Price Source: Bloomberg

Although we have not quite finished the first quarter, it is obvious that the broad market is off to a fast start this year. A great deal of that performance was attributable to the stellar rise of Apple shares but there has also been a healthy serving of general improvement in the economic prospects both in the US and Globally.

The question one has to ask is: how much longer can the market run?

To answer that, one must consider what is driving the market. And, in general, the drivers are generally positive and sustainable. Of particular interest is the strength in Housing and Banking for which we can take XHB (chart) and IYF (chart) as proxies. If these two related sectors are showing signs of recovery, there is hope that the great American Consumption Machine can be cranked up to its former glory.

Looking at the S&P 500 earnings breakdown, the only “fly in the ointment” is the estimate that cashflow is due to drop (down 10.9%) even though earnings are still bounding forward (up 8.8%) in 2012. However, one should note that much of the discrepancy will be due to banks writing back unused loan loss reserves (a plus for earnings but a non cash item) and increased dividend payouts (negative for cash flow but a good thing for shareholders). These are to be expected and even welcomed as the recovery slowly gathers some momentum.

Click table to see full sized

The forecasts for 2013 and 2014 are probably too “straight-lined” to take seriously at this point. Around half the earnings on the S&P 500 are derived outside the US so they are still susceptible to troubles in Europe or China. However, it is fair to say that most of the potential bad news appears to be in the market. It will take a serious shock event (Iran, perhaps?) to knock the markets at this point.

So, for the next few weeks, there is little reason to be concerned that the main indices have burst out of the gates a bit faster than in the past few years. The Fund King System numbers are running in the teens for most risk assets with some sub sectors reaching into the 20’s and 30’s.

The actual number will probably come in at least 1% over or under the official 7.5% target. But all of China’s provinces and Special Municipalities are now on notice to make sure that the numbers they serve up to Beijing are in accordance with the new policy. Conspicuous bank lending to property developers is no longer in the cards.

Looking beyond China, how does this downgrade impact markets around the world? The immediate knee jerk reaction is negative but it will be interesting to see if investors can shift their mindset from the immediate aftershock of the Global Financial Crisis. In 2008/2009, demand from China, India and Brazil amongst other emerging markets was crucial to sustaining overall global demand. The largest non-financial companies in the US and Europe would have suffered much more severely without the boost of emerging markets demand. Additionally, China was a major purchaser of US Treasury bonds as China sought to recycle its massive trade surplus with the US. That position has now shifted to the Federal Reserve.

Now, however, a slowdown in Chinese demand may not prove as catastrophic as it would have three years ago.

In the US, there is both slack in the economy and signs that domestic demand is on the mend. Bank lending growth, which had been moribund despite heroic efforts from the Federal Reserve to pump high powered money into the financial system, is finally starting to show the early signs of a recovery. Housing prices at this point are a lagging indicator because there is so much built up inventory both on the market today and likely to come onto market at any sign of better activity. The real issue for the US economy is whether the nascent recovery will get strangled by higher commodity prices feeding into inflation. A China coming off the boil at this point could be just what the Bernanke FED needs to keep an accommodative monetary policy running into 2013 without kicking off double digit inflation.

In Europe, the European Central Bank (ECB) has decided to take a page from the Federal Reserve and double down on their Long Term Refinancing Operation (LTRO) which offers troubled European Banks three year money at 1%. Like QE1 & QE2 (Quantitative Easing) rounds in the US, European banks have done the sensible thing and turned the money around into ECB deposits or matching maturity sovereign debt in order to catch the fat spreads at the lowest risk possible. Europe is more exposed to Chinese demand for capital goods than the US but it is obvious that Europe is heading into recession regardless. In fact, it is Europe’s weakness that probably tipped the scales and forced the China to downgrade its GDP target. So, basically, China’s growth is not the most burning issue in Europe’s capitals these days. A more pressing question is whether the ECB is complicit in an effort to drive down the value of the Euro so that export dependent Italy, investment dependent Ireland and tourist dependent Portugal, Spain, Italy and Greece can regain a competitive advantage.

