Market Outlook | December 1, 2014

“In times of rapid change, experience could be your worst enemy.” (Jean Paul Getty, 1892-1976)

Rapid Reminders

A year ago (2013) some Emerging Market economies like Brazil and Turkey saw their stock markets collapse. Around the same period, gold prices began to crumble reminding investors that cycles do turn very quickly. In fact, the gold bugs fixation was overly enthusiastic with ambitious forecasts that seem rather moot now. The biased and hyped opinions dominated financial circle discussions but eventually the market behavior has the last say (or laugh).

Similarly, the spectacular growth of some EM seems like an old classic movie script. The record highs for EM fund (EEM) were last seen in October 2007. Active participants must be careful when digesting passionate views from so called pundits and analysts. A dogmatic approach (ignoring clues) to market comes with a heavy penalty when the script changes.

This year the strength of the dollar (relative to other currencies) has turned into a vital macro trend. At the same time, crude prices have dramatically decelerated by resetting all types of expectations and forcing analysts to reexamine implications from consumers to oil rich nations. Intended or unintended consequences are lurking, but the trend for oil is much clearer.

Sudden, unexpected shifts should serve as a collective reminder. How many expected Gold below $1,200 and Crude below $70? Not many! Perhaps these are lessons to recall when thinking ahead to the next theme and the next year. Beloved themes and ideas can crumple quickly where a proper time to react can be limited. That’s been the message from currencies and commodities, and there is wisdom to take away and apply for other markets in the near-future. Invincibility for a trend is not an option, but timing is always an intriguing challenge.

Dissecting the Narrative

For few years, stocks have been the “reliable and rewarding” global investment, especially in US equities. Investors have witnessed positive returns and that itself speaks the loudest for short-term decisions. Essentially, the current stock market dynamics create comfort and builds false future assumptions, too.

“According to the weekly sentiment survey from the American Association of Individual Investors (AAII), bullish sentiment increased from 49.12% up to 52.15%. This marks the eighth straight week that bullish sentiment has been above its bull market average of 38.6%, which is also the longest streak we have seen in 2014.” (Bespoke, November 28, 2014)

When risk taking is fueled further by low interest rate climates then it further justifies the lack of alternatives. So the suspense of interest rate directions has not been overly mysterious (in hindsight). Rather, it’s been one sided—Low and lower. In a similar manner the volatility measures continue to dip lower, reaffirming further calmness. In 2015 -How low can rates and volatility go? The conditioning from the Fed’s actions and messages may trouble many to see a world of rising rates or rising volatility. For now arguing both is rather visionary and not backed by near-term performance.

Importantly, lessons from the supply-demand dynamics for crude suggest that one day/moment reality sinks in and prices adjust quickly and the cheerleading analysts will depart from their charged views. It may seem normal to keep thinking low rates equal higher stock prices for the months ahead. Yet, it's rather adventurous to expect this and that is the unknown risk. The mental challenge of thinking something is predictable and to be expected is a dangerous approach as record highs blind participants. Thus, the mystery for the next equity move awaits as for now, and the record highs are celebrated.

The Mindset

The claim that equities are the favorable investment is gaining more merit, more acceptance and raising fears of participants— being hubristic is not deemed as a major factor in the claim. The last 24 months have proved to the casual observers that naysayers are missing out on an upside. The psychological impact of missing an opportunity leads to a rush of capital allocation and that’s been a theme for months and months. Amazingly calling bubbles in stocks have been the wrong choice from a timing perspective, and moving ahead it is a test of nerves for those looking to double down on the risk-reward.

An overriding theme that shapes minds revolves around interest rates, as usual. No matter how many data points cross the wires, the endgame for risk-takers is: Where do I allocate capital? Even if the real economy is not vibrant, even if small business health is not fully resorted, there is more emphasis on chasing returns. The buyback magic that lowers the shares of stocks is an influential trend that should not be dismissed. Corporate profit is a powerful statement, but weakness in sales may surprise many ahead. Planning for surprises is what most analysts struggle to do and the herd mentality is less willing to hear and, perhaps, this is the time to reshape the mindset before 2015.

