Market Outlook | May 27, 2014

“The difference between life and the movies is that a script has to make sense, and life doesn't.” (Joseph L. Mankiewicz 1909-1993)

Experts humbled

Hedge fund managers, for the most part, might be amazed or, to put it accurately, humbled by what has transpired in the market. The unshakable trend of a record high stock market index with severely low interest rates and a nearly non-existent volatility lives on – not to mention last year’s correction in commodities and emerging markets, which have failed to regain momentum. Sure, nothing major has formed into a new trend-shifting catalyst when viewing year-over-year thus far.

For how many months and weeks can this rate-stock-volatility pattern repeat itself? Is there natural risk to all this? Is the Fed a conductor of this market script? Is the lack of global options for liquid and established assets? The value of fund managers is being questioned by those who think this speculative exercise is a lay-up when using hindsight, as some guidance is known to increase danger, of course. Whether bravado, danger or somewhere in between, moods are improving and the Q1 flow shows more capital flowing into hedge funds. Nonetheless, performance is where it counts and that has been a challenge for most managers:

“‘A lot of people were hoping this year would turn out to be a stockpickers’ market, but that has turned out to be anything but the case so far,’ says Troy Gayeski, partner and senior portfolio manager at SkyBridge, a $10.3bn investor in hedge funds based in New York. With the average hedge fund suffering the worst start to the year since the financial crisis, making just 1.2 per cent, according to the industry data provider Preqin, only a few managers, many concentrated in trading in concentrated company-specific events, have prospered.” (Financial Times, May 20, 2014)

Record highs in the S&P 500 index are nothing new, despite the colorful headlines they provide. Select areas like Tech and Biotech are reexamining the upside potential, and plenty of fundamental concerns persist in some sectors. Flight to quality is one trend that’s been seen before, with rotation to dollars and Treasuries. If this demand for quality and safe assets continues, then the argument for reduced risk-taking can be made. For now, a rise in volatility or massive risk reduction is not quite visible. It would have to be an event that finds a way to organically form despite experts’ attempt to speculate.

Continuously puzzling

Suspense is one thing and luck is another, but the drop in US 10 year Treasury Yields and surging stock markets have given a whole new meaning to status quo. The gloom-and-doom theatrics were off, the inevitable correction seems deferred and proclaiming further upside may be feared as much as betting against this market, it seems. After all, investment opinions are plentiful, but investable liquid assets offer limited options. For now, the market verdict suggests: Despite lukewarm economic growth, US stocks are favored and other developed markets are gearing up to follow a similar direction. Not quite the murmurs of “rich” valuation, pending a rise in volatility or risk of rising rates, which various money managers proclaimed across various public venues. Trepidation is natural when indexes are at uncharted territories of record highs, and follow-through to rising expectations is usually harder and harder to match. Thus, one cannot be overly amazed at the cautionary tale that’s rehashed on daily basis. Measuring the level of hubris in the market is one thing, but guessing the potential top is a daunting exercise.

Managing expectations

US midterm elections, pending Russian/Ukraine tension, election results in Europe, BRIC-related growth conditions and further earnings and economic status reports will be deeply analyzed in the summer months ahead. Yet, attention is better suited for grasping the interest rate policies of central banks, the conductors of risk-reward expectations and market tone. At this stage, the combination of more faithful bulls and discouraged short-sellers leads to a dynamic that has helped the S&P 500 index reach the 1900 range. The faithful participants will continue to test their luck. Surely, a multi-year bull market is viewed as more than luck, by any logical measures. However, how much of this luck is Fed/Central Bank driven? This is a collective question with suspense.

Grasping drivers of risk is desperately required for money managers seeking bigger rewards. Several false signals of tops in US markets have misled plenty, but there is some value to pursue in emerging markets. Emerging markets seem less risky than other markets following last year’s major price correction and immense capital outflow. Surely, a follow-through is awaited. Therefore, the market soon will determine if betting on developing markets is riskier than dabbling with long-term emerging markets. Interestingly, emerging markets (EEM) have jumped by 16% since February 3, 2014. Perhaps, a noticeable capital rotation into EM out of developed markets will provide the clearer picture of pending risk-reward perception. Maybe then the Fed-driven market will require adjustments, and with alterations, turbulence is known to follow for a bit.

