Market Outlook | May 19, 2014

“The desire for safety stands against every great and noble enterprise.” Publius Tacitus (56 – ca. 117)

Seasonal reflection

What has changed since the end of last summer? This is a question to bring up ahead of this summer’s months, when a trend shift is pondered while the status quo continues to flex its muscles by marching on. Humbling for money managers of all sorts, real economy worries have proven unproductive when speculating on stock market indexes. Yet there is unease in moving forward – a sense of puzzling patterns or a tune that's not quite in sync.

Perhaps, identifying what has not changed in nearly nine months is easier: a high stock market, low volatility and positive investor sentiment. A hint of a crack in the bullish run occasionally teased gloomy observers, but skeptics are left to admit that timing a "collapse" is brutally difficult, with false signals being a tricky factor.

Low interest rates and high stock markets combined with a not-so-impressive economy are in place and confirm the general trend felt in September 2013. The fact is accepted, as this message has been very clear. The crowd trusted in the Fed, so the guidance for the defining script is awaited. The art of the words used by the Fed might be what the audience wants, rather than an absolute answer. So many gray areas persist: economic vibrancy, rate hike speculation, housing recovery, long-term labor market, the impact of demographics, etc. Yet, the public markets seem to indicate mixed and conflicted signals, which may explain the paradoxical holding pattern.

Grasping paradox

The search for markets’ ultimate truth is somewhere between the high demand for “safety,” growing demand for risky assets and ongoing standstill in price behaviors of key macro indicators. In other words, safety seekers continue to rotate to liquid and dollar-denominated areas. Risky asset inflows benefit from low interest rates, which are credited with enticing investors to take additional risk in search of higher return targets. Plus, the inherent low volatility creates a sense of comfort, with the perception that turmoil is not lurking. Meanwhile, the S&P 500 index, although near record highs, has not hinted at a convincing directional move. Therefore, 2014 thus far can be characterized by a standstill market action, but suspenseful discussion points offer subtle hints.

The flight to quality is seen in the rotation into liquid, dollar-denominated assets ranging from US equities to Treasuries and high-quality real estate in key cities. Clearly, the much-discussed topic of lower US 10 year yields might explain why there is distrust in economic recoveries from the US to Europe to emerging markets. Perhaps, this lack of confidence will be confirmed in a vivid and broad manner in upcoming months.

Meanwhile, the results of Ukraine and Russian sanctions have shown some behavioral changes as Russians dump the ruble.

“Russians ditched the ruble in March at the fastest pace in more than four years, official data showed, as the currency was hit by fallout from the worst standoff with the West since the Cold War over Ukraine. Central Bank data showed late last week that the total demand for foreign currency, chiefly the dollar and the euro, reached $14.9 billion in March, the highest since January 2009, the aftermath of the global financial crisis.” (Reuters, May 12, 2014)

This is another clear sign that the rush to safe assets continues in BRIC and other emerging markets. Clearly, last year, risky assets such as emerging markets witnessed massive outflow and have underperformed the US indexes. Surely, from Brazil to Turkey to Russia, social and political unrest has been felt, which gives another reason for investors to favor the US and select developed markets. This also ties into the “safety first” mentality that has persisted since the ‘08 crisis.

Dealing with what’s dealt

The endless search for hints on interest rates or vital catalysts from the Federal Reserve consumes the time of pundits. As the stakes increase at this junction, plenty of “Fed speak” speculation will get worthy or less worthy attention. However, it begs for actionable ideas and timing, which is the daunting task of active managers. It’s hard to dismiss the fact that low rates encourage taking on risk, but do not necessarily improve fundamentals or economic indicators.
It’s fair to say that growth and small-cap segments of the markets have realized that sustaining recent success is a challenge. This has led to further sell-offs throughout the year, as small caps underperformed compared to the larger US companies. Amazingly, this pullback is not stopping investors from buying on recent weakness:

“Investors poured $6.3 billion into U.S. equity ETFs in the past week, and surprisingly, about a third of that new money landed into the largest small-cap ETF in the market, the $24 billion iShares Russell 2000 ETF.” (ETF.com, May 16, 2014).