So, interestingly, China doesn’t really matter quite as much as it has in the last three or four years as a global engine of demand. It will be interesting to see if the markets recognize the admittedly temporary change in circumstances.

The System numbers do not suggest a significant change in fortune…don’t let a 50 basis point cut in China’s GDP rate spook you unless you are overexposed to Shanghai luxury apartment units.

Are you holding out for the Ice Cream Sandwich version of the Android operating system? Does the acronym LTE excite you? Do you think that Microsoft might finally get things right with Windows 8 running on an ARM chip? Do you think Apple at $500 a share is merely a milestone? Will Amazon surprise us all with new and improved Kindle offerings?

Here are a few of the main companies in the tablet/smartphone wars and how they rate currently. It is interesting to note that while we have seen very impressive performance from Apple, they are not the only ones in the running.

Samsung Electronics (+27.92%, Company Info) The massive Korean conglomerate is both supplier and competitor to Apple and most of the key players in the IT/Cellphone/Consumer Electronics field.

Hon Hai Precision (+25.65%, Company Info) In the news recently for its Foxconn subsidiary, the main contract assembler Apple and most other name brand consumer electronic companies.

HP (+14.27%, Company Info) After some serious strategy wobbles, HP is promising to redouble its efforts.

Apple (+13.22%, Company Info) It’s the biggest stock in the S&P 500 and the excitement building around the iPad3 is driving component makers in Asia into frothy territory.

Microsoft (+11.77%, Company Info) Windows 8 in two flavors and compatibility with ARM chips. Could 8 be the lucky number for a company that has struggled with mobile versions of its main operating system over the years?

Google (+10.98%, Company Info) In addition to the Android platform, the company is trying to acquire Motorola Mobility.

Dell (+9.63%, Company Info) Dell’s forays into tablets have not panned out so far.

nVidia (+2.8%, Company Info) Primarily a high end graphics chip designer, nVidia is taking its engineering expertise into the smartphone arena with “Tegra” chips that boast up to 5 “cores”.

Motorola Mobility (+1.93%, Company Info) The “pioneer” of the mobile phone is trying to make a comeback under the RAZR badge.

ARM (+0.46%, Company Info) ARM designs the RISC chips that sip power compared to mainstream CPUs from AMD and Intel, a critical factor for battery powered devices.

Asustek (-0.27%, Company Info) is a threat on both the ultrathin laptops and tablet space.

Sony (-7.17%, Company Info) The company has made a concerted effort to produce a competitive tablet. Can they still bring out the old Sony magic?

Amazon (-18.13%, Company Info) Although the Kindle Reader in all its forms is a tiny, loss-making part of the Amazon retailing empire, the Readers are cheap and popular.

HTC (-28.08%, Company Info) Despite its success with Android based handsets, it has weathered a fair bit of legal strife, primarily from Apple.

What should you conclude?

As we climb the “Wall of Worry”, there are other trends which are not dependent on Central Bankers and European Politicians.

With Greek mobs burning buildings to celebrate the deals being struck to tame the Greek Sovereign Crisis, one can sense that the market has fully discounted nearly every ugly outcome from this real life financial tragedy. A Eurozone recession, bank bailouts, austerity programs and at least one or two exits from the Euro are “baked in” to the market.

As a result, the most watched measurement of volatility, the VIX, is at a very subdued level.

Source: Bloomberg.com

So this week, we think it is worthwhile to look at the risks in the market to see what might drive the VIX to much higher levels.

The two big macro risks which spring immediately to mind are a military strike against Iranian nuclear facilities and an inflationary spike in the US.

