Market returns were mixed this past week following a 205 point drop (-1.5%) in the Dow Jones Industrial Average (DJIA) on Friday.  Several third quarter earnings “misses” by Google, Microsoft, McDonald’s, Chipotle Mexican Grill, and General Electric among others raised concerns about the strength of the economy.  Markets have been unforgiving towards companies when their earnings have not met expectations.  Chipotle shares fell 16.3% last week and are down 29.2% over the past month, Microsoft is down 7.8% over the past month while losing 1.9% last week, and GE lost 2.0% last week and is down just 1.0% for the month.  The largest company in the world in terms of market capitalization, Apple, has fallen 13.6% from its recent mid-September high.  The common theme among all of these companies is that revenues are not growing as fast as they had been, and margins are getting squeezed.  McDonald’s and Chipotle are facing higher food costs, Google is lacking pricing power for its services as more users focus on mobile devices, and Apple is seeing competition explode in the mobile device space.  The Wall Street Journal reported Saturday that, “nearly six in 10 companies are reporting weaker sales than Wall Street expected, and revenue for the S&P 500 is expected to slip slightly below where it was a year earlier by the time all reports are tallied.”  The markets have taken notice.

Despite Friday’s loss, the DJIA gained 15 points (0.1%) for the week and the S&P 500 gained 0.3%.  The Russell 2000 fell 0.25% and the tech-heavy NASDAQ lost 1.3%.  Three weeks into October, the DJIA is off 0.7%, the S&P 500 is down 0.5%, the Russell 2000 has dropped 2.0%, and the NASDAQ has given back 3.6%.  With 42 weeks now completed for 2012 (yes, there are only ten weeks left in the year) all the major indexes are up led by the NASDAQ’s 15.4% gain followed by the S&P 500 which is up 14.0%.  The Russell 2000 is up 10.8% and the DJIA is up 9.2%

Like the major indexes, performance by the major economic sectors was mixed.  Materials led the eleven sectors with a gain of over 2%.  Utilities, Financials, Energy, and Real Estate followed and were all up between 1% and 2%.  Information Technology was the weakest sector losing just over 2% followed by Telecom, and Consumer Staples.  For the year, Financials is now the best performing sector with gains of just over 21%.  Consumer Discretionary, Health Care, and Telecom have all returned greater than 18%.  Utilities, Energy, and Consumer Staples are the weakest sectors but all have positive gains for the year.

International markets did well for the week.  The MSCI (EAFE) index was up 2.5% and the European-only STOXX 600 gained 1.7%.  The Asia/Pacific region helped the MSCI (EAFE) index with a solid 2.1% gain (its best performance in the past five weeks).  The Emerging Markets region gained 1.0% and the Americas region added 0.4% for the week.  In Brussels, the European Union (EU) held a major summit on Thursday and Friday agreeing to create an EU-wide banking regulator with the ability to recapitalize banks with funds directly from the European Stability Mechanism (ESM).  However, the European leaders did not announce a schedule or amount for Greece’s next round of bailouts, and Spanish President Rajoy continued to retreat from seeking money from the ESM for his country’s troubled finances.  Markets reacted negatively to the news about Greece and Spain on Friday.  I remain firm in my belief that Europe has a very long way to go before it is out of trouble and I believe that economic weakness in Europe is beginning to hurt China and is a contributing factor to weak revenue growth here in the US. 

Bond sector performance was also mixed last week.  Overall, the Barclays US Aggregate Bond index was down 0.2% for the week.  US Treasury yields increased over the week making extended duration Treasuries the poorest performing sector of the week.  The US 10-year yield closed Friday at 1.766% compared to the previous week’s close of 1.660%.  The US 30-year yield finished the week at 2.937% up from the previous Friday close of 2.833%.  Spain saw the yield on its 10-year sovereign fall to 5.372% from the previous week’s close of 5.625% although the yield did rise slightly on Friday after the EU announced that Spain had not asked for bailout funds.  The game of chicken continues to play out in Europe.

