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Prieur Perspective: New Wave of Risk Aversion Hits

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Uncertainty takes its toll on markets worldwide.

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Despite having crisscrossed Heidi's country, I've yet to find the elusive Swiss gnomes to glean what they make of financial markets at this juncture. Meanwhile, the past week has been characterized by a fresh wave of risk aversion, as uncertainty over the global economic outlook took its toll on stock markets, commodities, and precious metals, and investors favored safe-haven assets such as government bonds and the Japanese yen.

The S&P 500 Index, Dow Jones Industrial Index and the Reuters/Jeffries CRB Index -- all now in corrective mode -- closed down for a fourth consecutive week, while US Treasuries recorded gains for a fifth straight week and the Japanese yen for 4 out of the past 5 weeks.

The yen is often seen as a global barometer of risk aversion. The graph below demonstrates the strong inverse relationship between the movements of the yen (against the euro, in this case) and those of the Dow Jones World Index. As shown, a falling yen indicates risk tolerance (and a willingness to buy risky assets) and a rising yen shows risk aversion (and an indisposition towards risky assets). A downturn in the yen exchange rate could be a good indicator to keep an eye out for confirmation of better times ahead for stocks and commodities.



Also featuring prominently in investment discussions during the week were the viability of the Public-Private Investment Program (PPIP) and the merits of a second stimulus package -- calls for this comes at a time when estimates of trillion-dollar fiscal deficits and unsustainable debt levels are raising inflation expectations and putting upward pressure on long-term yields, thus partly undoing the Fed's monetary easing.

The past week's performance of the major asset classes is summarized by the chart below -- a set of numbers that indicates risk aversion is creeping back into financial markets.



A summary of the movements of major stock markets for the past week, as well as various other measurement periods, is given below. As the second-quarter earnings results in the US start rolling in, the American and most other markets closed the week in negative territory, with the Shanghai Composite Index being one of the few major benchmarks to make headway.

With the exception of the NASDAQ Composite Index, the major US indices are all back in the red for the year to date.



Stock market returns for the week ranged from top performers Nepal (+5.3%), Croatia (+3.0%), Uganda (+3.0%), Ecuador (+2.9%), and the Philippines (+2.4%) to India (-9.4%), Egypt (-8.5%), Argentina (-8.2%), Russia (-8.1%), and Kuwait (-7.6%) at the other end of the scale.

Of the 98 stock markets I keep an eye on, a majority of 64% recorded losses, 34% showed gains, and 2% were unchanged. (Click here to access a complete list of global stock market movements, as supplied by Emerginvest.)

John Nyaradi (Wall Street Sector Selector) reports that as far as exchange-traded funds (ETFs) are concerned, the winners for the week included "all things short" such as ProShares Short MidCap 400 (MYY) (+3.5%), ProShares Short SmallCap 600 (SBB) (+3.2%) and ProShares Short S&P 500 (SH) (+2.0%). Among the long ETFs, WisdomTree Dreyfus Japanese Yen (JYF) (+3.7%), CurrencyShares Japanese Yen (FXY) (+3.7%) and iShares MSCI Taiwan (EWT) (+2.9%) performed well.

On the losing side of the ledger, ETFs were centered in the energy sectors, including PowerShares Solar Energy (PBW) (-12.3%), Claymore Solar Index (TAN) (-12.1%), and United States Oil (USO) (-10.1%). Market Vectors Russia (RSX) (-12.6%) also had a rough ride.

The quote du jour this week comes from Richard Russell, 84-year-old doyen of newsletter writers who has been scribing the Dow Theory Letters for the past 50 years. Russell said:

"The whole bailout campaign stinks to high heaven. It was created and run by Wall Street -- FOR Wall Street. Again, I say, personally, I wouldn't have lifted a finger to bail Wall Street out. Let all these Wall Street thieves stew in their own toxic juices. Thieves should be out on the street or in jail, not luxuriating in government bailout money.

"In the end, the bailouts will simply extend the bear market in stocks and the economy. The Wall Streeters will be richer, and the nation will be poorer, choking on trillions in debt that will keep future generations struggling to deal with the sins of Wall Street. Too bad Obama didn't have the courage (or knowledge) to tell the nation what was going on. Obama should have said, 'sit tight' and 'this too shall pass.' Unfortunately, after the trillions spent in bailouts, 'this too will not pass.' "


Back to equities: The key moving-average levels for the major US indices are given in the table below. The S&P 500 Index on Tuesday breached the important 200-day line to the downside (for the third time in 26 trading days), joining the Dow Jones Industrial Average and the Dow Jones Transportation Index in bearish mode. The US indices are also all trading below their respective 50-day moving averages.

I've also added the BRIC countries and South Africa (my home country) to the table. All these markets are above the 200-day averages, having previously broken out of base formations. However, with the exception of China, the emerging markets have all recently broken below their 50-day moving average support lines. Importantly, the 50-day lines are in all instances still above the 200-day lines and therefore not yet threatening the bullish "golden crosses" established when the 50-day averages broke upwards through the 200-day averages.



Additionally, the Dow Industrial Average and S&P 500 Index on Tuesday also broke through the "neckline" of a head-and-shoulders formation -- a bearish event. For more on this, key levels, and the most likely short-term direction of the S&P 500 Index, Adam Hewison's (INO.com) short technical analysis provides valuable insight. Click here to access the presentation. The analysis was done on Tuesday, but is still as relevant today as it was a few days ago. (Adam also covered the outlook for crude oil and the dollar/yen exchange rate in recent analyses. Click the links to view these.)

The first meaningful pullback since the March 9 low has brought the bears out of the woods. According to Bespoke, the weekly poll of the American Association of Individual Investors (AAII) shows bearish sentiment currently at 54.65% -- higher than any other point since March 5.



