Market Outlook | December 22, 2014

“Unreasonable haste is the direct road to error." Moliere (1622-1673)

Hasty Bounce

The recent run-up in stocks seems so sudden when considering the prior weeks’ big sell-offs and heightened volatility. Sure, for US stock indexes all-time highs are a few points removed. Another record high would hardly be surprising at this stage given the pattern in 2013 or 2014. As investors digested the hard commodity decline (led by oil) of recent weeks, a bounce back in US stocks was not surprising, but a roaring broad index recovery presents some challenges for bargain hunters. The Fed’s crafty or practical script (keeping interest rates low) has yet to create panic. Instead, a stimulating equity markets further reflects the US relative attractiveness. At what point is slow growth an issue for corporate earnings? At what point is the US less attractive than other markets? What’s more attractive than US equities? Answering or guessing at these questions might present fruitful future ideas (if any).

Amazingly, the volatility index that soared above 20 this month quickly descended back to 16. Turbulence came and went in mid-October and could again in mid-December. Worries of unstable Crude prices and less vibrant Emerging Markets (EM) are at the forefront of investors' minds. For now, flocking into “safer” themes has been the great escape for those judging by the scoreboard. For example, the strength of the Dollar the second half of this year reflects further instability in Eurozone and EM. This recent hasty market bounce back can not quite eliminate the mystery of the unexpected events, related to currency and commodity markets in months ahead.

At the same time, any thoughts of higher interest rates remain damp as signs of higher yields are a rarity in developed markets. Even the so called risky markets in Europe, such as Spain and Italy, are seeing extreme low yields. Both nations' 10 year government yields were trading below 2% at the end of last week. Yes, growth is not visible in the Eurozone, but the panic of default has calmed down as well. This creates a state of confusion regarding perception of risk. This set-up encourages plenty of investors to stick with the established trend.

Mind Games

A series of short-term market responses have led to an up and down fourth quarter. The rush to buy cheaply valued oil and gold company stocks is one wave of looming interest for some. Similarly, bargain hunting in “discounted” EM is in the minds of classic value investors. The rush back to all-time highs appeals to the hopeful, who await new record highs. Ultimately, the rapid bounce reflects the well-known status quo (higher stocks, lower rates) and at times felt like it was never-ending. Of course, that’s a repetitive pattern that’s putting some investors in a state of complacency. Last week's Fed announcement found a way to lift stocks higher from a mild fragility. Yet, thinly traded volume ahead of the holidays begs some questions about reading too much into the day-to-day action. Perhaps, the sharp corrections from this October and December presented mild hints that are still being understood. Not overreacting to one or two moves is a mental test for risk-takers at this period.

The Relative Search

Hindsight is deceptive because it makes situations appears simpler than they were in real-time. Assuming low interest rates, lower commodities and higher stock markets from a few years ago were not as easily evident as historical data presents today. Equally, expecting a trend-shift/reversal turned out to be inaccurate because timing is a guessing game and risk is always part of the equation. Being skeptical is healthy at times, but perception drives reality more than one can imagine. Depressed wage growth compared with stock market record highs exposes a massive disconnect. Yet, an illusionary perception can trick not only the irrelevant investor, but the so called experts, too. A lesson that’s timeless and clearly exhibited in 2014.

The interconnected markets have been shown to respond quickly and the “relatively attractive” theme eventually gets rewarded. When EM currencies declined, investors flocked to the US Dollar. When Gold and Crude sold-off heavily, more capital inflow went into Equities. When junk bonds failed to hide their risky nature, more capital is bound to flow into Treasuries or lower risk bonds.

When markets are confused about what’s really relatively attractive, then increase in volatility is only natural. Such common patterns and relationships influence behaviors in a meaningful way.