The US Dollar index fell 0.1 % last week principally on the strength of the Euro, which closed Friday at $1.302 to the US Dollar.  The Euro is now virtually unchanged over the past two weeks reflecting the ongoing uncertainty of currency traders.  I believe that a strong Euro is one of the key signals for the “risk on” trade with investors.  For now, it appears that traders believe that Europe will get its act together, just not yet.   

The Dow Jones UBS Commodity index fell 0.4% last week marking the third consecutive week of declines for this broad commodity index.  WTI Oil lost $1.81 per barrel (-2.0%) closing Friday at $90.05.  It appears that oil traders are feeding off the news coming from corporate earnings reports and are growing concerned that the overall decline in US and global economic activity will translate to decreased demand for oil.  The price of gold fell $38.10 per ounce (-2.2%) to close Friday at $1721.60.  Over the past two weeks, gold has now fallen $59.20 per ounce (-3.3%).  Reviewing a number of different gold analysts’ comments about recent trading, about the only consistent themes I could find is that traders are like most investors today—uncertain, and that most of the effects of the Federal Reserve’s third round of quantitative (QEIII) easing was fully discounted into the price of gold when it was trading at the upper $1700’s.  It appears that gold has pulled back as investors question the efficacy of QEIII. 

RELIVING THE CRASH OF OCTOBER 1987

This past Friday marked the 25^th anniversary of the Crash of 1987 or Black Monday as it is often called.  At the time, I was a young US Army captain teaching ROTC at the University of Cincinnati and pursuing my Masters in Business Administration.  I clearly remember walking into the offices of the business college’s graduate program around 2 PM and hearing everyone talking about the “crash” that was underway.  I was just an interested spectator of the markets that day, and the pain felt by investors did not have a direct impact on me.  Over time, I grew fascinated about what had happened and what led up to that fateful day when the DJIA lost 508 points representing 22.6% of the market’s value.  My interest was so keen that I ended up writing my MBA thesis on “portfolio insurance,” one of the culprits blamed for the staggering loss that day.  In the end, I came to understand that many factors contributed to the huge sell-off that Monday in October.  With the anniversary date just passed and a 205-point sell-off, I could not help but take time to use some of the tools I use today and compare that timeframe to today’s markets.  Using data provided by Dorsey Wright & Associates and Google, it is possible to go back and look at what happened just prior to the crash and afterwards.

The New York Stock Exchange Bullish Percent (NYSEBP) is the key technical indicator I follow.  This indicator provides me with an idea of the overall trend in equity markets by looking at the nearly 3000 stocks that trade on the New York Stock Exchange (NYSE).  At any moment in time, a stock is either in a buy or sell signal using point and figure charts (I will not cover the concept of point and figure charts here, but if you have questions, just call me).  The NYSEBP adds up all of the stocks on a buy signal and divides that by the total number of stocks on the NYSE.  The result is the NYSEBP.  The higher the NYSEBP, the stronger the markets.  Additionally, the NYSEBP can either be increasing or decreasing.  If it is increasing it means that investors are generally buying stocks (demand is in control), while when it is decreasing, investors are selling stocks (supply is in control).  The value of the NYSEBP is that it is dependent upon the collective actions made by many traders over a wide swath of stocks.

The second indicator I look at is momentum.  In this case, the monthly momentum.  Simply put, the monthly momentum indicator takes any investment, in this case the DJIA, and compares its current average to its moving average over the past five months.  If the DJIA (or any stock or index for that matter) is trading above its moving average, that is a bullish signal.

