Note that previously, my financial forecasts were on the same page as my macroeconomic outlook (all the way at the bottom). I decided to separate them into their own post in case readers want to escape all the analysis and go straight to the point, what my opinions are on the markets.
Want to see how I got to these opinions? See my updated macro analysis here.
Equity (S&P 500 = Representative) & Commodities Markets:
–Market Situation (Near-term)–: In the short-term I am cautiously bearish. We have a clear and present danger with the Eurozone. Equity markets are paying more attention to developments over there. In my view, it is appropriate to pair back or hedge against risk until this is resolved. Keep an eye on the Spanish 10-Yr yield for clues on whether Eurozone sovereign debt woes are improving or deteriorating. A financial blowup in the region would result in negative consequences for investors and the global economy. Sentiment and confidence would be damaged and large selloffs in financial markets could likely set off negative feedback loops throughout the global economy.
If the Eurozone situation is resolved, there may a decent relief rally due to high bearishness already. If we do rally, we need to be aware of a possible head-&-shoulders pattern or double-top forming. I would be watching to see if the index could break through the resistance line created by the left shoulder. If it can’t, it would be a further signal to continue pairing or hedging risk. The neckline would become the line in the sand for the bulls, which may coincide with the bull market trendline in place since early 2009. If it does break through the left shoulder resistance to the upside, then a re-test of the bull market highs would be probable. If it breaks through the highs in a strong fashion, then we probably have another leg up in the bull market. Additional risk could be added to the portfolio, but I’d maintain a cautious stance and tight stops to defend against a bumpy medium-term. At the current time the market is trading in a neutral manner. Investors are pausing for a resolution in the Eurozone, while recently lackluster economic data have raised questions on the strength of the recovery.
–My Outlook–: Over the medium-term I have a more bearish outlook for equity markets and commodities. Near the beginning of the year, I forecasted that these markets would roll over at some point this year. I believe that we may be in the topping process. It is important to look at what the charts are telling us at this point. The S&P 500 will be testing its 200-day moving average in the near-term. It will be pivotal for the index to successfully retest this mark if the bull market is to continue. I’ll be keeping a close eye on all the main indices (Dow Jones Industrial Average, S&P500, and Nasdaq Composite) for similar tests. A failure to hold here would signal a medium to long-term change in trend. I’d keep an eye on whether the index could break back above the moving average or whether we eventually have bearish crosses of the 50 and 100 day moving average over the 200 day moving average lines.
China will be an increasing headwind in the upcoming quarters affecting not only equities, but commodities as well. I’ll be focused on how this theme progresses. Looking at how Emerging Market indices in general have seriously lagged the US portrays tougher times ahead for those economies. Aren’t we depending on these countries to lead us in the global recovery? Doctor copper nor the 10-yr treasury yield have been sending positive signals either. Job related indices have show remarkable weakness in the past week, which signals a tepid job market in the months ahead. Furthermore, there’s a large sense of complacency among investors as far as the VIX is concerned, having cracked the 20 pt barrier only a few days ago, despite a dismal macroeconomic backdrop. These signs are cause for concern in my view.
If Ben decides to initiate QE3, it would significantly cloud the equity outlook given that there would be an external force attempting to influence asset values. Obviously one would think to buy on the increasing possibility if Ben showed less reticence towards the idea. What he decides to do may be of upmost importance to the equity outlook so I’ll be keeping my eyes and ears open for any sign that he is considering another round of monetary easing. An agreement to institute another round may result in yet another risk related rally and a lower dollar, similar to the events that transpired in the tail-end of 2010.
In the end however, I don’t feel like we’ve experienced a market low that would be characterized by a sense of indifference and hopelessness towards US equities. That would be a secular market low. With the large imbalances that exist in the US and global economies I believe we will see one in the years ahead.
Treasury Market/Interest Rates:
—My Outlook—: In the short-term, I’m cautiously bullish on the 10-yr Treasury. I would lock in some of the gains resulting from my call to purchase the asset in February. I would also be paring back due to the upcoming debt-ceiling vote just to be on the safe side. One can never overestimate the common sense of politicians. Note that I would reduce my position by approximately 20-40%. Treasuries have a potentially large tailwind at their back if the Eurozone issues aren’t resolved in an orderly fashion. The US Dollar would likely benefit as well, which is why I remain bullish on the currency.
Over the medium term, I am still bullish on US Treasuries. Fears of higher inflation leading to hyperinflation are overblown in my view. The wall of worry remains high for this asset class. From my point of view, the US consumer is tapped out because of too much debt. As long as you have that factor and a tepid recovery in the job market, companies won’t have the necessary pricing power to create an inflationary spiral. Emerging markets are actively suppressing economic growth for fear of inflation eroding rural savings (think Egypt and Middle East riots). The risks facing investors are daunting and I don’t believe that they are accounted for in current US equity prices. It seems that Mr. Bond Market is figuring it out as we have seen a clear divergence between 10-yr yields and equity prices in recent months (see chart below). Sources of demand for Treasuries will continue to come from retirees, banks, and pension-funds. While we may see the pricing in of a credit quality premium (US = AAA?), it should be offset by an overall deflationary outcome for a time.
Regarding the longer-term, something very worrying occurred when the markets rose in the second half of 2010. Quantitative easing did NOT achieve the goals Bernanke said the policy would achieve. Rates did NOT go down. They’ve moved higher in the months after. In the years ahead, I’m beginning to see a situation where we may see a sustainable recovery in China producing some very unexpected consequences in the US. Continued QE may be laying the groundwork for a period of significant increases in commodity prices, which would bring about the downside from the Treasury market top.
—Keeping An Eye Out—: China China China. Once China embarks on a sustainable recovery driven by consumption, the secular bull in Treasuries will be done in my view. On a more granular level, I’ll be looking at consumer inflation expectations as well as the job market and consumption.
This completes my financial markets forecast. My next update will occur around mid-December/early-January.