Market Outlook | March 9, 2015

“The art of simplicity is a puzzle of complexity.” Doug Horton (1891-1968)

Summary

The long celebrated bull market remains intact, but questions are being asked. Pressure is building for US stocks for two primary reasons: 1) The reported government data continues to suggest improving economy (i.e labor conditions), which triggers possibilities of interest rate hikes. When investors look two steps ahead they quickly interpret the perception of rate hikes as negative for stocks. 2) QE has been magical in the lift-off of asset prices. With the stimulus efforts winding down and current valuations not so cheap, justifying another powerful upside move with no major breather seems less pragmatic for average investors.

Stock Volatility: Part laughable & mostly unfathomable

Low volatility in stocks has been the norm for a long while. Mild spikes of turbulence have been mostly short lived. Occasionally, day to day traders may be obsessive about the mild swings, but there has yet to be anything meaningful. Meanwhile, long-term fund managers have not feared volatility as serious threat. It begs the question, why is stock volatility so low? Is the ebb and flow of this market credible?

Just like European bond yields (with few exceptions) continue to go lower, the decline in volatility echoes the same ol' signal of an audience that's “not worried.” Has volatility been numbed by QE or predicted by the Fed? Perhaps. A mystery for now, but when low rates (rate cuts) become the fashionable and over-arching theme from Asia to central Europe to Latin America, then it is safe to say that markets seem more "predictable" than usual. Over 19 central banks have cut rates this year including Oman, Turkey, Poland and Indonesia. Of course, the perception of “predictable” is here on a relative basis. At the end of the day, nothing is actual predictable despite all the noise from pundits, analysts, and government officials.

Amazingly, QE is the driver of higher stocks and lower volatility and is the same factor that’s producing scramble for higher yielding assets. Basically, QE, the "simple" tool of lowering interest rates, is the same tool that ignores the complex and uneasy climate for business operators.

Mild Awakening

Last year's turbulence in currencies and commodities served as a reminder of the slow environment global cycle. Danger has been reflected from Russia to Brazil and from commodity sensitive currencies. It comes as more like a gut check regarding the fragile conditions of Emerging Markets and the slowing growth rate that is driving lower commodity supply. It is no secret that Euro Zone and Emerging Markets are not robust in their economic growth.

1) Outflow of stocks—more outspoken bearish sentiment and mild sell-offs after a range bound action.

2) Relentless Nasdaq momentum has triggered questions regarding a potential 'tech bubble,' given the high valuations. Are the bubble-like traits serious?

3) US Dollar along with US assets are heavily sought after as we learned last year, but there are not enough bargains to attract newer capital. The 'safe haven' rotation is not in early innings. In fact, the more EM currencies collapse the more the dollar benefits. The world's misery is the US dollar's benefit. A strange, but vital, reality.

It is only a matter of time before a referendum on Fed policies is looming, at least in US. Sure, ECB is yapping about the glorified QE in a time where US markets are getting tired (or numb) of the tricky stimulus efforts of low rates. What if suppressed volatility is a myth or an illusion? The celebrated six-year bull market has been challenged by bears before and triumphed with vigor. Yet, the triumph is not substantive if wage growth, middle class jobs, and corporate health fail to share alongside this asset appreciation celebration.

Puzzling, But Practical Questions:

• S&P 500 and other broad stock indexes are near all-time highs. Therefore, what if job data continues to improve? How much upside is left in stock prices?
• If the Economic conditions are improving, as data suggests, then rates would have to rise? Rising rates are interpreted as bad news for stocks.
• In post QE world, who knows how valuations will play out in the US?

The current market pricing for equities is hard to defend for quarters and years ahead. QE is not a long-term solution, either. And volatility index appears disconnected from reality. Not an attractive set up for pragmatic observers even with the glossy "all-time highs" environment.

Article Quotes:

"In the United States, years of Federal Reserve stimulus aimed at reviving the real economy led to the wave of share buybacks while firms neglected capital expenditure (capex). Few people expect European firms to match the staggering sums in the United States, where over $2 trillion of stock was bought back between 2009 and 2014, according to Reuters data. Nevertheless, about $8 billion worth of buybacks have already been announced by a dozen European companies this year, including ABInbev (ABI.BR) and ASML (ASML.AS). That appetite is likely to keep growing: European firms have over $1.5 trillion in cash on their balance sheets and few obvious places to reinvest it to earn a return. Borrowing costs are already at record lows relative to their earnings power, and with the ECB set to depress rates further with its quantitative easing (QE) program, buybacks are an easy answer. If the United States is any guide, big buybacks will attract criticism. A report by Barclays from September found that, even though capex remained the top form of U.S. cash-flow spending, the rate of growth of buybacks had far outstripped capex and this meant less cash was being reinvested for growth." (Reuters, March 5, 2015)

"If monetary policy is too aggressive and expectations of inflation start to rise, so too will interest rates. Like the golfer back on grass, the central bank can then use normal interest-rate policy to rein things in. The main problem with QE recently is precisely that central banks have been reluctant to take a full swing, to do “whatever it takes” to restore inflation expectations. The problem is more acute in Japan and Europe than in the United States, though it has been a problem here, too. So far, all the new money hasn’t created inflation — but it would if banks started unloading the massive holdings of reserves they received from the Fed. As long as those holdings remain bottled up in the banking system, there is no direct effect. Central banks assure us not to worry because if things ever do heat up, they have more than adequate tools to deal with the problem before inflation spikes.

The central banks are almost certainly right in theory, though one can imagine practical circumstances where exiting from QE could get tricky. Obviously, central banks can simply reverse the process as the global economy strengthens, selling off long-term bonds to soak up reserves. Then that money doesn’t get into the economy to cause inflation. And if all else fails, the central bank does have other tricks up its sleeve. For example, the Fed might be able to invoke financial stability concerns to force banks to temporarily hold much higher reserves. Such a move would be hugely controversial, but in emergency situations, central banks are used to that." (Boston Globe, March 1, 2015)

Levels: (Prices as of Close: March 6, 2015)

S&P 500 Index [2071.26] – Signs of selling pressure appear at 2100. Overall, the bullish trend is intact; however, buyers are losing vigor in the near-term. Interestingly, in December visible signs of buyers started to stall at 2080. Again, that will be tested in the near-term, despite the cheery all-time highs achieved on February 25th.

Crude (Spot) [$49.10] – A multi-week bottoming process appeared around $50. Further upside momentum isn't quite visible. Interestingly, the 50-day moving average now stands at $49.82, which is in-line with current prices.

Gold [$1,202.00] – The January run from $1,180 to $1,280 seems very short-lived and lacked follow-through. Signs of stabilization seem to be around $1,200 for now.

DXY – US Dollar Index [97.66] – The dollar strength continues to re-accelerate. Despite the multi-week pause, the demand for the US dollar remains intact, even given the turbulent global climate.

US 10 Year Treasury Yields [2.24%] – Interestingly, the 10-year yield is back at familiar levels from few months ago. The 200-day moving average stands at 2.30%. Perhaps, the January 2015 lows of 1.63% established lows in the near-term.


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