Looking back to 1987, the DJIA closed out September at 2596.28 and was up a strong 27% through the first nine months of the year.  The DJIA continued to rise the first couple of days in October nearly reaching the highs of the year that had been achieved in late August.  However, a troubling signal had been flashed by the NYSEBP on September 4^th when this important indicator reversed to signal that supply was now in control.  So while the DJIA continued to climb for another month, the NYSEBP was retreating.  As Tom Dorsey of Dorsey Wright & Associates likes to put it, “the generals were still on the field fighting while the soldiers had all turned and fled.”  Additionally, the monthly momentum had reversed by the end of September.  The broad market was weakening while the key index was climbing masking possible trouble to many investors.

Today, there is a lot of worry out there.  The DJIA had a 205-point sell-off on Friday.  The Europeans are a mess, the fiscal cliff is rapidly approaching, investors are nervous about the elections, and the US and global economies are slowing.  The Investment Company Institute reported that for the week ending on October 10^th investors were pouring cash into bond investments and cutting positions in their stock investments.  Unlike 1987, however, the NYSEBP has held its ground in October and stocks remain in demand.  In other words, the soldiers are still on the field fighting.  Additionally, the monthly momentum for the DJIA recently turned positive after being negative since June.  With all the worry in the minds of investors and negative headlines, the markets are saying that stocks are still favored.  Reality and perception are not always the same.  From a technical standpoint, today is very different from 1987.

LOOKING AHEAD

Last week’s economic data did little to change the view that the economy is plodding along.  Some data was good, some mediocre, some not so much.  Traders will now turn their attention to this week’s data looking for trend signals.  This is how investors have spent most of the year and this week will be no different.

The key economic events for the coming week are the release of the first estimate of the third quarter Gross Domestic Product (GDP) on Friday and the Federal Open Market Committee (FOMC) meeting Tuesday and Wednesday.  The GDP number is extremely important, and as I said last week, the number (and all data reported between now and November 6^th) will be heavily scrutinized because it is the last GDP report prior to the election.  Consensus is expecting an increase to 1.9% compared to 1.3% in the second quarter.  The FOMC meeting is not expected to produce any headlines.  The Federal Reserve’s last meeting set the FOMC’s policies for the next few quarters, so investors are expecting little more than a confirmation of the previous monetary policy announcements.  September new home sales will be released on Wednesday morning.  This is an important report because housing remains such a critical component to the US economy and may give some insight to the third quarter GDP number.  Consensus is anticipating a slight increase in new home sales to an annualized rate of 385,000.  Initial Jobless claims on Thursday morning is expected to report a slight decrease from last week’s rate of 388,000 to 372,000.  Finally, September Durable Goods Orders will be released on Thursday.  Consensus calls for an increase to 7% from August’s unexpected decline of 13.2%.  All of the week’s reports may offer some insight into how the GDP number will look on Friday morning.

The NYSEBP gained 0.93 to close Friday at 66.26.  As I noted earlier, the soldiers are still on the field and demand remains firmly in control.  The NYSEBP would have to fall to 61.38 in order to reverse and put supply in control of stocks. The CBOE Volatility Index, referred to as the VIX, and is a measure of future volatility in the stock market, did rise last week and finished the week at 17.06 compared to last week’s close of 16.14.  Although elevated from the previous week, the VIX remains somewhat subdued.

The Dorsey Wright & Associates analysis of the markets has remained unchanged for most of the summer and now into the fall.  Data indicates that US stocks and Bonds are the two favored major asset categories followed by Foreign Currencies, International stocks, and Commodities.  Middle capitalization stocks are favored, as is growth over value, and equal-weighted indexes over capitalization weighted indexes.  Equal-weighted indexes are those where each stock in the index is weighted the same, while in capitalization-weighted indexes the larger stocks have the largest weighting consistent with their size relative to the other stocks.  The relative strength sector weightings favor Consumer Discretionary, Health Care, and Financials.  Financials pushed Real Estate to the fourth position this past week, but it would not cause me to sell or reduce Real Estate positions at this time.  US Treasuries and International Bonds are favored in the Bond category, while US and Developed Markets are favored within the International stock category.  Energy and Agriculture are the favored sectors within the Commodity category.