Interconnected Message

On one end interest rates are low because of the soft global growth from Eurozone to Emerging Markets and even the not so robust growth in the US. Meanwhile, the decline in crude prices reflects slower and weaker global growth. In both cases, the economic growth is slow when viewing it through the oil and interest rate patterns that are screaming. There is a weakening economy that’s masked by heating stock markets; and surely this message is hardly surprising these days.

How much longer can this economic weakness be ignored? The conductors of financial markets might have an edge in crafting a message to justify the unimpressive economic conditions and impressive stock behavior as good progress. As for interest rates, there is a mysterious element that lingers with the ECB awaiting to decide on easing policy. The world fixated on easing policy (i.e QE) has shaped the status-quo and it feels like the norm, but safe to say it is not fully understood. However, the unimpressive economic conditions are being slowly understood by various indicators.

Article Quotes:

“Russia, the world’s largest producer, can no longer rely on the same oil revenues to rescue an economy suffering from European and U.S. sanctions. Iran, also reeling from similar sanctions, will need to reduce subsidies that have partly insulated its growing population. Nigeria, fighting an Islamic insurgency, and Venezuela, crippled by failing political and economic policies, also rank among the biggest losers from the decision by the Organization of Petroleum Exporting Countries last week to let the force of the market determine what some experts say will be the first free-fall in decades… Oil and gas provide 68 percent of Russia’s exports and 50 percent of its federal budget. Russia has already lost almost $90 billion of its currency reserves this year, equal to 4.5 percent of its economy, as it tried to prevent the ruble from tumbling after Western countries imposed sanctions to punish Russian meddling in Ukraine. The ruble is down 31 percent against the dollar since June.” (Bloomberg, November 30, 2014)

“The ECB warned that riskier corporate bonds and some forms of bank debt are already looking overpriced as investors search for yield in an environment of ultra-low interest rates. The central bank identified an abrupt reversal of this search for yield as the main danger to financial stability in the region. That threat would be exacerbated if, as expected, the ECB extends its purchases of asset-backed securities and covered bonds to include mass government bond buying, a policy which works in part by boosting the prices of riskier assets… While there were signs of “excessive froth” in the market for high-yield corporate bonds and some Cocos – a form of bank debt which behaves like equity should a bank fail – the ECB’s report found that “normal” corporate bonds and equities did not show any indications of overvaluation. The problem highlights a challenge facing central banks across the world. Many monetary authorities have taken on more responsibility for safeguarding the health of the financial system, while at the same time pursuing an aggressive monetary policy that some believe has done more to spur asset prices than revive growth.” (Financial Times, November 27, 2014)

Levels: (Prices as of close: November 28, 2014)

S&P 500 Index [2067.56] – The second half of the year has displayed that the index can stay around or above 2000. The August and October corrections led to a bounce back to 2000, which continues to shape a more bullish signal. Yet, the 200 day moving average of 1935 seems further removed now than mid-October.

Crude (Spot) [$66.15] – The massive break-down continues. The break below $80 added further pressure; and shockingly and quickly the lows reached $65.69 last week. This massive drop is a realization of a long awaited supply-demand imbalance as emotion driven responses will need time to settle.

Gold [$1,194] – Stuck below $1,400 and attempted to bottom at $1,200. Downtrends since the July highs of $1,340 reinforce the lost momentum within the cycle peak. A quick recovery does not seem feasible, but stabilization around $1,200 appears practical.

DXY – US Dollar Index [88.35] – The mid-summer eruption of the index led to a critical shift of strengthening the dollar. The shift is setting multi-year highs, and surely reshaping the currency markets.

US 10 Year Treasury Yields [2.16%] – Yields are struggling to stay above 2.20%. Recently, resistance built around 2.60%. Any move below 2% is most likely to trigger responses. For now, annual highs of 3.05% seem very far removed.



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