Market Outlook | February 13, 2017

“Never become so much of an expert that you stop gaining expertise. View life as a continuous learning experience.” (Denis Waitley)

To grasp the current debate between bulls and bears, it helps to understand the mindset of investors and the power of perception. With the expanding list of unknowns regarding macro events, it's amazing to see that angst is mostly suppressed and anxiety is barely visible despite the murmurs of “bubble-like” traits within the financial service industry. The dominance of the status-quo is remarkable, and speculating the catalyst of a pending correction is suspenseful.

The Bulls Mindset

With stock markets roaring to all-time highs, the confidence of Bulls is hardly shaken given the ongoing resilience witnessed from past worries. Volatility indicators have been knocked down, which only signals that turbulence is not feared by most. Amazingly, VIX (Volatility index) being closer to 10 and near 10-year lows only feels like an exclamation point for those who've ridden the pre- and post-Trump stock rally. Political rifts and Federal Government posturing aside, there is a clear-cut agreement of a bull market. Even the Dow 20,000 mark was not needed to re-confirm the known bullish run, despite mixed real economy data that have puzzled experts and casual observers. 

Hubris or not, the status-quo of ultra-low interest rates ends up boosting the prices of stock and real estate prices. Plus, high-profile money managers have been skeptical for 2-3 years, and that public skepticism did not derail US stocks, either. That said, some participants may be asking: Why listen to "experts"? Not to mention, Hedge Funds, on average, have not thrilled investors and even endowments have struggled to outperform in this bullish environment. Anti-establishment Trump is wrestling with re-writing and redefining the well-established market narrative. Thus, the simplicity of this ongoing stock market run is centered on “stick with what's working” especially when fixed income, commodities or non-US investments have had their own shares of turbulence recently. The perception of risk is muted and the urgency of "not missing out" in the current rally plays into investor behavior and decisions. Also, passive investors who bought a basket of US stocks are quite pleased and even encouraging those who sat out to join the rally. This is how momentum is built and extended.

The Trump-Yellen relationship is in early stages, but participants are not completely convinced that rates will go much higher and the Dollar will get stronger. On both points, there is a lot to be seen from weak dollar policy to the Fed's search for a justifiable rate-hike. Even mysterious elements end up leading folks to choose US stocks as the best relative option. At the end of the day, Trump and Yellen may not mind higher stocks, which serves as a tool to boost both their egos, despite their fundamental policy and political differences. Even the Trump-Yellen politically charged disagreements have remained tamer than anticipated. Perhaps, the power of the bullish run feeds into old habits that are hard to change, and why change them? The burden of proof of a pending shift in sentiment is on the bearish crowd, at least, that’s the message from the markets. This week, Yellen will address and rate hike implications, and, surely, it will be digested and dissected carefully by pundits and investors.

The Bearish Perspective

To start, the bearish argument is made by some pointing to the stretch valuations or the natural need for a breather in share prices. Others have been citing the Central Bank induced low rate environment that has fueled an appreciation in asset prices, leading to more risk-taking and reckless actions.  At the same time, the low rate environment has a mixed impact on the real economy and ultimately highlights the disconnect between financial markets and small businesses.

Equally, there are questions of eroding fundamentals as highlighted in the retail sector and other areas feeling the effects of technology. NASDAQ high flyers such as Google, Facebook and Amazon have greatly benefited in the new economy, but other companies and business models have been tested or left behind. NASDAQ is flirting with all-time highs, but public and prove entities don't share the same joy.  There are questions about collective job and wealth creation:

“Some indicators of labor-market slack also increased, which should push away inflation concerns. The underemployment rate, which includes people stuck in part-time work who want a full-time job, rose to a three-month high of 9.4 percent.” (Bloomberg[BD1] , February 3, 2016 )

Simply, the Sanders and Trump rise reflected some of the struggles in the real economy for a much broader US population. Yet, the political banter and chatter for the greater need of policy driven stimulus is being received with concerns. There are real issues that are worrisome in current economic models, where the mismatch between skills and demand has left a challenging labor market.

The bearish view has been proven dead wrong at various junctions in recent years, as the multi-year price appreciation continues. Perhaps, investors are numb from hearing about too many warnings too often. Plus, the distant memories of 2000, 2008 and 2011 fail to spark a nervous breakdown. In other words, the known concerns aren’t going to sucker punch investors. More or less, it’s been backed in.  Lack of major defaults and crash-like events have been absent to alter the bullish narrative, but merely “we’re due” is what keeps the pessimists less active. Yet, the strange part of this muted turbulence is the Brexit and Trump results. Both historic outcomes have obviously reawakened concerns of globalization via the referendum on the political status-quo. Brexit and Trump results naturally suggest an outright demand for nationalism at all cost.  In a quick gut-check, the majority would say, Nationalism would inversely impact this market that’s been shaped by globalization in recent decades. However, the market isn't digesting these events and quantifying Brexit/Trump is not quite easy, thus worries are deferred for now. 

