Market Outlook | October 20, 2014

“Things sweet to taste prove in digestion sour.” (William Shakespeare 1564-1616)

Digestion

September 19th marked a wake-up call for markets and now the digestion period is in full gear. In the game of speculation, the hunt for catalysts is usually sought after, but after bigger events the postmortem analysis creates further buzz. Risk is not avoidable, once the choice is made to participate in the speculation game. Of course before the mid-September cooling, the complacent market saw turbulence priced low and optimism priced too high. Surely, that led to an inevitable adjustment as investor appetite turned a bit sour.

Sudden but major changes do not occur on a quarterly basis and timing; the markets serve as a mystery that creates intrigue. This October plunge has brought back the dramatic flair of fragile markets. For the current generation of participants, sell-off or crisis are not unusual considering the 2011 mild panic and 2008 historic crisis. Surely, even in the “silent” and “not so silent” bull market of recent years had enough skeptics traumatized by past events. As usual, the great unknown is figuring out when will the market decide to make a big move? When do participants collectively decide to sell-off or shy away from risk? And of course, at what point does selling become exhaustive or when does the market turn back its less turbulent ways? These questions were pondered this weekend in articles and discussions as well as occupying the minds of investors. Either way, a healthy correction ends up serving as a mere sanity check for all.

Mild Shock

Relative to the first nine months of the year, the recent moves require further and sober digestion, especially at the extreme ranges of last week: On October 15th, the S&P 500 index reached lows of 1820.66, the US 10 year yields touched 1.86%, and the volatility index (VIX) peaked at 31.06. It was a period where the mild panic kicked in and emotional responses took over rational thoughts of any kind. Meanwhile, Crude hit $79.78 briefly on October 16th putting an exclamation point to the current cycle slowdown. Are all these exaggerated levels at extremes or warning signs? The market has responded. Now investors' reactions will determine how the year ends from here. General sentiment is leaning towards buying stocks and appears to support adding further risk.

It is no secret that negative market moving elements were brewing even before late September considering dollar strength and commodity weakness. Sure, a few periods of sell-off attempts were briefly witnessed in the beginning of the year and in the spring. Both corrections failed to leave a lasting effect.

Thinking Ahead

At this junction rational minds wonder if the “improving economy” story lives on. Oil prices are now dramatically down and borrowing rates remain low. Does this fuel the consumer driven economy? In terms of housing markets, the refinancing trends continue:

“A gauge of U.S. mortgage refinancing jumped 10.6 percent last week, the most since early June, the Mortgage Bankers Association said Wednesday. The share of home-loan applicants seeking to refinance climbed to 58.9 percent, the highest since mid-February, from 56.4 percent, the group said. In December of 2012, after the 30-year average rate hit a record low of 3.31 percent in November, borrowers wanting to refinance accounted for 84 percent of applications.” (Bloomberg, October 17, 2014)

Consumers may benefit from lower oil and heating prices according to some. That’s to be explored, but as for Energy investors, the price declines have hurt the commodity as well as the stocks. The energy fund (XLF) has dropped nearly 24% from June 27th to October 17th. A theme that has changed dramatically for investor’s fortune, but the impact on economy will be shortly discovered.

Before this autumn the Eurozone conditions worsened despite chatter of further stimulus. Like the 2011 lessons, Europe is trying to shake-off the damaging conditions of no growth. In addition, the Russia-Ukraine tension stirs further instability along with China, Iran and other macro developments. Not to mention, 2013 reflected massive sell-offs in Emerging Markets. Thus the sudden inter-connected panic that stirred is not overly shocking. Now sensitivity grows for short while where data points might be biased towards negative interpretations. In addition, countries that heavily rely on Oil to drive their economies will feel the effect as well, which can spark a changing geopolitical landscape (more on this below).



Unsynchronized

Perhaps the economy may revive from sluggish conditions, but market related concerns can persists. For a while the cycle between real economies versus stock prices seemed disjointed and uncorrelated. In the past many asked: How can stocks rise if the real economy is not stellar? Now, the same folks may ask: How can the economy rise if stocks are shaky? Fragile markets await corporate earnings, investor sentiment, and the Fed’s script. The reliance on the Fed, reduction of shares available, and lack of alternatives have dramatically benefited stocks in the last five years. The art of all this is the understanding that the market drums to its own beat better than the economy. To assume both move the same direction is a flaw, but to dismiss it is equally flawed, too. The rest is risk taking and dealing with the Fed’s messaging which thus far has been influential in shaping investors' minds. The pressure to keep the optimistic light on is building for the Fed. Right now enough believers may persist, but if the Fed is ever defeated psychologically then another wave of panic awaits. For now the Fed’s popularity and ability to cool concerns is still high.

