Tuesday, October 26, 2010

Starting at Neutral

Hello! This is my first blog, so without knowing where to start I figured I'd jump right in...

My intention for this blog is primarily documenting the wide range of thoughts and questions about financial markets and the economy that drift through my mind on a daily basis. If by doing so I manage to answer these questions in time or provide insightful trading ideas, then my goals will have been achieved as well. Along the way I will offer links to insightful articles that have either helped shape my current thinking or, ideally, answer any of the multitude of questions presented. Before I get going, let me also provide a brief background on myself...

At an early age, as part of a gift from my grandparents, I received my first shares of stock: 7 shares of Disney and Coke. Intrigued, I read about and followed the stock market through its rise and fall in the dot-com bubble. During college I studied finance and economics while dabbling in the markets as a small time investor. Internships provided previews to the worlds of day trading, hedge funds and financial advisors. After college, I initially worked for an options market making firm, where I was afforded significant capital for trading and gained insight into high-frequency trading. Then the Great Recession hit and my career path completely changed course. Now, as a part-time graduate student and full-time analyst in the financial industry, my mind is consumed and amazed by the previously unthinkable events witnessed in financial markets and the global economy over the past 2 to 3 years. (Given my current job, I feel compelled to state that any and all comments, opinions or recommendations solely reflect my own personal views and are in no way connected to my employer.)

Today -
   With one week remaining until the eagerly awaited Fed meeting and Congressional elections, U.S. stock markets have maintained or held on to their significant gains over the past 7-8 weeks. Assumptions of $500 billion to $1 trillion in QE2 and Republicans garnering control over the House, and possibly Senate, have created an ideal backdrop for stock market optimism. Combined with near record low interest rates, a weakening dollar, better than expected Q3 earnings, the sweet spot of the presidential cycle and numerous technical bullish indicators, it's no wonder why most investors share David Tepper's recent view that investing in stocks is "win-win."
   The past week, and most noticeably today, impressively strong correlations between markets have started to break down. The dollar, which appears to have set a near-term low on 10/15, rallied higher by nearly one percent. Treasuries followed suit, selling off throughout the day and leaving the 30 year yield pushing on resistance at 4%. However, after selling off strongly in the pre-market and at the open, stocks and commodities rallied back to ultimately finished flat or even higher on the day. Considering these trends over the past week provides further insight into the specific decoupling of the stock market. While the dollar has rallied 3-4%, bonds, gold and oil have all sold off by several percent. Surprisingly to some, stocks have seesawed between failed breakouts and corrections, resulting in small gains across the indices. Although the correlation between markets has been running at historic highs and could simply be reverting to the mean, further strength in the dollar will likely warrant caution in the equity markets.
   The strength in stock markets today appeared most influenced by better than expected consumer confidence and IBM's announcement of a $10 billion stock buyback plan. Although the headlines read positive, both reports should be considered in context. Consumer confidence moved up slightly from the previous reading, a seven-month low, but the outlook for jobs actually weakened. As for IBM's buyback plan, the stock is currently trading at an all-time high and it's important to recall that firms don not have a particularly good track record in terms of buying back stock. Ultimately, fear of being short or missing a fed-induced rally may provide short term protection on the downside.
   Although the election results are important, the Fed's imminent decision and announcement of QE2 will likely have far greater ramifications for markets in the near term. The debate over the necessity and outcome of QE2 has been ongoing for quite some time, however, Bernanke Leaps into a Liquidity Trap by John Hussman of Hussman Funds (http://www.hussmanfunds.com/wmc/wmc101025.htm) provides several interesting new considerations.
   Looking forward, the implications of Hussman's analysis provide some pertinent questions. If QE2 simply reduces the velocity of money and fails to create an increase in aggregate demand, is the stock market overvalued? How long can market distortions created by QE2 last in the face of continued weakness in the economy? Knowing the history of Japan's failed attempts at QE, why is the U.S. convinced the same flaws will not arise? Shiller's P/E has often provided reasonable medium and long-term investing guidance...will the current high value correctly predict sub-5% returns for the next decade?

   These questions will only be answered in time, but my money remains cautious at the moment...

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