Military Strike Against Iran

Even though the US and EU have been tightening the sanctions regime on Iran of late, the Islamic Republic appears to be forging ahead with its “peaceful” nuclear enrichment program. The leadership of Iran protests that nuclear weapons are not the goal while Israel is playing the “bad cop” to the Obama administration’s “good cop”. There are a few points (as highlighted in the Wall Street Journal) that make an Israeli airstrike in the coming months credible:

1. Syria, Iran’s ally and Israel’s neighbor, is embroiled in near civil war conditions,
2. the rest of the Arab world would not mind seeing Iran’s influence in the Middle East taken down a peg,
3. Israel does have the airforce and bunker busting ordinance to inflict serious damage on Iran’s nuclear enrichment facilities,
4. Israel has a track record of attacking nuclear facilities in Iraq and Syria when development seemed to threaten its existence.

The risk of a strike is low (Stratfor seems to think it very unlikely) but not low enough for investors to ignore. Iran’s most likely response will be to mine the Straits of Hormuz to choke off a significant amount of the world’s daily oil flow and a conventional ballistic missile strike on Israel. Although the US will certainly be informed of any strike, may be complicit in providing resources and is winding down the second of its two recent adventures in the region, Iran will not want to take on the US directly in its retaliation.

The market reaction? A short sharp price spike in Oil, Precious Metals and “safe” assets like US Treasuries is the most likely. Building a small exposure to these assets (particularly the first two) is a sensible precaution. If nothing happens, an economic recovery and the risk of US inflation would probably benefit energy and precious metal asset classes anyway.

Inflationary Spike in the US

The consensus for a long slow recover in the US is another “baked in” conclusion in the market. However, taking the recent past and projecting it in a straight line into the future is a risky bet. An inflationary spike (a temporary move to double digit inflation, for example) could arise if banks were to start lending out the high powered money created by the Federal Reserve in response to the Global Financial Crisis.

Could it happen? Already, we are seeing signs that the most bombed out property market, Las Vegas, is starting to see some clearance in January. Prices don’t have to move up for the banks to start to see the light at the end of the tunnel and restart their mortgage lending machines.

For an incumbent president running for reelection, a reigniting of “animal spirits” amongst loan officers at the banks is not a fire that the deflation-phobic Bernanke FED is going to rush to fight. With a commitment to keeping rates low through 2014, the FED can allow banks to rebuild their balance sheets while dominating the secondary market in Treasuries to keep interest rates on US debt low.
Whether the FED is able to stuff the inflation genie back into its bottle once released is another matter.

Traditionally, hard assets like commodities would be a desirable hedge against this type of inflation. However, with global demand likely to remain subdued in the short term (on the back of a European recession), hard assets in the US (like real estate), may be the better choice for the first move. If the inflation stokes demand that spills over into export orders for China, then industrial commodity plays would be an excellent way to catch the second wave.

“When the only tool you have is a hammer, every problem begins to resemble a nail.”
- Maslow’s Maxim

The market is gearing up for the announcement of another round of Quantitative Easing to be dubbed QE3, although one could argue that QE3 has already started with the opening of practically unlimited swap lines between the US and European Central Banks.

The signs that the Risk Markets need a kick to keep the party rolling are popping up around the globe:

US

GDP was a bit soggy in 4Q. There are plenty of reasons for disappointment:

1. a bit too much inventory build,
2. a worrying drop in the savings rate,
3. lower 4Q earnings surprises and growth than 3Q numbers, and
4. 1.5 – 2% GDP growth rate which means that US voters will go to the polls in November with around 8.5% unemployment.

To confirm the slow growth trend, the FED has made the unprecedented announcement that it will keep rates at current near-zero levels for the next three years. Team Obama may hope that the Republicans tear themselves apart in the primary season but that is no reason not to try a few more Keynesian and Monetarist kicks to the system to spruce up the economic backdrop for the autumn.

China/Asia

Asia typically greets the first day of trading after Chinese New Year with a rally, especially for a “Dragon Year”. However this year, only Taiwan managed to pull out a positive day on delayed reaction to strong Apple numbers. Hong Kong and Chinese investors parsed poor real estate sales results over the Chinese New Year Holiday and took the Hang Seng Index down towards the so recently breached 20k mark.