What does this say? Plenty of investors continue to believe this market rally or are potentially desperate to chase returns. The multi-year bullish run is not easily dismissed/ignored, even if known hedge fund managers proclaim that there is a top forming. Skepticism at times looks like it has lost its voice among market participants. The bullish ride is continuing, but reaching record highs is not as easy as it used to be. As stated above, some are seeking shelter in less risky assets.

Basically at this point, the good fortune for bulls will reach an inevitable end, but identifying the end game is a costly exercise that requires a bit more luck as much as skill. Accepting this is a healthier approach to risk-reward management.

Article Quotes:

“Europe’s banking crisis is unresolved. Loans to finance fixed investment continue to fall. Remarkably, the European Banking Authority’s latest stress test for the eurozone’s banks does not contemplate the possibility of deflation in its adverse scenario. The implication is clear: The banks’ capital shortfall will be understated, and the amount of new capital they will be required to raise will be inadequate. If the goal is to restore confidence and get the banking system firing on all cylinders, this is not how to go about it. … And everyone knows that Europe’s much vaunted banking union is deeply flawed. It creates a single supervisor, but only for the largest banks. It harmonizes deposit-insurance coverage but does not provide a common deposit-insurance fund. The resolution mechanism for bad banks is incomprehensible and unworkable. The associated resolution fund will possess only €55 billion ($76.6 billion) of its own capital, whereas European bank liabilities are on the order of €1 trillion. Finally, there is that pesky matter of public debt, which is still 90% of eurozone GDP. European officials propose to work this down to their target of 60% over a couple of decades. You read that right. Check back to see how they’ve done in 2034.” (Project Syndicate, May 12, 2014)

“Mexico has long languished in the shadow of Brazil when it comes to economic and financial bragging rights. But for Brazil’s big banks, faced with sluggish growth and intensifying competition at home, Mexico suddenly has a new allure. Grupo BTG Pactual opened its first Mexican office in January with a staff of 20 and began trading local stocks in March. The firm is just one step ahead of its biggest rival, Itaú BBA, the investment banking arm of Itaú Unibanco Holding, Brazil’s biggest lender. That firm expects to gain a Mexican broker-dealer license in July and begin trading by the end of the year, says Alberto Mulas, a former Mexican national housing commissioner who is CEO for Mexico at Itaú BBA. … The Brazilian banks have reason to look abroad. The attractions of their domestic market have grown dull of late. Brazil’s share in Latin America’s merger and acquisition transactions slid to 56 percent by deal value last year from 71 percent in 2008, according to data provider Dealogic, whereas its share of Latin American equity offerings fell to 41 percent from 85 percent over the same period. By contrast, Mexico is proving increasingly lucrative. The country’s share of the Latin American M&A market rose to 17 percent last year from 8 percent in 2008, whereas in equities it jumped to 34 percent from 9 percent.” (Institutional Investor, May 1, 2014)



Levels: (Prices as of close May 16, 2014)

S&P 500 Index [1877.86] – For more than three months, the index has spent most days trading between 1880 and 1840. Interestingly, a move above 1880 did not attract more buyers. And a drop below 1840 did not last long, with selling pressure pausing. It’s fair to say, this is a neutral and established range.

Crude (Spot) [$102.02] – Struggled in the recent past to surpass $104. Meanwhile, $100 appears to be an agreeable point for buyers and sellers temporarily.

Gold [$1299.00] – Signs of bottoming around $1280 and a sluggish climb back to $1300 ranges. Ongoing demand for yielding assets and a lack of fear has not helped stir upside momentum.

DXY – US Dollar Index [80.04] – After dancing with fragile annual lows, some signs of stability to such a familiar level. July 2013 highs of 84.75 serve as the upside barometer if there is a reversal.

US 10 Year Treasury Yields [2.52%] – Interestingly, last May, new lows of 1.61% surprised participants, but that was the annual low and certainly short-lived. During the last nine months, a trading range between 2.60-2.80% became too familiar. A slip below 2.60% has signaled a noteworthy move. For now, this remains the key macro indicator that’ll drive perception.




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.