Market Outlook | October 13, 2014

“In seed time learn, in harvest teach, in winter enjoy.” (William Blake 1757-1827)

New Season

The autumn season has marked a market cycle filled with realizations of long ignored and accumulating dangers. Ultimately the inevitable reality check for the global economic and geopolitical health is more visible than before. A bullish run conducted by the Fed has headlined the script, but substance needs to back perception given share price appreciations.

At a quick glance, Emerging Markets (EEM) declined over 10% since early September. Similarly, the Nasdaq dropped around 7% since September 19th and the small cap index (Russell 2000) is down over 13% since July 1st. Various signs of weak economic data points came and went without major emphasis. Nonetheless, stocks are showing that invincibility from reality is unsustainable. The antiquated and classic Dow Jones Index is down on the year (for scorekeepers) despite the excessive cheerleading sequences of prior months. Talks of rate hikes turned out to be a mere chatter. To the surprise of many, the US 10 year Treasury yields stood below 2.30% as of Friday. The yields are dramatically low when considering analysts' expectations from the start of the year. Inflation expectations continue to be lower. This setup in rates and inflation showcases the lack of growth. Rightfully so, this creates more unease for longer-term investors.

The summer months provoked grand changes to the status-quo mindset that began since the 2008 recovery. Some of the drastic changes are highlighted by:

1) Crude prices declining at a rapid pace
2) US Dollar’s strength and momentum
3) Stock markets struggling to make new highs

Some crowds await a stock market rebound, then a rally from these levels. Surely, the power of the recent perception and the familiar patterns left create a bias towards positive sentiment. Yet, how are these current market levels deemed “cheap”? How can the current sell-off be ignored again like prior 4-5% broad US index corrections? Risk, valued so cheaply in early July, has erupted in the last 15 trading days. This awakens new sorts of thoughts. Safety may be set to trade at a premium and hope appears deeply overvalued.

Macro Climate

In last twelve months investors had a chance to prepare for potentially unsettling patterns. Sure, mid-term elections are approaching in the US which can shift political perceptions and dynamics. Amazingly, what has transpired in the last twelve months is stunning to quantify. First, Middle East nations lack any further stability, as has been documented in the past few years. Second, the Western world attempts to restore economic fruitfulness, yet revival remains extremely difficult especially in European economies . Third, events in Ukraine, fragile relationship with Russia and China, and Eurozone stimulus efforts appear enough to stir concerns. Or at least future concerns appear to be brewing. Elements of a cold war like traits reappear in some form, and the geopolitical saga will find a way to affect the day-to-day eventually. Even if macro items do not drastically drive the market; at some point, analysts will have to question impact on globalization after decades of facing various challenges.

Psychological Points

Last Wednesday the Fed sparked a massive rally, only to see Thursday and Friday turn into a selling frenzy. The ongoing theme of the Fed "saving the day" has been the mantra for this (and most) rallies, yet lack of rally during the last two days may have rattled the Fed's ability to orchestrate a rise in asset prices via confidence. In looking ahead, further declines may require the Fed to step in for further emergency actions – if we get there. Simply, the spike in turbulence (VIX) last week begs the question of the Fed's role as a last resort or next move. After all, t majority of participants believe and accept the power of the Fed-led rally. A true test has yet to play out between earnings, macro changes and whether or not recent sell-off is enough.

Meanwhile, the Nasdaq index, which stayed above its 200 day moving average for so many days is being challenged now. The sudden shift is catching the attention of basic technical observers. Buyers may be enticed to buy at a very slight discount, but if that fails to induce then selling pressure looms. Some believe that earnings may tell a better-than-expected story. Others will be in suspense as they ponder the dollar's impact on earnings. Perhaps, market mood swings may turnout to be more sour that expected.