Europe

And not to be left out, Europe is preparing for another cycle of summits to solve the “Euro Crisis”.
Whatever solution bubbles up from the cauldron this time, it seems to be too late to save Greece from exiting the Eurozone. The real question now is whether the Eurozone can draw a line at Spain and Italy (Portugal appears to be the other acceptable casualty of the Euro Crisis). No matter what the politicians decide, recession (and worse) will haunt the Eurozone for most of 2012.

What is the System Saying?

The system can be described as somewhat lukewarm about risk assets with a definite preference for US listed equities. Top ratings for funds and ETFs are in the teens and for S&P 500, there are a few rating in the 30s and 40s. Given the extremely high likelihood of another round of government stimulus and Central Bank pump priming, one should wait for the next burst of bullish enthusiasm before taking profits.

What does this mean for riskier assets? A bullish forecast off the back of a January rally is a dangerous one. Right now, the positives and potential negatives suggest another volatile year.

Housing Stocks Come Back to Life

There is no doubt that the US is starting to rouse from the GFC imposed slumber. A Financial Crisis induced recession is harder to bounce back from than the more common inventory cycle recession. One consequence (amongst many) is that one traditional avenue of entrepreneurial capital (residential real estate) has not be readily available to finance new business start-ups because of falling housing prices and general bank reluctance to extend credit to the private sector. That deep freeze appears to be thawing a bit. The bellwethers of the US domestic housing market (ITB and XHB for ETFs, LOW, HD, PHM, and LEN for individual stocks) have turned up strongly. Will this be a “head fake” like the last time XHB surged from July 8th 2009 to April 23rd 2010 (+89%)? Perhaps, but with other positive “green shoots”, this surge (from October 4th 2011, +58%) may not reverse as dramatically as the last one. Given the sharp run-up and some good earnings reports, don’t be surprised if there is a correction in the coming weeks, though.

The housing sector bears watching. If entrepreneurs can unlock capital in residential housing, the Great American Job Creation Machine can crank back into gear (recent job report numbers are rounding errors compared to what they should be for a full blooded recovery).

Summer in Europe?

Unfortunately in our interconnected world, the troubles brewing in Europe still look likely to cause more heartburn in the next few months. There is little doubt that Europe has failed to sort out the sovereign debt crisis of its periphery to the satisfaction of financial markets. Credit agency downgrades only confirm what most market players have been saying for months…the sums do not add up. The next “final deal” will just be one of a series of “deals” that will see a series of painful writedowns for the banks. Bank Capital is being bolstered largely by clever accounting tricks these days. And with hedge funds buying up troubled sovereign debt and relatively cheap Credit Default Swaps, the prospect for an orderly “voluntary” haircut looks somewhat diminished. The rot is spreading from the periphery to the core and until the Germans are forced to make some hard political decisions, the rot will continue to spread inward.

So what is left for Europe? Very likely…devaluation.

In a rambling article for Bloomberg, two professors from MIT make the case that Italy is crucial to the Euro’s survival and that unlike most other European countries, Italy has a significant amount of trade outside the EU (55% of exports according to the authors). Given those two factors, a Euro trading at parity with the US dollar should help Northern Italian exporters boost exports enough to make a difference. And, since Italy boasts a massive and vulnerable bond market, any improvement should help to relieve pressure on the Euro’s long term survival as a common currency (ETF: FXE).

How will this play in the US and other emerging markets?

In the short term, it means that a summer holiday in Europe might be a great bargain. In the medium to longer term, a more competitive Europe could hamper any manufacturing renaissance in the US as a large swing in exchange rates allow German exporters to price more keenly than US Midwestern component makers (and makers of commercial aircraft). For China, the authorities in Beijing probably have enough fiscal and monetary firepower to overcome the negative effects of a Euro devaluation (the Eurozone is both a large customer and competitor of China).

