What’s a Four Letter Word for Risk Aversion?

Good Evening: After giving ground in recent days, U.S. stocks found their footing on Thursday. The S&P 500 had been fidgeting around just below 1000 since Tuesday’s downdraft, but the widely watched index managed to finish above this psychological barrier today. Whether this rebound after the 4% pullback from last week’s high signals either a pause in the selling or a resumption of this year’s rally is debatable, since the market action on the Thursday before Friday’s employment release is usually attributable to noise and position-squaring. After a bevy of firm economic reports this week, among the less debatable notions is that the U.S. manufacturing sector has climbed up off the canvas. At issue, therefore, is just how sustainable will be this uptick in activity, as well as just how much of it was anticipated in the S&P’s 55% rally since the March low. After shunning risk in the seventeen months subsequent to October of 2007, market participants have gorged themselves on risk positions during these last six months. It seems fair to ask if risk appetites might be getting set to shift back toward abstinence, and it might also be worth entertaining a notion or two about what might cause investors to push back from the table. Would it surprise you to learn that chief among the threats to wealth preservation might be our elected representatives in Washington, D.C.?

A small rebound in Asian equity prices during the overnight hours had our stock index futures pointing to modest gains this morning. An uptick in both initial and continuing jobless claims then undercut the bullish sentiment somewhat, but equities nonetheless managed to open higher. The major averages were hovering with gains approaching 0.5% when the ISM non manufacturing (read: services) survey results were posted. Though the headline number of 48.4 was just about in line with expectations, the U.S. service sector is still contracting, and the details of this report made for interesting reading. BAC-MER covers the positive and negative aspects of this release quite well in the piece below, but what caught my eye were the inventories and prices paid components.

Contrary to the widely perceived notion that inventories are falling (thus leading to a boost in production in the months ahead), the majority of respondents indicated inventory levels were too high, implying future production cutbacks. Unless one expects a disheartening bout of stagflation, it was just as disturbing to see the prices paid component spike to 63.1 in August from 41.3 in July. Note please that the size of the service sector of the U.S. economy dwarfs that of the manufacturing sector, so it’s interesting to see the services survey tell such a different story than the highly touted manufacturing survey released this past Tuesday. While I don’t want to make too much of this one economic release, the service sector will bear watching in the months ahead.

U.S. equities dropped back below the unchanged mark in the wake of this data point, but they didn’t stay there for long. Investors were happy to see ECB president, Jean-Claude Trichet, murmur his concern about the fragility of the European economy (see below). Trichet’s reluctance to take his foot off the monetary accelerator any time soon was especially well received. Taken in context with yesterday’s minutes of the August FOMC meeting, it seems as if Western central banks still lack the will to remove the monetary stimulus programs now in place. Without the will to do more than talk about a distant “some day”, it seems a safe bet that the Fed, ECB, and BOE can find a way to keep the policy throttles wide open.

Perhaps it has been the promise of central bank accommodation for an “extended period” that has been bolstering equities since last spring, but precious metals market participants, too, have started to take notice (see below). Gold and silver are attempting to break out to the upside after a long period of consolidation. The upside eruptions by Au & Ag are, in part, computer-driven by trend-chasing CTAs, but it is hard to ignore that these rallies have coincided with statements made by Western central bankers. Central bankers in the rest of the world have also provided a bulwark of support for the yellow metal. Almost unmentioned in the press was last month’s announcement by the World Gold Council that central banks have become net buyers of gold for what seems the first time in eons. My thanks go to Bill Fleckenstein for pointing out this nugget of information.

With mining stocks leading the way for a second straight day, the major U.S. averages drifted higher for most of the rest of today’s session. When an afternoon sell off fizzled, a late rally took hold that sent stocks out on their highs for the day. Though tomorrow’s employment data loomed in the windshield, investors drove the averages to gains of between 0.7% (Dow Industrials) and 2.3% (Dow Transports). The grab for stocks put a small dent in the demand for Treasurys, though, and yields rose between 2 and 5 bps across the curve. After their nice run of late, bonds were due for a breather, and the same looked to be true for the dollar. Suffering declines in recent days, the greenback made a comeback of sorts today by finishing mixed after opening lower. Commodities, at least the ones not found in the periodic table, were down today. A drop in energy and agricultural prices more than offset the rally in the metals complex as the CRB index retreated 0.3%.

When Lehman failed almost one year ago, the desire to take risk all but disappeared. Down went almost every currency and nearly every asset class; only the U.S. dollar, Treasurys, and certain sovereign bonds found willing buyers. Even gold succumbed to the “risk aversion” trade in 2008, but 2009 has been a different story. Gold rose with risk appetites for most of this year, and now that risk aversion may be reasserting itself, gold continues to levitate. The wings beneath gold’s feet may or may not be technically driven and temporary, but it may be a little-noticed and still-developing tailwind that is causing investors to rethink where their portfolio risks might now lie.

The final two articles you see below will rivet your attention, and they do not make for happy reading for equity investors. Rising stock markets have tremendous healing powers, but they may soon be called upon to help heal the budget deficits in the U.S. and the U.K. The AFL-CIO is pushing the Democratic party for a transactions tax on equity trades, while the Chairman of Great Britain’s FSA has proposed a similar tax in the U.K. Most readers will scoff at this concept, rightly branding it as misguided, foolhardy, and bearish for stock prices (and therefore counterproductive). But unsound economic policy concepts have found their way through the legislative process before, or have we already forgotten the “windfall profits tax” on oil companies during the 1970’s?

Wall Street has suffered during the Great Recession, but not, at least in the eyes of many average citizens, as much as has Main Street. The recriminations and paybacks for the sins committed during the credit bubble have been on hold, awaiting their turn in the new administration’s busy domestic agenda. Stimulus came first (done); reforms are second ( in process, a new push in healthcare begins next week); and tax policy is slated for 2010 (hint: the phrase “fair share” will figure prominently). I don’t really give the equity transactions tax idea much of a chance of passing, but it’s a lead pipe cinch the thirst for revenues and the anger at Wall Street will intersect somewhere in the 2010 tax code, leaving investors feeling less than joyful. The long arm of the law (more precisely, of the lawmakers) will soon be reaching into a pocket near you. It will be left to the sticky legislative process to determine just which ones will be pilfered, but the sitting Congress did not get elected on a platform of “soak the poor!”.

Left to contemplate just what risks to wealth might be coming, and from which direction, Mr. Market’s growing fascination with gold starts to make sense. No matter what the Labor Department conjures up in its employment estimates tomorrow, the potential danger to wealth preservation from monetary policy (quantitative easing and its grudging withdrawal) and fiscal policy (increased taxes cum spending) is clear and present. Risk aversion may soon have a new, four letter word to describe it — gold.

— Jack McHugh

U.S. Stocks Gain as Retail Sales Beat Forecasts, China Rallies
Gold Rises to Six-Month High as Weak Dollar Spurs Metal Demand
Trichet Expects ‘Uneven’ Recovery, Signals No Rush on Exit
Fed Tries to Prepare Markets for End of Securities Purchases
Turner’s ‘Tobin Tax’ Proposal Criticized by Kaufman, Ferguson
AFL-CIO, Dems push new Wall Street tax
Service sector still contracting.pdf

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