"The onus is now on bulls to keep stocks buoyant. The technical breakdown of stocks is complete. Unless stocks rally robustly for several days -- not just a one-day surge -- stocks are likely to test 850 on the S&P 500 and then the very important 825 level ...," added Bill King (The King Report).

Richard Russell highlighted the latest statistic from Lowry Research, saying:

"Turning to the current market, what to me is most significant is that Lowry's Buying Power Index (demand) is collapsing. As a matter of fact, it's now below the level that it was on March 9. Meanwhile, the Selling Pressure Index (supply), after moving sideways for months, is now trending higher. This is a bearish combination and calls for a very defensive stance. On top of everything else, total NYSE volume is fading, particularly on days when the broad market is higher. It's obvious that buyers of stocks are becoming scarce. Despite 'Green Shoots' nonsense, the stock market doesn't like what it sees. And neither do I."

The last word on stocks goes to Teun Draaisma, highly regarded equity strategist at Morgan Stanley, who argued that there were "plenty of opportunities to make money beyond the market direction call" by pursuing a strategy that he described as "the middle ground," as reported by the Financial Times.

"Macro and the next big market move have become everyone's favorite investment topic over the past 2 years. We suspect it is time to move on to the micro of sectors, stocks and styles," he said.

Draaisma's large "middle ground" of investment opportunities includes "the forgotten market" Japan and "sectors that are cheap and under-owned with improving fundamentals" such as utilities, telcos, and energy. Also "buying stocks with a management change, financial restructuring, or a change of focus can be very lucrative."

The technicals undoubtedly look ugly, and investors will now focus on the second-quarter earnings reports as a test of whether stock prices have run away from fundamental reality. While investors wait for Mr. Market to show his hand, a cautious approach is warranted but that shouldn't preclude one from finding stocks that look cheap.

For more discussion on the direction of stock markets, see my recent posts Stock Markets Rolling Over, How to Play a Stock-Market Correction, Technical Talk: S&P 500 -- Expect Retest Sequence, Rosenberg Interview: Cold Truth About the Economy and Markets and Video-O-Rama: Fresh Wave of Risk Aversion. (And do make a point of listening to Donald Coxe's webcast of July 10, which can be accessed from the sidebar of the Investment Postcards site.)

Economy

The latest Survey of Business Confidence of the World conducted by Moody's Economy.com says:

"Global business sentiment continues to improve. At the start of July confidence is as strong as it has been since the start of last October. Expectations regarding the outlook towards the end of this year rose strongly again last week to their highest level since spring 2006. Business sentiment remains consistent with a global recession, but the downturn is quickly moderating."

Edward Hugh (Global Economic Perspectives) said:

"Global manufacturing took another step towards growth in June -- but the process was, as ever, uneven. The JPMorgan Global Manufacturing PMI posted 46.9, its highest reading since last August. Only 4 PMIs -- those for China, India, Turkey, and Sweden -- posted growth readings in June (although Sweden is not included in the JPMorgan survey). There was a general easing in the rates of contraction recorded elsewhere. The next 2 to 3 months will now be critical in order to decide whether the [manufacturing] sector is going to move over to expansion mode, and if it does, at what pace."



The IMF's World Economic Outlook reported that the global economy was beginning to emerge from the recession but "stabilization is uneven and the recovery is expected to be sluggish." Economic growth was projected at 0.5 percentage points higher than in April 2009 or a 1.4% contraction in 2009 and 2.5% growth in 2010. Advanced economies were expected to contract by 3.8% in 2009 and expand by 0.6% in 2010, whereas emerging markets would slow sharply, growing by only 1.5% in 2009 before rebounding to 4.7% in 2010.



Interestingly, the report also published financial stress indices for advanced and emerging economies, showing these have receded markedly since the beginning of 2009. However, the report mentioned that "improvements are far from uniform across markets and countries" and "bank lending conditions are expected to remain tight and external financing conditions constrained for a considerable time."



A snapshot of the week's US economic data is provided below.

July 10
The $787 billion fiscal stimulus package -- facts lost in policy rhetoric
Trade gap posts significant improvement in May
Consumer outlook turns a bit sour once again

July 9
Initial Jobless Claims report -- distortions from seasonal adjustments

July 8
CEO Business Confidence moves up in the second quarter
Mortgage Purchase Index suggests an increase in home sales during June and possibly July
Consumers continue to borrow less but pace of decline is notable

July 6
ISM Survey points to moderation in pace of decline in economic activity

Also, late payments on home-equity loans rose to a record in the first quarter as 18 straight months of job losses and a slumping economy left more borrowers unable to pay their debts, the American Bankers Association reported (via Bloomberg). Delinquencies on home-equity loans climbed to 3.52% of all accounts from 3.03% in the fourth quarter.

Summarizing the US economic outlook, with specific reference to the stimulus plan, Asha Bangalore (Northern Trust) said:

"At the present time, it is necessary to assess if the stimulus package is working in the preferred direction and if modifications and enhancements are called for, but it is imprudent to declare that it is not successful and a sheer waste of tax dollars or that a bigger package is necessary.

"In recent days, much to the chagrin of economic bears, a wide range of economic reports point to improving economic conditions. Without doubt more bullish economic data are necessary to confirm that the economy is on firm footing. The intensity and nature of the economic and financial market crisis that has been under way suggests that economic miracles will not materialize in a short period, which means that a weak economic report does not translate into going back to the drawing board in a panic."


Week's Economic Reports

Click here for the week's economy in pictures, courtesy of Jake of EconomPic Data. Click here for a summary of this week's economic calendar from Yahoo.

The US economic highlights for the coming week include the following:



"If you get all the facts, your judgment can be right; if you don't get all the facts, it can't be right," said Bernard Baruch.

No positions in stocks mentioned.
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