One can only guess whether China will continue to diversify its foreign exchange holdings into Euros. Given the likelihood of a significantly lower exchange rate in the not too distant future, it would not be surprising to see the People’s Bank directing its traders towards other currencies for the time being. Given the massive size of the foreign exchange reserves and China’s desire to hold down domestic inflation, the US dollar is probably the only reasonable home for recycling the trade surplus (ETF: UUP).

Source: Bloomberg

However, investors should probably look elsewhere for comfort.

Although China’s multi-decade economic rise is beyond dispute, China’s GDP pronouncements are more about Beijing’s economic policy thinking than a hard accounting of the sum total of goods and services produced in the PRC over a particular quarter. In my association with the Chinese markets, they have been playing this game since at least 1992 when the B share markets opened to foreign investors in Shanghai and Shenzhen.

For the next few announcements, a number too close to 8% would be signal leadership concern for a stalling economy and that a massive state intervention (a credit loosening) is imminent. A number which leans closer to double digits would signal concerns of domestic economic overheating and would foreshadow a credit tightening cycle to tame inflationary pressures. The thresholds change slightly from year to year but the game does not. China is signalling a “wait and see” stance for the time being. For Chinese provinces and municipalities which rely heavily on a bubbly property market to keep their finances in order, that message is not the one they are waiting for. Domestic demand in China is still driven primarily by investment rather than private consumption. And especially since the Global Financial Crisis, much of that investment has been skewed towards the property sector.

In the meantime, one of the “canaries in the mine” has definitely slipped off its perch. The Baltic Dry Index has halved since mid-December. Despite the name, the BDI covers shipping routes across the globe and the primary cargoes are coal, iron ore and grain. The index is subject to impressive swings because the supply of ships is fairly inelastic while demand for cargo is highly elastic That said, a 50% drop attributed to weaker Chinese demand for iron ore shipments, is not something one should ignore.

Source: Bloomberg

Australia’s “Two Speed” Economy

If China is in fact cooling its demand for iron ore in response to a general domestic slowdown, one should look at the short side of the Australian ETF, EWA. The Australian market is heavily weighted towards resources and financials and any trouble with Australia’s largest export market should show up in the market soon.

Obviously the ponderous elephants today are the financial markets around the globe which have risen only after dramatic flourishes by the ringmasters (Central Bank worthies and European politicians). However, when these ringmasters let their arms down to prepare for the next flourish, the elephants have been dropping their trunks around the world. Without the ringmaster, market participants are not willing to step out of line and risk capital (note the repeated approaches to but few breaches of the 200 day moving average on the SPX). And this observation is not just a reminiscence of youth. Thanks to Bloomberg, it is not hard to plot the increasingly correlated nature of the main equity indices.

Data Source: Bloomberg

I constructed this chart by taking the weekly correlation measurements at monthly intervals. At the far left it measures the correlation for 12 months (Dec 15 2010 – Dec 15 2011). The next point is from Jan 15 2011 – Dec 15 2011 (11 months) and so on until the last data point on the right which measures just the past month. The function on Bloomberg is CORR for the Correlation Matrix.

What do I think this means?

Although this is a non-standard “study” of the market, I think it demonstrates pretty clearly how dramatically the nature of the markets have changed over the year. What surprised me the most was how much GLD’s relationship with the SPX has shifted (much to the chagrin of gold bugs with 2000 price targets). I also looked at TLT as a proxy for treasuries and its correlation moved from -0.79 to -0.87 through the same period. I suspect that the “dead hand” of policy risk (both political and monetary) has stamped down the risk appetite amongst investors for any significant investment time horizon.

I think there are two key take-aways from these “observations”.

First, we need to watch for opportunities to sell puts and calls when the VIX is high because there are not the usual amount of “asset allocation” opportunities to make money. With little divergence to play for and markets that appear range bound in the medium term, clipping options premiums may not be a bad way to pass the time.

