Market Outlook | February 22, 2016

“The bargain that yields mutual satisfaction is the only one that is apt to be repeated.” (B. C. Forbes 1880-1954)

Inter-Connected Struggle

Since peaking in November 2015, the broad US stock market indexes are reminding investors that concerns are looming. In August and in early 2016, the selling pressure for US stocks picked-up and reality check began sinking in. The much discussed correlation between Crude oil and stock market is defying old sayings and slogans. In fact, Crude and US stocks are in desperate need for collective revival, as strange as it may seem. The common thought that lower oil prices lead to victorious results for consumers (or broader economy) is proving to be not that simple. Decline in Oil prices impacts bank loans, energy producers, and local economies as well as US producers. Surely, it impacts indexes such as the S&P 500 to Dow Jones, which are feeling the drag in 2016 down 6.2% and 5.9%, respectively.  Of course, global growth itself is murky, adding further negative pressure.

OPEC nations are feeling the pressure to stabilize the price of Crude. The balancing act between oversupply and production cut is a dramatic twist that’s playing out. Russia and Saudi Arabia are feeling the pain from the demise of Oil prices. Thus, both nations are incentivized to lessen the blow by tinkering with supply. Odd alliances between nations are created for the sake of digging out of economic desperation.  However, with supply glut already a major issue, along with Iran entering the world market, justifying higher oil prices seems like a daunting task with Crude dancing below $30 per barrel.

Anemic Inflation = Weak Growth

Way back, when QE came into the mainstream discussion, the idea was to increase "inflation expectations.” Amazingly, the quest to increase inflation ended up failing the same way economic revival has not produced a meaningful result. This is a reflection of the slow global environment from the US to the Eurozone.  Simply, it is worth noting the complete failure of QE and central bank stimulus efforts.

For those that still believe in the Fed, the warning signs are all clear, and January 2016 showcased investors' early distrust of the monetary policy. Outrage is forming, but to be fair, the Fed has limited powers and that's been clear since early-on. Like all government institutions, the Fed is forced to defend their plan and to continue to make an appealing case for their bullish outlook.  Interestingly, in the last three months, believers of the Fed’s plan are shrinking based on sharp sell-offs, rampant volatility, a spike in Gold prices, and lower treasury yields. As European Central Bank (ECB) contemplates more easing, maybe one should pay attention to the disconnect it has created. Rising stock prices are not to be confused with robust real economy, as has been stated many times. By now, US investors are fully realizing that ol’ trick, which lacks substance and is filled with “academic” hype.

Perhaps, the political climate showcases the disconnect between financial theory and ground level sentiment. The non-establishment candidates in recent US elections are representing the voices of angry voters. The real economy has been bleeding for a while and, surely, the unemployment data does not tell the full story. The Fed’s rate hike last year was hardly justifiable, and, now, the scramble continues. Beyond the conflicting data and the unconvincing message by the Federal Reserve, investors are confused— which is raising volatility.

Bargain Hunting

Now, the contrarian or forward-looking perspective suggests a revival in inflation and commodities.  Perhaps, the Dollar is overcrowded a bit and the US relative edge will continue to play out. ‎As sentiment became too negative last week, some buyers stepped in seeking early bargains. 

As Tech and Biotech appear over-valued by some measures, investors are seeking "cheap" ideas and entry points. What exactly is “Cheap”? Areas that have been battered in the last five years, which is mainly related to emerging markets and commodities. Thus, the risk-reward seems appealing for some energy areas, but there is danger looming. The energy demise impacting bank loans has yet to play out. Distress buyers flocking to the energy space may not get the timing right, but are highly motivated by bargains.  The temptation for bargains will remain, but flushing out all the negative cycle related issues takes time. Thus, the risk-takers await a suspenseful period with more than the usual volatility persisting on daily basis.

Article Quotes

“The nation's biggest banks may be in good shape even if beleaguered oil producers start defaulting on their loans, but smaller regional lenders have a lot more to lose. Loans to energy companies by the five megabanks from Citigroup (C) to JPMorgan Chase (JPM)  account for no more than 40% of common equity capital, a measure used by regulators to assess a finance company's strength, ratings firm Moody's has said. At nine regional banks, however, such loans never account for less than 40% of capital, and at some, they represent 110% of it, the New York firm said in a report this week. That compares with a median ratio of 10% to 15% at the roughly 60 regional banks that Moody's evaluates, prompting it to warn that credit scores at six of the lenders are in jeopardy…. The size of the regional banks' energy loans -- pushed higher because many have significant operations in the most oil-dependent states --Texas, Oklahoma and Louisiana -- significantly increases their risk, Moody's said in the report. ‘The credit quality of even the most conservatively underwritten energy loans could deteriorate in the current environment,’ the firm said.” (The Street, February 19, 2016)

“Foreign observers who are interested in China’s development should pay more attention to the development of China’s private sector. Its growth may have more long-term benefits for the Chinese people than the political process of democratization. After all, the private sector has assimilated the majority of China’s labor force, and its fate directly impacts the happiness and financial security of hundreds of millions of families. Each choice these private enterprises make matters to China’s economic growth and its political progress. The global expansion of these companies also has an impact on the world economy, including the United States and Europe. These economic changes might also bring new dynamics to international politics. Among China’s private enterprises one has to mention Alibaba, the Chinese e-commerce giant headed by Jack Ma and counting net assets of 255 billion renminbi ($39 billion). Though a private company, Alibaba receives generous support from the Chinese government. The World Internet Conference, for instance, has been based in Zhejiang Province since its start in 2014. Zhejiang Province also happens to be where Alibaba is headquartered; on China’s internet, the province is often referred to as Alibaba’s home base. Two months ago, when Xi attended the second World Internet Conference, Alibaba was the first company he visited. The G20 Summit in 2016 will also be held in Zhejiang. The summit will include top-level meetings between key business and industrial figures, something advantageous for Alibaba as well.” (The Diplomat, February 18, 2016)

Key Levels: (Prices as of Close: February 19, 2016)

S&P 500 Index [1,917.78] – The battle unfolds between buyers and sellers between 1,850-1,950.  However, as last year proved, buyers continue to lose steam at 2,100.

Crude (Spot) [$29.44] – As a reminder, December 2008 lows of $20 proved to be a bottom then. Now, a potential bottom is forming a little below $30. Several catalysts are needed as supply glut remains a dominate factor for prices.

Gold [$1,231.15] – Staying above $1,200 can stir further confidence for gold bugs. Some price stabilization appears to take hold. Gold is up 17% since the December 17, 2015 lows.

DXY – US Dollar Index [96.60] – Interestingly, last March and April the DXY failed to hold around 100, which seemed like a major hurdle. Dollar strength remains intact, but has stalled for several weeks.

US 10 Year Treasury Yields [1.74%] – An emphatic decline in yields in 2016 sends a strong message about risk-aversion. A rush to safety and unconvincing growth numbers are reflected in lower yields.

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