to small cap underperformance and other worries of sustainability, but the “cautious” crowd is struggling to get mass following. The Gold aficionados and those fearing inflation have quieted down a bit after revisiting prior assumptions. The dollar is strengthening, inflation is hardly a worrisome topic and Gold prices are much lower than most expected. Similarly, beyond a 10% broad index correction, the downside pressure for stocks has been limited for equity markets.

Even European yields are much lower than imagined when compared to 2011, as the orchestrators of financial markets continue tout their brilliance via easing. Thus, believers keep piling on risk as the desperate search for yield is a reality. Turbulence in all angles has disappeared and the reappearance early this fall was short-lived. The list of issues that were feared to cause market shock (i.e. earnings, weak economy and macro instability), now seems less likely to catch the attention of risk takers. As the balance tilts again towards optimism, some see it as a result of limited option for capital to seek reliable returns. Strange dynamics shape perception, which eventually turns into a temporary (or extended) reality. Complexity aside, the herd mentality is sticking to this story with the Fed's reinsurance serving as a confidence booster.

Cycles & Sense

The commodities markets continue to reflect the fundamentals of supply-demand as well as the impact of cycles. As Crude prices showcased in recent months, in a world of slow demand and expanding supply (especially in the US via drilling), eventually come under pressure. Perhaps, the supply-demand dynamics are making more sense and are clearer for commodities than other mysterious markets. Fair to say, the boom and bust nature of commodity cycles is natural and easily understood in hindsight, of course.

Not to mention, the decade old boom in commodities reached a peak from a cyclical point of view. Most of the commodity run-up in the 2000’s was driven by Emerging Markets demand, and slowing demand has been visible even before the supply expansion. Nonetheless, for speculators digesting the oil and gold prices demise the answer might be more tangible to grasp without much mystery to dissect. Surely, the drop in oil prices sparks talk of countries negatively impacted and potential impact on foreign policies; also further regulatory discussions of commodity trading rumblings continue. However as the postmortem analysis continues for oil and other commodities, plenty of noise distracts from the basic root of market-moving forces. At the same time now that commodity prices are much lower, the impact on consumer behavior, international trade and corporate earnings begs further questions.

Deceivingly Obvious?

The parade around US stocks is not a new theme; however, the remarkable run impresses further at each record high. Reconciling why prices are going up (and why the status-quo might change) requires a few questions and explanations. Is it share buybacks that lower the supply of available stocks or lack of alternatives in this messy world? Is it the demise of commodities or the promising revival of US economy? Is it mainly Fed/interest rate driven or a reflection of optimism for very large corporations?

Although, presented as a simple tale, in the current trends in stocks may not be quite cut and dry like the boom and bust of commodities. These questions above are debated by writers of articles, casual financial observers and speculators alike. Yet, the perception of stocks being the relative favored solution in this climate is widely accepted. Awaiting surprises is a healthy approach even if all seems too simple, too sure and deceivingly obvious. Until, the rate hike expectations change dramatically the status-quo seems unshakable.

Meanwhile, the Fed is changing the script (on key indicators for economic health) as we go, thus having a basis to make future predictions is more of a wild card. The moment the trust in the Fed breaks this calmly scripted tale can face a dark awakening. For now, punditry is not going to manufacture fear or hint of rate hike timing. Living in the present seems a practical and safe approach for most investors.

Article Quotes:

“Why focus on wages and prices now when much of the developed world is concerned about deflation, or a decline in economy-wide prices? As I said at the start, everyone is focused on wages—for different reasons. The real median income in the United States is still 8 percent lower than it was in 2007. Some of the reasons for sluggish wage growth are unique to the current expansion, including the creation of a preponderance of low-wage jobs; the still large number of part-time workers (10 percent more now than before the recession) and the gap in wage growth between full- and part-timers; the ability of U.S. companies to shift production to low-wage countries; and the greater share of compensation flowing to health benefits. The unsolved question is what to do about it. Faster economic growth, the obvious solution, remains elusive as economists debate whether potential GDP has slowed permanently, in which case cyclical solutions can only do so much. In the long run, an economy can only grow as fast as the growth in the labor force and productivity, neither of which is showing much oomph. For its part, the Fed seems determined to see wages rise before it begins to normalize its benchmark rate. Given the wide gap between zero and some neutral rate, waiting for a signal from wages will be too late. It may seem like a trivial point now, with neither prices nor wages posing any kind of an immediate threat. But when the economy is finally able to walk without assistance, it is important for policymakers, in particular, to know if they are looking forward or looking back.” (Caroline Baum, The Manhattan Institute, November 18, 2014)

“The UK government delivers services and support such as defense, and financial and social protection. Sharing the costs is part of contributing to UK society. If all income tax is devolved, people living in Scotland will pay no taxes directly from their income for these quintessential UK services. That would weaken the ties that bind all member nations of the UK and erode the solidarity at the heart of it. Second, the UK is ceding a large part of its revenue base and its ability to manage the economy. Income tax accounts for 27 per cent of UK tax revenues. The result is that, for the first time in 300 years, a UK government would no longer have control over its power to raise income taxes. It could be left in a position where it determines the rate of income tax only to find it impossible to implement in Scotland, Wales and Northern Ireland. And its proposals in England could be voted down if it had no majority there. It would no longer be master in its own house… If we do not find a similar settlement we risk ending up with the same institutional strictures of the eurozone: an integrated monetary union without a fiscal union. No one voted forthat.” (Financial Times, Alistair Darling, November 23, 2014)

Levels: (Prices as of close: November 21, 2014)

S&P 500 Index [2063.50] – Intra-day highs of 2071 set the benchmarkfor next record highs as the re-acceleration continues.

Crude (Spot) [$76.51] – The multi-month decline continues. Below $80 sparks another wave of concern as November 14th lows of $73.25 are closely watched. A 32% decline since summer highs is significant and may cause watchers to wonder if the bleeding is poised to slowdown.

Gold [$1,190.00] – Struggling below $1,200 as the multi-month decline lives on. Several occasions in the last year and half suggest strong odds for recovery at $1,200, but the weakness has not alleviated.

DXY – US Dollar Index [88.31] – Strength continues. The dollar strength reflects the continued easing pattern in Europe and China. Relative appeal of the dollar remains intact.

US 10 Year Treasury Yields [2.30%] – For about two months yields have failed to surpass 2.40%, reaffirming the low rate environment. This month the narrow range stands between 2.27-2.39% and appears firm for now.

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