Second, we need to watch for the divergence. Although I have not done an exhaustive study, it makes sense that market convergence and divergence would happen in waves. As we saw in the 2008/9 period, the high correlation into the meltdown was matched by a divergence once the markets started to rally off the bottom. If history is any guide, a shift towards more divergence should spell the end of the current slog. At that point, we should see winners and losers emerging and asset class breakouts (hopefully to the upside). It will be a concurrent indicator at best but with the current lack of confidence, that may be a useful confirmation of a change in trend.

S&P 500 in 2008

Source: Bloomberg

This year, we are faced with a similar pattern. There is good news in the S&P 500 (75% of the companies have exceeded expectations in 3Q numbers) and the US economy is still growing (albeit at a sluggish 2-3% pace). When this pattern appeared in 2008, the US economy was already in recession (started from December 2007, declared on December 1st 2008).

This time around, while there is a significant risk that the US economy is already tipping into recession (ECRI declared one in September), the two big issues dominating the market continue to be the European Sovereign Debt Crisis and the Political Gridlock in the US.

The Euro Crisis impacts the largest economic area in the world on a combined basis. Unfortunately, the central design flaw of the Euro (monetary union without fiscal union) has been exposed. There is too much sovereign debt in Europe and too much of it is owned by European banks which in turn have too little capital to absorb any losses. Germany is the only player with the economic and political clout to resolve the problem and it has yet to decide on which expensive resolution to adopt.

The US continues to struggle with political gridlock which in normal economic circumstances might not be such a problem. However, with such tepid consumer demand growth and a corporate sector keener to horde cash than invest in new projects and employees, the issue of the federal budget is causing deep anxiety amongst investors. For the middle of the road voter, who will once again swing the election next year, the choices are stark and surprisingly well understood. The Republican plan emphasizes spending cuts and will translate into an immediate reduction in GDP. The Democratic preference for stimulus spending financed with higher taxes will lead to a more gradual reduction in GDP but runs the risk of blowing out the deficit and attracting the negative attention of the bond market.

Neither outcome is particularly good for corporate profits and stock market performance. This is why we are seeing the October rally start to fade.

S&P 500…last six months.

Source: Bloomberg

What should investors do?

The System continues to favor short ETFs, short term US government paper and Gold. In other words, there is no underlying momentum in risk assets that should give one confidence at this time. The fate of the macro-economic foundations of half the globe’s GDP is in the hands of politicians who are faced with no easy choices and one of the leading forecasters of business cycles has called for a recession in the US.

We have often observed that the Bull Market slogans of the 80′s and 90′s (Buy and Hold…Buy the Dips) have served investors poorly since the dawn of the new millennium. At this juncture, we would remind investors of that observation continue to maintain a cautious investment stance.

Investors in global equity markets must feel very much like poor French farmers in Eastern France in the beginning of 1940. The Bulls and Bears have both lined up impressive resources, politicians and central bankers are playing a high stakes game of chicken in Europe and twitchy investors (hedge funds, perhaps?) are jumping back and forth between “risk on” and “risk off” trades to attempt to eke out enough performance to hang onto some of their funds at the year end redemption sweepstakes.

For the week ahead, there doesn’t appear to be anything too dangerous on the economic front and with Italy and Greece poised for new, technocrat governments, the political side might not yield any surprises for a few days.

That said, the S&P 500 is having a difficult time cracking rhrough to the positive side of the 200 day moving average.

The Fund King System is still suggesting a cautious outlook with low positive ratings on US government bonds, gold and Japanese Yen. The rest of the field is still rating in negative numbers, suggesting that discretion is still the better part of valor as we approach the holiday season.

New Developments

We will soon be releasing our app for the Android system as soon as we have worked out all the kinks. An iPhone/iPad app is on the to do list as well.

The improvements in the code will also be retrofitted into the systems that we use on the website.