Article Quotes:

“Energy junk bonds now account for a phenomenal 15.7% of the $1.3 trillion junk-bond market. Alas, last week, JPMorgan warned that up to 40% of these energy junk bonds could default over the next few years if oil stays below $65 a barrel. Bond expert Marty Fridson, CIO at LLF Advisors, figured that of the 180 ‘distressed’ bonds in the BofA Merrill Lynch high-yield index, 52 were issued by energy companies. And Bloomberg reported that the yield spread between energy junk bonds and Treasuries has more than doubled since September to 942 basis points (9.42 percentage points)… Oil and gas are inseparable from Wall Street. Over the years, as companies took advantage of the Fed's policies and issued this enormous amount of risky debt at a super-low cost, and as they raised money by spinning off subsidiaries into over-priced IPOs that flew off the shelf in one of the most inflated markets in history, and as they spun off other assets into white-hot MLPs, and as banks put now iffy bridge loans together, and as mergers and acquisitions were funded, at each step along the way, Wall Street extracted its fees. Now the boom is turning into a bust, and the contagion is spreading from the oil patch to Wall Street. Energy companies are cutting back. BP, Chevron, Goodrich... They're not cutting back production by turning a valve. They'll keep the oil and gas flowing to generate cash to stay alive, and it will contribute to the glut.” (Econintersect LLC, December 21, 2014)

“At U.S. debt auctions in 2014, investors submitted bids for $6.3 trillion of interest-bearing Treasuries, or 3 times the amount sold. Since 1994, the bid-to-cover ratio this year has been exceeded only twice—in 2011 and 2012. Before the financial crisis, the high was 2.65 times... Investors bought a record 58 percent of Treasuries at auctions this year, while dealers purchased less than any other year since the government began releasing the data in 2003. Average daily trading has fallen to 4.1 percent of the total outstanding, from 13.1 percent a decade ago, according to Fed and Treasury data compiled by Bloomberg. ‘It’s gotten to the point where the market depth, the liquidity that dealers can provide has been reduced, even for Treasuries,’ Michael Lorizio, a senior trader at Manulife Asset Management, said by telephone from Boston on Dec. 18. The amount of bonds sold at auction to fund U.S. spending is decreasing as faster economic growth boosts tax receipts and shrinks the deficit, which is set to narrow further in 2015. The Congressional Budget Office estimates the shortfall will decrease to $469 billion in the year ending Sept. 30 from $483 billion last fiscal year. That would be the smallest funding gap in seven years. The deficit has declined in four of the past five years since peaking at $1.4 trillion in 2009.” (Bloomberg, December 21, 2014)

Levels: (Prices as of close: December 19, 2014)

S&P 500 Index [2070.65] – Despite hitting a low point in mid-October (1820.66) and mid-December (1972.56), the index is a few points removed from all-time highs (December. 5th reached 2079). The last two months have showcased the sharp-sell offs followed by stronger bounces.

Crude (Spot) [$57.81] – Following the massive sell-off, there has been some attempt of stabilization between $54-$58. It is amazing to think that Crude stood at $107.73 on June 20, 2014.

Gold [$1,199] – In several occasions the technical charts suggest a bottom at $1,200. This has brought about mixed feelings from investors. Nonetheless, a follow-through above $1,200 has not been visible.

DXY – US Dollar Index [89.59] – The demise of Emerging Market currencies has played a key role in the dollar maintaining its strength. The well-defined uptrend since July tells a revealing story.

US 10 Year Treasury Yields [2.16%] – The prior attempt to hold above 2.15% earlier this month did not work out. The 2% lows of December 16th are on the radar of those tracking yields closely. For several weeks, yields have stayed below 2.40%, setting the tone for the current cycle.


Dear Readers:

The positions and strategies discussed on MarketTakers are offered for entertainment purposes only, and they are in no way intended to serve as personal investing advice. Readers should not make any investment decisions without first conducting their own, thorough due diligence. Readers should assume that the editor holds a position in any securities discussed, recommended or panned. While the information provided is obtained from sources believed to be reliable, its accuracy or completeness cannot be guaranteed, nor can this publication be, in any Publish Post, considered liable for the future investment performance of any securities or strategies discussed.