Finally, share buybacks have limited the supply of shares outstanding in recent years, contributing further to increase in share prices. Whether a gimmick or a tactical move, buybacks helped lift many large company shares. Skeptics wonder at some point if this momentum can slow as well. It is one of many factors, but the supply-demand dynamics of stocks are certainly critical. In fact increased buybacks have left a strong mark in this bullish run.
Early sell-offs are not initially over dramatized, but when various factors begin to point towards shakier conditions then deceleration occurs faster than imagined. Thus, minor clues are not to be taken lightly, especially at this cycle junction.

Article Quotes:

“Since then oil prices have dropped to nearly four-year lows, pushing the sale price of Mexico’s main crude stream well below the $83 level that is the basis for next year’s budget. One-third of Mexico’s budget is funded by oil revenue in response, the government last week paused its purchases of insurance from large investment banks against lower oil prices. according to market participants. Mexico’s growth screeched to a halt last year after the government was slow to open the public purse strings, but recent data indicated that the economy grew a stronger-than-expected 2.52 per cent in July. If the government is forced to cut spending it could put the recovery at risk.

As volatility has increased, costs have risen for the hedging programme. The latest 5m-barrel batch of put options to appear on a new US derivatives database, dated September 29 and identified by market participants as part of the deal, showed a premium of $2.77 per barrel, almost twice that of the first batch 12 days earlier. The current premium would be higher still if Mexico were to trade now. Mr. Lacaze estimated the hedging programme, for about 180m barrels of net oil exports, was less than half finished. Mexico’s hedging effort has been further complicated by new rules requiring basic deal terms with Wall Street banks to be made public in data repositories.” (Financial Times, October 12, 2014)

“At home, Chinese media each day feature news from Hong Kong but avoid images of the demonstrations themselves, and instead focus on collateral impact such as snarled traffic, empty shops and experts who highlight risks to Hong Kong’s reputation as an international finance center. As proof of U.S. backing for protests, the editorial cited alleged activity by a senior official of the National Endowment for Democracy, a foundation funded by the U.S. Congress, including meetings held with protest organizers months ago. The official, Louisa Greve, couldn’t immediately be reached. On social media, Ms. Greve has appeared to support Hong Kong’s student protesters. Her most recent post to Twitter on Oct. 4 makes reference to the United Nations’ International Covenant on Civil and Political Rights, to which Hong Kong is a party under prehandover agreements and which sets out requirements for fair and democratic elections.

For years, China’s government has tracked the activities and donations of U.S. groups like the National Endowment for Democracy. A task force of mainland scholars was set up five years ago to study “the activities of U.S. [nongovernmental organizations] in Hong Kong and their impact on Hong Kong’s politics and policies,” according to an outline of the project’s works.” (Wall Street Journal, October 11, 2014)

Levels: (Prices as of close October 10, 2014)

S&P 500 Index [1,906.13] – Since September 19th the index has fallen over 5%. Technical indicators alarms observers as the 200 day moving average stands at 1,905. The late July to early August sell-off was short-lived. Therefore, short-memory suggests an oversold bounce is due. Interestingly, the August 7th lows of 1,904 remain critical in the weeks ahead.

Crude (Spot) [$85.82] – Since June 20, 2014 the commodity has declined over 20%. From supply-demand standpoint, not quite alarming considering expanding supply and slowing demand. However, from a price movement perspective this downtrend is notable. The four month deceleration sparks a massive global trend.

Gold [$1,220.50] – Since September 9, 2011, gold prices have dropped over 35%. At around $1,200 some selling pressure may ease temporarily. No evidence of a trend change, but three years of sideways patterns confirms the sell-off from a cycle peak.

DXY – US Dollar Index [85.91] – After a surging run since July, there has been a very slight pullback. Yet, the strong dollar theme lives on. Quite a statement from the macro standpoint as the sustainability remains suspenseful.

US 10 Year Treasury Yields [2.28 %] – 2014 continues to amaze most pundits at how low rates can fall. Three percent was very short lived. Then 2.60-2.80% remained a steady range from February to April. Recently, staying above 2.60% has proven difficult as 2.26% marked the low last Thursday.

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