Paul L. Merritt, MBA, AIF^®, CRPC®

Principal

NTrust Wealth Management

P.S.  If you think this type of analysis would be of benefit to anyone you know, please share this communication with them.

Past performance is not indicative of future results and there is no assurance that any forecasts mentioned in this report will be obtained.  Technical analysis is just one form of analysis.  You may also want to consider quantitative and fundamental analysis before making any investment decisions.

Information in this update has been obtained from and is based upon sources that NTrust Wealth Management (NTWM) believes to be reliable; however, NTWM does not guarantee its accuracy. All opinions and estimates constitute NTWM's judgment as of the date the update was created and are subject to change without notice. This update is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. Any decision to purchase securities must take into account existing public information on such security or any registered prospectus.

Emerging market investments involve higher risks than investments from developed countries and involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation. The main risks of international investing are currency fluctuations, differences in accounting methods, foreign taxation, economic, political or financial instability, and lack of timely or reliable information or unfavorable political or legal developments.

The commodities industries can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Past performance is no guarantee of future results. These investments may not be suitable for all investors, and there is no guarantee that any investment will be able to sell for a profit in the future.  The Dow Jones UBS Commodities Index is composed of futures contracts on physical commodities.  This index aims to provide a broadly diversified representation of commodity markets as an asset class.  The index represents 19 commodities, which are weighted to account for economic significance and market liquidity.  This index cannot be traded directly.  The CBOE Volatility Index - more commonly referred to as "VIX" - is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500^® Index (SPX) option bid/ask quotes. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.

TIPS are U.S. government securities designed to protect investors and the future value of their fixed-income investments from the adverse effects of inflation. Using the Consumer Price Index (CPI) as a guide, the value of the bond's principal is adjusted upward to keep pace with inflation. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease.  Interest payments on inflation-protected debt securities can be unpredictable.

The NYCE US Dollar Index is a measure that calculates the value of the US dollar through a basket of six currencies, the Euro, the Japanese Yen, the British Pound, the Canadian Dollar, the Swedish Krona, and the Swiss franc.  The Euro is the predominant currency making up about 57% of the basket.

Currencies and futures generally are volatile and are not suitable for all investors.  Investment in foreign exchange related products is subject to many factors that contribute to or increase volatility, such as national debt levels and trade deficits, changes in domestic and foreign interest rates, and investors’ expectations concerning interest rates, currency exchange rates and global or regional political, economic or financial events and situations.

Corporate bonds contain elements of both interest rate risk and credit risk. Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value. U.S. Treasury bills do not eliminate market risk. The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income. 

 The bullish percent indicator (BPI) is a market breath indicator.  The indicator is calculated by taking the total number of issues in an index or industry that are generating point and figure buy signals and dividing it by the total number of stocks in that group.  The basic rule for using the bullish percent index is that when the BPI is above 70%, the market is overbought, and conversely when the indicator is below 30%, the market is oversold.  The most popular BPI is the NYSE Bullish Percent Index, which is the tool of choice for famed point and figure analyst, Thomas Dorsey.

All indices are unmanaged and are not available for direct investment by the public.  Past performance is not indicative of future results. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poors and is a capitalization-weighted index meaning the larger companies have a larger weighting of the index.  The S&P 500 Equal Weighted Index is determined by giving each company in the index an equal weighting to each of the 500 companies that comprise the index.  The Dow Jones Industrial Average is based on the average performance of 30 large U.S. companies monitored by Dow Jones & Company.   The Russell 2000 Index Is comprised of the 2000 smallest companies of the Russell 3000 Index, which is comprised of the 3000 biggest companies in the US.   The NASDAQ Composite Index (NASDAQ) is an index representing the securities traded on the NASDAQ stock market and is comprised of over 3000 issues.  It has a heavy bias towards technology and growth stocks.  The STOXX^® Europe 600 is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index.  With a fixed number of 600 components, the STOXX Europe 600 represents large, mid, and small capitalization countries of the European region