Market Outlook | December 8, 2014

“Trust the instinct to the end, though you can render no reason.” (Ralph Waldo Emerson 1803-1822)

Magical Perspective

Several weeks ago in mid-October, the S&P 500 index stood around 1,850, volatility picked up a bit and Crude was above $80. Then a remarkable turnaround took place in less than two months: Stock markets continued to re-accelerate from short-term worries, Crude demise decelerated with urgency and rising volatility evaporated at a fast pace. A mild twist and turn was witnessed as the end result restored the bull market. Responses from broad indexes illustrate the lack of worry of external macro events.

During this same period, the Dollar did not flinch while maintaining its strength; while commodity related currencies and indexes seem more fragile than imagined. The Crude demise reminds risk-takers that commodities cycle is regrouping after peaking from last decade’s upside momentum. Various explanations aside, the commodities cycle strongly coincides with most Emerging markets such as Russia and Brazil, which are seeing their currencies and stock markets sell-off rapidly. This marks a sour period for economies heavily reliant on oil and other commodities.

The themes are well defined for now, the status-quo is more understood and ugly surprises seem rare. Thus, panic and anxiety about US markets have been silenced again as we head into year-end. Amazingly, perception seems more vital for financial markets than real economy, perhaps. Wage and job growth are tricky measures of well-being, but the stock market is an easier indicator to frame a positive perception. Conditions in European economies are not overly rosy, this includes in Germany and France. More data points await, but a softer growth is not a new discovery. As stock values rise easily there is a feeling that conditions are improving. That’s the magic of perception, after all.

Trust Emboldened

In the “Fed investors trusted,” so inevitably any break to this trend is most likely to be driven by Central Banks. Considering all options is the situation that awaits in looking ahead. The Fed created a magical appreciation in stock value, erasing volatility and skepticism. The same familiar themes keep repeating:

1) Investors flocking to stocks and other risky assets due to lack of alternatives.
2) Anticipation of further QE in Europe – following US and UK footsteps.
3) Volatility at very low levels as the Fed driven script is successful to synchronize investors responses.
4) Developed markets favored in this climate than Emerging Markets.

For many years these themes above resurfaced and betting against them has not been overly wise. At this stage, guessing the market or volatility turning point is a daunting task that would be categorized as near gambling. Yet, one has to wonder about pending catalysts in the months and years ahead. As the brilliance of the Federal Reserve is touted in academic and media outlets, the nature of risk-reward still exists. The Fed might have eliminated the severe volatility in recent years, but can the Fed eliminate the nature of risk-reward? The same reward the Fed created surely can become the undesired risk.

Sanity Check

Plenty of economic data points have illustrated the struggles of global markets since 2008. From China’s data to consumer demand to wage growth, there are data points that illustrate a concerning element. As US real estate and stock prices rise in a profound manner, sentiment and perception are easily and generally influenced. If perception is more powerful than reality, then one shouldn't be surprised if this perception turns negative very quickly. The mere fact that volatility is low does not suggest it will be lower for a decade or so. The low-rate environment, albeit a three decade trend, is not quite a given for next 30 years, either. The multi-year highs in the Dollar index and multi-year lows in commodities remind us that sudden shifts do occur.

Article Quotes:

“I have long been worried that the European Central Bank has been slow to address the threat of deflation. But a fall in energy prices is not a good reason for panic because deflation can be good, bad or something in between. In the depression of the 1930s it was undoubtedly bad, because it reflected excess supply and deficient demand. In the late 19th century it was good. During the misnamed Great Depression of 1873-96, there was average annual real growth of 2 per cent despite a decline in the general price level, spurred by shrinking land values and falling prices in older industries. The experience of falling energy prices comes closer to the 19th century example than the 1930s. The problem with a malign deflation is that consumers defer spending decisions because they expect things to become cheaper. Yet history suggests that a rise in real incomes resulting from falling energy prices is more likely to encourage people to spend. That said, there are other very powerful deflationary forces at work in the eurozone, such as the restrictive German fiscal diktat and an ECB monetary policy that is delivering below-target inflation of just 0.3 per cent. By putting downward pressure on inflation, the fall in energy prices will add to the pressure on the ECB to move to full US-style quantitative easing.” (Financial Times, John Plender, December 7, 2014)

“With U.S. output at a 31-year high and imports at the lowest level since 1995, producers seeking the best possible price for crude are straining at having to keep sales at home. Removing the ban could erase an imbalance between U.S. and foreign crude prices by expanding the market for shale oil… The Government Accountability Office, Congress’s investigative arm, in an October report concluded that exports may lower pump prices by as much as 13 cents a gallon, even as they raise U.S. oil prices. That would happen because gasoline is pegged to Brent, a global benchmark price, rather than West Texas Intermediate, GAO said” (Bloomberg, December 5, 2014)

Levels: (Prices as of close: December 5, 2014)

S&P 500 Index [2,075.37] – Since the October 15th lows, the index has gained 14% to yet another all-time high. A dramatic turnaround to the established bullish trend. No tangible signs or clues of a stop forming at this stage.

Crude (Spot) [$65.84] – Struggling to find a bottom. The intra-day lows on December 1st of $63.72 suggest some sign of a desperately needed clue. Nonetheless, the price reflects low investor demand and expanding supply, and that realization has led to a powerful sell-off.

Gold [$1,209] – Another attempt to stay above $1,200. Inability to stay above this mark may signal another wave of selling. For now, the long drawn out bottoming process remains intact.

DXY – US Dollar Index [89.33] – The explosive run continues. The next critical range is passing the 90 range to re-ignite continuation of these multi-year highs. Momentum for the dollar continues to be positive.

US 10 Year Treasury Yields [2.30%] – The last two months showcase a form of stability between the 2.20-2.40% range. June 2007 highs of 5.32% seem far removed. In a similar manner, the July 2012 lows of 1. 37% seem farther away (in terms perception) than closer at this point.







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