MARKETS SPECTATOR: Bears loosening their grip

Since Obama was re-relected president, investors have been intent on pricing in the worst case scenario for the US economy. But as the bears lose their grip, a bounce is on the cards.

It’s been a week since President Obama was re-elected and in that time equity markets have been on a fairly bumpy ride as investors grapple with the consequences of his re-election and price in the uncertainty of the much talked about, but highly unlikely fiscal cliff.

Who in their right mind would drive the US economy off this cliff! It’s not a mere bump in the road but rather a cliff that would swiftly plunge the US back into recession, as well as sapping the last drop of public confidence in the whole political and economic system. Hence, my view that it simply won’t happen. It can’t!

Those at loggerheads will almost certainly play a tough game of brinkmanship but when it comes to the crunch, there will be a compromise. There are already signs of it, yet markets haven’t woken up to this fact yet, choosing instead to just focus on the doom and gloom story.

Think back to the debt ceiling debate 18 months ago. How many times did the Republicans come out and say they were willing to compromise. That’s right, they basically didn’t.

Yet, in only a week since the Republicans were comprehensively beaten in the race to the White House there are some very encouraging signs. We’ve already seen house speaker Boehner say that the GOP are willing to compromise on a plan that includes an increase in revenues, rather than just spending cuts. This is a huge step in the right direction.

He wasn’t the only one hinting towards the willingness to strike a balanced deal. Overnight, a top economics aide to presidential candidate Mitt Romney, Glenn Hubbard wrote: "there are ways to raise revenue without increasing marginal rates. Tax deductions should be scaled back, especially in the areas of mortgage interest, charitable giving and employer-provided health insurance”.

I know these are just words and at the end of the day, it going to require firm action, which will be the big test. But the markets have been reacting as if the chances of a solution have deteriorated rapidly. This couldn’t be further from the truth. Compared to last year, I think they are miles ahead of where they were.

The first trading session after Obama’s win, when markets dropped significantly I wrote that it looked like markets were going to price in the worst case scenario first, and then ask questions later. The market has been focussed on one thing, and one thing only. It has completely ignored positive news (economic data, signs of a willingness to compromise from Republicans) and focussed exclusively on the downside risks.

After the best part of a week heading lower, the bears look to be slowly losing their grip. Volumes haven’t been strong on down days and the weekly S&P 500 chart below is showing a significant contraction in this week’s trading range compared to last week, although there are a few trading sessions still left.

Source: Iress

On top of this, the S&P 500 is sitting just above the key 50 per cent Fibonacci support level, which is one of the more popular and closely watched levels. Overall, it’s starting to look and feel like the markets oversold in the short term and due for a bounce of some sort. However, we’re still likely to have plenty of uncertainty in the coming weeks.

In Australia, I think there’s less uncertainty. Yes, we’ve been broadly following Wall Street lower but I don’t think that will last too long. The issues plaguing US markets are very US centric and really have quite a limited impact on the domestic market – hence the outperformance we have witnessed recently.

Of more importance in my view is how Asia is performing, particularly China. Over the last month, it has become increasingly clear that the third quarter probably marked the low point in Chinese GDP, with momentum starting to pick up. This is fast becoming the consensus view, although only a small amount of participants have actually started repositioning their portfolios to reflect this.

The weekly XJO chart below shows that it is only four weeks since the local market hit a peak compared to 9 weeks on the above S&P 500 chart. This is clear confirmation of the Australian outperformance we’ve mentioned.

Source: Iress

The local market is also showing early signs of trying to hold above the major support level labelled. And if you compare the two charts, you can see straight away that the pullback seen here is much more orderly and shallow.

As I wrote yesterday (MARKETS SPECTATOR: On the hunt for high yield, November 13), the theme of Australian outperformance is set to continue, driven by 1) the flow of money towards high yield assets and 2) the reallocation of money towards China-facing stocks like Australian resource names.

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