However, Greek bonds are rising again, the Eurozone crisis is being slowly revisited and prior concerns, such as status of Italian banks, cannot go away. In other words, the many unsolved issues from before leads the bears to worry. In fact, financial times put it best:

“Failure to tell truth to power lies beneath much of what is going wrong in Europe right now. It may not be the principal cause of the Greek debt crisis, which is now on its umpteenth iteration. But it is more than a mere contributing factor…. Europeans are not used to such bluntness. The Germans protested. The European Commission protested. So did the Greeks. They all want to keep up the fairy tale of Greek debt sustainability for a little while longer.” (Financial Times, February 12, 2017)

Reconciliation

The bull-bear debate has been one-sided for too long. Yes, the markets are typically biased on the bullish side, so some of this complacency is less surprising. The truth is not clear and bound to have a paradox. Yes, anxiety seems tame for now. One thing is clear, the catalyst of an all-0ut panic is difficult to calculate since the list of worries has mounted.

For now based on macro indicators, investors are very comfortable with the prevailing status-quo of low rates, contained inflation, and ongoing investor search for yield. Maybe there is a bigger message, regardless of Trump and Brexit, interest rate polices are what captures the financial markets. More and more, US stocks aren’t caught up in foreign policies or political clashes, but sensitivity to rates remains a critical reality.  As long as US 10 year yields fail to surpass 3%, inflation fears seem muted. Volatility spikes do not seem visible from the sharp uptick in rates. The last major spike in volatility was on August 28, 2015 when the VIX (Volatility index) reached 53.29 after bottoming at 10.88 on August 7, 2015.  (Worth noting: VIX today is around 10.85).  A three week stock market sell-off period in August 2015 was the last time that the markets truly panicked and rattled the bulls.  Perhaps, lower yields and failure of central banks to stimulate the real economy is what will give more legitimacy for the bearish argument.  In an amazing way, the fewer signs of economy revival, the friendlier environment for stocks.

Article Quotes

Hedge Fund Performance:

“Professional investors are more informed, more highly educated and more competitive than ever before. Yet they are all competing for a shrinking slice of the alpha pie. This is what author Michael Mauboussin calls the paradox of skill. Mauboussin says, ‘It's not that managers have gotten dumber. It's precisely the opposite. The average manager is more skillful than in past years. The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results.’How many institutional investors bother to ask themselves if the investment managers they are investing with are lucky or truly exhibit skill?... The increased competition and larger capital base made it nearly impossible for these funds to keep up their outperformance.” (CNBC, February 7, 2017)

Ongoing Doubts:

“Inflation expectations, which surged immediately following the presidential election, have stalled in recent weeks. That suggests investors are questioning the economic growth the new administration hopes to deliver. The strong dollar has also prompted import prices to cool. And investors have recently dialed back expectations that the Federal Reserve will raise interest rates at least three times this year. A slew of economic data this week as well as Fed Chairwoman Janet Yellen’s semiannual testimony before Congress will likely reinforce these modest expectations The so-called Humphrey-Hawkins hearings, beginning Tuesday, will mark Ms. Yellen’s first appearance before lawmakers since Donald Trump was sworn in as president. Mr. Trump criticized her sharply during his campaign and GOP lawmakers have considered taking steps to subject the Fed to greater congressional scrutiny, topics which Ms. Yellen will undoubtedly face.” (The Wall Street Journal, February 12, 2017)

Key Levels: (Prices as of Close: February 10, 2017)

S&P 500 Index [2,316.10] – Record highs again. Since November 4, the index has rallied over 11%. Since breaking above 2,100, the index solidified an explosive bullish run.

Crude (Spot) [$53.86] – Trading between $50-54 in the past 2+ months. This is due to a combination of near-term stability and lack of catalysts at the current junction. The supply-demand dynamics that kept Crude below $50 are changing via OPEC agreement, but soft demand is still mysterious.

Gold [$1,228.30] – Strong case to be made that Gold has bottomed out around $1, 150.00. That said, visualizing a meaningful move requires optimism given the 4 year sideways pattern.

DXY – US Dollar Index [100.80] – Back to the common and familiar 100 range.  After peaking on January 3, 2017 at 103.82, the strong dollar trend has taken a breather. Since mid-2016, the dollar acceleration has been a major theme.

US 10 Year Treasury Yields [2.40%] – Confronting critical level. Interestingly in June 2015, Yields peaked at 2.49% and declined. Now, Yields are approaching similar levels. If the status-quo remains with rate-hike policies, surpassing beyond 2.50% seems challenging. A suspenseful period awaits for those seeking notable directional moves.

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