Market Outlook | April 20, 2015

“Without art, the crudeness of reality would make the world unbearable.” George Bernard (1856-1950)

Summary

The public markets continue to rely on Fed guidance while having less emphasis on the day to day ground level fundamentals. The low yield environment continues to reach a less bearable climate as key markets continue to see negative yields. The Fed is wrestling to justify an interest rate hike, but the economic data remains mixed and not quite convincing. This elevated stock market mixed with a sluggish global economy creates an unsettling conflict. And frankly, this conflict (or disconnect) needs to be settled soon despite the Fed’s artistry in navigating this climate.

Script Accepted

The roaring indexes across several continents reaffirm the power of central bankers as mass followers continue to pile into equities. The clear script of bidding up asset prices and enhanced risk taking has been quite visible and nothing new. Momentum driven names are gaining more interest from investors. In addition, more Merger & Acquisitions (M&A) talks have mixed with more inflow of yield chasing capital. There has been an increase in return chasing, especially in innovative themes such as technology and healthcare.

“Dealmakers forecast soaring growth in health care M&A over the next 12 months, as buyers continue to seek innovations to meet the market demands created by the Affordable Care Act, according to Mergers & Acquisitions' Mid-Market Pulse (MMP), a forward-looking sentiment indicator, derived from monthly surveys of approximately 250 executives and published in partnership with McGladrey LLP.” (Mergers & Acquisitions, April 15, 2015)

At the same time, in the most innovative and highly popular themes, there are questions being asked about valuation levels. As unprofitable companies are viewed as amazing growth stories, the irrational mindset becomes reflected in some recent IPO’s. In fact, Western European IPOs are at a 15-year high according to Reuters data (April 17, 2015). Yet, with markets being so Fed/Central Bank-centric, the breakdown of momentum names hasn't been fully felt yet in a tangible, panic-driven manner. Thus, bullish confidence does not appear fragile, at least from a psychological point of view. Instead, the desperation element of finding good growth stories and higher yielding assets is mildly blinding. The concept of “increasing risk” has taken a backseat, which is not new but with time becomes riskier.

Brewing Hints

Last week, there were hints of unrest as two common worrisome themes resurfaced. Firstly, the good ol’ Greek debt concern was back on the radar. It never left the minds of risk managers, but with Eurozone stocks roaring and with some indexes reaching all-time highs, a rude reminder was a bit inevitable.

Secondly, mainstream observers highlight the Chinese margin crackdown as what lead to sell-offs on Friday. Surely, the bubble-like behaviors are visible in Chinese equities, which have skyrocketed in last seven weeks. The sensitive sentiment response itself is telling that quick money has bid up assets and the merits of price appreciation may lack further real economic substance:

“Beijing wants banks to lend more to smaller private firms that drive the bulk of growth, but bankers say they run a higher risk of default than state-owned giants, given endemic book-cooking.” (Reuters, April 17, 2015)

Surely, justifying elevated stock price levels (as well as ambitious outlooks) is not constrained only to China but applicable in developed markets. Thus, the interconnected sell-off last Friday is worth observing closely. A follow through to this sell-off may lay the ground for a much needed breather in the US, Eurozone, and Chinese equity markets. At least, we know there is unease and it is not isolated to a region. That’s the brief message from the action of one trading day.

The Art of Bracing

If hints are accumulating and if the bullish run is not in the early innings, then the buried volatility index is only gearing up. Timing a burst in volatility has been proven to be near “impossible,” and surely those that tried have been proven wrong. Yet, near-term historical analysis should not blur one's logical senses. Sentiment is bound to change faster than imagined typically, but the market hints will be the fortune teller rather than analysts and pundits of all kinds.

Amazingly, the Fed has a story to sell, albeit in a calming manner. The same applies for other central bankers. The QE has been one calming manner for financial markets but less so for real economies across various regions. At times the responses by public markets seems so irrational, and at times what’s irrational becomes the norm. Yet, with commodity cycle sluggish, growth dismal to anemic, and more capital than ideas something must correct—at least logically. Even if markets have welcomed risk-taking for a while, the choice of further risk taking is up to individual managers and participants. Thus, blaming the Fed for one's misguided risk-taking is an unpraiseworthy approach, especially with looming hints.


Article Quotes:

“So what would bring the bond bull market to an end? A tightening of Federal Reserve policy might not do it, not least because the gap between Treasury and German bond yields is already high. Any surge in Treasury yields would prompt buying by European investors. A return to healthy global growth might not do it either, because of the problem already referred to: a surge in bond yields might end up sabotaging such growth because debt levels are still so high. The trigger for a crash would thus need to be a rise in inflation on such a scale that central banks would be forced to act, regardless of the growth consequences. Some bears think that this will be a two-stage process in which deflation is so severe that the authorities will be forced to target inflation by opening both the fiscal and monetary taps.”(Economist, ‎April 16, 2015)


“In a speech on Thursday, Boston Fed President Eric Rosengren noted that the Federal Reserve's policy committee in March provided two conditions for raising short-term interest rates. First, the policy statement indicated that the Federal Open Market Committee needs to see further improvement in the labor market. Second, the Committee needs to be reasonably confident that inflation will move back to its 2 percent objective over the medium term. ‘At this time,’ said Rosengren, ‘I do not think that either condition has been met. Although there has been noticeable improvement in the labor market over the past few years, ‘since March the indicators have been a bit mixed. Furthermore, inflation remains stubbornly below our target of 2 percent.’ When the Fed publishes Committee members' forecasts, many observers focus on the interest rate projections. But Rosengren urged a focus on ‘the recent striking reduction in the longer-run estimates of the unemployment rate and the reduction in the level of the federal funds rate that FOMC participants expect to see in the longer run,’ as well.” (Federal Reserve Bank of Boston, April 16, 2015)


Key Levels: (Prices as of Close: April 17, 2015)

S&P 500 Index [2,081.18] – For the third time this year, prices failed to hold above 2100. This suggests a fading and pausing momentum during this multi-year run. Technical observers can identify two points if selling pressure materializes. First, the 2040 level in the near term, which is then secondly followed by 1980-2000. Buyers conviction tested in the days ahead.

Crude (Spot) [$55.74] – After making lows on March 18th, crude has made a sharp recovery rally. However, in the big scheme of things, the downside is in place as buyers and sellers wrestle between $45-55.

Gold [$1,204.35] – Revisits the $1,200 range again. It is questionable if the January highs of $1,295 are achievable in the month ahead. It is more or less stabilizing at this junction.

DXY – US Dollar Index [97.52] – After an explosive run in the past year or so, the momentum has stabilized for now. 94-98 is becoming familiar in recent trading ranges.

US 10 Year Treasury Yields [1.86%] – Once again the 2% range seems illusive. Further signs of declining yields lay ahead based on current momentum.



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