Monday, August 27, 2012

A healthy correction?

Last Monday, I wrote that I was getting bullish but equities looked a tad overbought and I was waiting for a corrective pullback (see Getting bullish, but wait for the pullback). As the markets appear to have begun to pull back last week, my intermediate term view remains bullish as signs of a global cyclical turnaround are everywhere.

Risk appetite is rising
Consider, for example, the chart below of the relative performance of the Morgan Stanley Cyclical Index against the market (in black) and the relative performance of the defensively oriented Utilities sector (in purple). Note how cyclical stocks have been turned up in early August and they broke out of a relative downtrend that stretches back to February. By contrast, the defensively oriented Utilities sector has rolled over significantly in the last few weeks.

Besides the Cyclical vs. Utilities turnaround, I see other signs of an upturn in risk appetite. The silver/gold ratio has started to turn up. Silver is often considered to be the poor man's gold and has tended to be more volatile and has acted as a good indicator of risk appetite.

The chart below shows the silver/gold ratio in the top panel and the gold price in the bottom panel. The silver-gold broke out of a downtrend that stretches back over a year. The bottom panel shows that the last time this breakout happened, which was in September 2011, gold rallied from roughly the 1280 level and ultimately topped out at over 1800, though the silver-gold ratio flashed a sell signal at about 1570.

I attribute these turnarounds in risk appetite and the cyclical outlook to stabilization in Europe. Draghi's comments appears to have taken the risk of a Lehman-style meltdown off the table (yet once more) and European equities are turning up as a result. The FTSE 100 recently experienced a golden cross, indicating an uptrend has begun.

Across the English Channel, the Euro STOXX 50 looks like it is about to see a golden cross soon, which is another sign of recovery.

Is the glass half-full or half-empty?
To be sure, there are risks that the current pullback could be something more serious than just a correction and develop into a serious pullback. In the short-term, I am watching closely how the market reacts to news for signs of how investor psychology is shifting (or not shifting).

Consider, for example, the market reaction to the FOMC minutes last week. Here is the key quote [emphasis added]:
A number of them indicated that additional accommodation could help foster a more rapid improvement in labor market conditions in an environment in which price pressures were likely to be subdued. Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.
The initial market reaction was the QE3 is imminent and stock prices went on a tear. Within a day, market participants started to ponder to meaning of the phrase "unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery". St. Louis Fed President James Bullard (non-voter) said that the minutes were "stale", largely because high frequency economic releases were relatively weak going into the FOMC meeting, but have turned up since. Fed watch Tim Duy also said the same thing:
Recall that as we headed into this meeting, the data had turned particularly weak. The pace of job growth had fallen dramatically from the start of the year, retail sales were flattening out, and GDP growth had slowed to 1.5%. This data combined with the downside risks from Europe raised genuine concerns that more easing was necessary. But they held back, instead waiting to see how the data evolved.

Since then, the data have turned upward, much more consistent with the Fed's medium-term forecast. The July employment report was stronger, retail sales picked up, and overall growth is looking stronger, with Goldman Sachs' GDP tracking estimate rising to 2.3% for the third quarter. In addition, equity markets are on firmer ground as the crisis in Europe has at least temporarily receded. While certainly not exciting, the better tone of the data is palpable. I think the better data influenced Atlanta Federal Reserve President Dennis Lockhart to shift his language away from his dovish July comments. In short, I would argue that the data since the last FOMC meeting has in fact pointed toward an improvement in the pace of the recovery, which I think will pull the middle ground back from the brink of additional asset purchases.
In a separate post about disagreements at the Fed, Duy concluded:
I tend to think that the middle ground will be pulled by recent data in the direction of Bullard, which is why I see QE3 as less of a slam-dunk than the minutes seemed to imply. Evans pushed his usual agenda; I would expect nothing less from him. He wanted more action before this summer's signs of slowing. No reason to expect the most recent data would change his view.
Supposing that Bernanke is silent on QE at his Jackson Hole speech, or is relatively ambiguous (e.g. we have the tools and we stand prepared to act), how will the market react?

I also wrote that I was expecting a disappointing August NFP release on September 6, given the deterioration of conditions from the Gallup survey. Should they come in at below expectations, will the market see it negatively, as a sign that the economy is weakening, or positively, as further impetus for the Fed to engage in QE3?

The realities of Draghi's "whatever is takes"
Across the Atlantic, Mario Draghi's statements about doing "whatever it takes" to hold the eurozone together has certainly gotten the market excited. On the other hand, it is highly unlikely that the ECB would announce any new programs at its meeting on September 6 ahead of the German Constitutional Court ESM decision on September 12. Bloomberg reports:
With the court set to rule on Sept. 12, investors looking for Draghi to announce a definitive purchase program at his Sept. 6 press conference might be disappointed, according to the officials, who spoke on condition of anonymity because the deliberations are not public. The program is still being worked on and staff may not be able to finalize it by then, said the officials, who are familiar with thinking on the ECB Governing Council. An ECB spokesman in Frankfurt declined to comment.
Draghi might hint at the nature of any programs that could be enacted, but I doubt if we would get much in the way of details or "modalities".
While Draghi is likely to give a progress report on the bond plan after the Sept. 6 rate decision, the ultimate design of the ECB’s program may depend on the uncertainty over the permanent bailout fund being resolved, so the officials said it makes sense to wait for the German ESM court ruling.
Full details of the ECB’s plan could be a month away, they said. While the Bundesbank opposes ECB bond purchases, it expects to be outvoted, one of the officials said.
How would the market react then?

Supposing that soon after a market friendly German Constitutional Court decision, the ECB announced a program that gave the market everything it wanted - the unlimited purchase of Italian and Spanish debt in a given maturity range. How will the market react? Will market participants view this as a sign that risk premiums are destined to come down, which would be bullish, or will they see this as an opportunity to put all their Spanish and Italian paper to the ECB, which would be bearish?

Will the market think the glass half-full or half-empty? Watch the market reaction to events. For now, my base case scenario is that we are experiencing a healthy correction in the context of an intermediate term uptrend.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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