Article Quotes:


“That interest-rate cuts [by the ECB] are on their way is now regarded as a done deal. The main lending rate will be lowered from 0.25%, probably to 0.15% or 0.1%. Much more strikingly the deposit rate paid to banks on overnight deposits, currently zero, will be lowered by a similar amount, to either minus 0.1% or minus 0.15%, in effect charging banks for funds they leave with the central bank. The ECB would thus become the first big central bank to move into negative territory, though a recent precedent has been set by the Danish central bank, which charged negative rates between July 2012 and April 2014 in order to stave off market pressures pushing up the krone, which is tied to the euro. What has been less clear is what, if anything, the ECB might do beyond this. Some easing of liquidity has been expected, for example by ceasing to sterilise its remaining holdings of government bonds bought between May 2010 and February 2012 through its ‘Securities Markets Programme,’ a euphemism for trying to arrest panic in bond markets under siege. But what has now emerged from Mr. Draghi’s speech is that the package is very likely to include measures designed to boost credit to firms in southern Europe. Mr. Draghi distinguished between two causes for low inflation, one general and one local. The general was the downward pressure on inflation across the euro area from the appreciation of the euro. Interest rate cuts should help to counter the broad disinflationary pressure arising from an overstrong currency. Money-market rates should move down to levels that discourage inflows of foreign funds.” (Economist, May 26, 2014)

“The director of an allied intelligence service once described the theft of sensitive business negotiation is as a ‘normal business practice’ in China. The Chinese government uses it to give Chinese companies an immediate advantage. China agreed to protect intellectual property when it joined the World Trade Organization (WTO) and has never really done so. The United States has in effect been asking them to play by the rules of both global trade and espionage, and the Chinese have ignored these requests. There are rules in espionage, implicit and unstated, but understood. One rule is to not overdo it; Snowden’s leaks showed that U.S. ignored this rule to its cost. Now China has been called out as well. The most likely Chinese reaction will be denial, a recitation of Snowden leaks, and threats to take action against U.S. companies. China will be tempted to retaliate. They could punish U.S. companies in China (another violation of WTO rules, not that this would bother them), they could indicate U.S. officials based on the Snowden leaks, but tit-for-tat indictments risk leading back to China’s own corruption problems. Fears of Chinese currency manipulation are wildly overstated – the Chinese economy is in bad financial shape (given the huge local debts) and can’t risk destabilizing the global economy – it would be the first victim. It would be in neither country’s interest to start a trade war. The United States could manage retaliation by letting the Chinese government know that it would take appropriate countermeasures in response. The United States is less vulnerable to Chinese pressure (even if individual U.S. companies are vulnerable). This is a case where the public good may outweigh the good of individual companies.” (Center of Strategic & International Studies, May 19, 2014).





Levels: (Prices as of close May 23, 2014)

S&P 500 Index [1900.53] – For the second time this month, 1900 was reached. Previously, the inter-day highs of 1902.17 (on May 13) marked the all-time highs. The 15-day moving average of 1883.67 sums up most of the recent trading activity around 1880. Record highs may be reached, but these ranges are too familiar early this year.

Crude (Spot) [$104.35] – April 16 highs of $104.99 are on the radar for many oil observers, and now, a few cents away from that point, the question of a further catalyst awaits.

Gold [$1298.00] – In the last several weeks, the range between 1280 and 1300 is developing as an uneventful pattern. A catalyst is deeply needed, and there are no hints from a chartist point of view.

DXY – US Dollar Index [80.04] – In the last four months, the dollar appears to have established a bottoming phase again. 79.50 seems to be the base and a stronger dollar is being closely tracked in the near-term

US 10 Year Treasury Yields [2.53%] – No major week-over-week change. This begs the question of how low yields can continue at this stage. 2.20% is the next key level, and anything below 2% can spark some uneasy responses.



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