Article Quotes:

“Twenty countries depend on petroleum for at least half of their government revenue, and another 10 are between half and a quarter. These countries are clearly vulnerable to big changes in the price and quantity of oil and gas that they might sell. But which ones would have the hardest time coping? One factor that will affect them is the diversification of their economies. In countries where petroleum is responsible for a lot of revenue but not much of overall economic output, there is at least the possibility of broadening the tax base. Starting with Qatar…, all the countries depend on petroleum for less than a fifth of gross domestic product. But some of them are lousy at collecting taxes, which is the revenue they'll rely on when earnings from oil and gas decline. According to estimates compiled for 2005 to 2007 by Andreas Buehn of the Utrecht School of Economics and Friedrich Schneider of the Johannes Kepler University of Linz, the shadow economy -- or black market -- may make up more than half of Nigeria's GDP, and more than 40 percent in Chad, Russia, Myanmar, and Ivory Coast. (Of course, this may be part of the reason why petroleum revenue accounts for so much of their governments' budgets.) Recovering from a dent in government revenue would be especially tough for any of them.” (Foreign Policy, October 17, 2014)

“The unorthodox steps the European Central Bank has taken since June – including a programme of private-sector asset purchases – have caused a steep fall in the euro. The single currency is down 8.4 per cent against the dollar and 4.75 per cent on a trade-weighted basis from its peaks this year. The weaker exchange rate will ease pressure on the ECB in its fight to raise inflation back to its target of just below 2 per cent. Mario Draghi, the central bank’s president, has said the currency’s earlier strength explains 0.4 percentage points of the fall in inflation since 2012. In that year, prices were growing 2.7 per cent a year. But just as this depreciation is starting to fuel inflation, the ECB must contend with a fall in oil prices that all but wipes out the effect of a sliding currency. A weaker euro should swiftly raise the cost of imported energy. Instead, Brent crude has fallen 9 per cent in euro terms this month alone. This is the main reason why eurozone inflation fell again in September to 0.3 per cent, a five-year low – a figure confirmed by data on Thursday. A cheaper euro will also please business leaders who have long called for action to curb the value of the currency. But economists warn it is hard to tell how far this bout of depreciation will help the region’s anemic recovery. In theory, a rise in company profits should support business investment, hiring and consumption. But analysts warn that the relationship between exchange rates and export volumes is far from clear-cut.” (Financial Times, October 19, 2014)

Levels: (Prices as of close October 17, 2014)

S&P 500 Index [1886.76] – From September 19 to October 15 the index fell 9.84%. A near 10% correction has taken place with a 200 moving day average sitting at 1906.02. Interestingly, 1906 is where the market closed two Fridays ago and the 10 day moving average stands at 1906 as well. Thus, it serves as a good barometer for sentiment. Either buyer momentum is short-lived or more heavy selling awaits.

Crude (Spot) [$82.75] – Fair to say, the collapse is intact as the selling pressure mounts. Amazingly, the commodity reached below $80, albeit not for long. Overall, the action suggests oil is severely beaten up and now approaching relatively “cheap” levels for some. Potential bounce back is inevitable but the duration of any pending price recovery remains a mystery.

Gold [$1,237.75] – Since last summer, Gold has danced in a familiar territory between $1,200 and $1,360-ish. Long drawn out bottoming process. The 33% correction from October 2012 to July 2013 has left a big dent in investors’ optimism. Shaking that off has taken a while. Finding a spark for a recovery to $1,400 has been talked about but follow-through has yet to materialize.

DXY – US Dollar Index [85.91] – Following a relentless run-up in the past few months’ signs of slowing. A mild pause is taking place. Hard to deny the strengthening dollar which has served as one of the key macro shifting movements in recent months.

US 10 Year Treasury Yields [2.19%] – This year, from May to late September, yields stayed between 2.40-2.60%. The dramatic turn in last few weeks drove yields below 2% for a short while.




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