Monday, December 9, 2013

MARKET UPDATE AND COMMENTARY
December 8, 2013



The Dow Jones Industrial Average (DJIA) and the S&P 500 posted their first weekly loss last week after eight straight positive weeks. For the week, the DJIA fell 0.4% and the S&P 500 dropped 0.04%. The Russell 2000 continued its recent trend of underperformance falling 1.0% while the NASDAQ posted a 0.06% gain.

With 49 weeks of trading completed for the year, the DJIA is up 22.2%, the S&P 500 is up 26.6%, the Russell 2000 has gained 33.2%, and the NASDAQ leads the major indexes with a gain of 34.5%.

Prior to last Friday, US markets traded down for the previous five trading sessions even as economic data were indicating growing strength in the economy. Friday’s nearly 200-point gain in the DJIA followed the release of the November Employment Situation report showing unexpectedly high jobs growth bringing the overall unemployment rate down to 7.0%. The consistent message of recent economic data is that the economy is growing steadily in the face of strong fiscal (governmental) headwinds and, I believe, has increased the likelihood that the Federal Reserve will begin reducing (tapering) its current $85 billion per month bond purchase program.

International markets have tracked the US markets relatively closely this year, but without the same level of gains. The European-heavy STOXX 600 index fell 2.7% last week but is up 13.2% for the year. The Wall Street Journal’s Developed Market index is up 20.7% for the year, while the Emerging Market index is down 5.6% and the Asia/Pacific index is up 8.6%.

The Commodities asset class has been a big disappointment in 2013. The Dow Jones UBS Commodity index is down 9.8% for the year; however, this broad-based commodity index has added 1.8% over the past three weeks led by a 13.0% increase in natural gas and 4.1% increase in WTI Oil. Gold remains very weak giving back 26.6% in 2013. The increase in energy prices and other consumable commodities, I believe, is a positive short-term indicator that investors believe a strengthening economy will increase demand for basic commodities and push up prices.

Interest rates continue to trend higher. The US Treasury 10-year yield closed Friday at 2.86% up from the previous Friday’s close of 2.74%. The Barclays US Aggregate Bond index lost 0.5% for the week and is now down 2.1% for the year. Remember that rising interest rates push the value of most bonds down and that this trend of rising interest rates leaves many bondholders at risk for further losses.

BUBBLE, BUBBLE, TOIL AND TROUBLE

As markets continue to remain at or near all-time highs, more and more articles are appearing warning investors of the over-extended position of US stock markets. The common thesis of these articles is that with the DJIA above 16,000 we must be in a bubble and gains in the stock market are artificial and induced by the Federal Reserve’s accommodative monetary policies. None other than Nobel Laureate and Yale Professor, Robert Shiller, told the German weekly publication, Der Spiegel, last week that “many countries stock exchanges are at a high level,” and that he is “most worried about the boom in the U.S. stock market.” The recent market pullback in the face of improving economic news certainly gave some credence to this point, but how do you explain Friday’s strong move?


I believe the answer to this critical question is corporate profits. As I have noted in previous Updates, corporate profits remain at near all-time highs in terms of a percentage of profits with respect to the Gross Domestic Product (GDP). The 3rd Quarter revision of the GDP reported corporate profits at about 10% of GDP and well above the historical average of between 6% and 7%. In the final analysis, I believe the value of companies is all about profitability and companies are making money today.

Looking at the overall valuation of markets, Scott Grannis of the Calafia Beach Pundit, blogged last week that the S&P 500 is, based upon historical averages, actually undervalued. He points out that there are many different ways to determine the overall price/earnings (PE) ratio (how much companies are valued compared to how much they are earning), and some do show the markets overvalued. However, Grannis believes that using NIPA profits (the Bureau of Labor Statistic’s calculation of total economic after-tax corporate profits) is the most accurate measure of profits, and that the NIPA PE ratio of the S&P 500 is about 12 compared to the historical average of 16. He goes on to explain that investors are pricing in very weak future earnings because many investors believe corporate profits will fall significantly going forward, yet the economic data that continues to be reported simply does not support this perception.

It is unrealistic to expect markets to move upward in a straight line, however, those investors who have listened to the bearish pundits and sat on the sidelines have missed the strong stock rally over the past few years.

The rise in interest rates since the middle of the year supports the argument that the economy is growing. Rising interest rates typically occur in a growing economy because investors tend to sell bonds and buy stocks. This trend is confirmed by cash flow statistics reported by the Investment Company Institute which show that through the week ending November 26th, taxable and municipal bond investments have had an outflow of $59.5 billion this year while US and International stock investments have had inflows of $157.9 billion. This buying and selling has, in my opinion, clearly put pricing pressure on bonds and pushed up interest rates.

Friday’s market action was significant because it was the first time that the market rallied recently on good news. The concern regarding tapering is real and I am not dismissing the potential psychological impact on investors when the Federal Reserve begins to (and they will) taper. If you belong to the school of investors who believe that the market is artificially high due to cheap money, then you would expect a pullback as tapering begins. If you belong to the school that believes markets have rallied because the economy is still growing and corporate profits will continue to remain strong (as I believe), then we should expect to see the upward trend in markets to continue. I do expect there will be increased volatility as the two schools of thought battle it out in the months to come, however, as long as the economic data continue to support economic expansion and corporate profits remain strong, the rising trend of markets should continue.

LOOKING AHEAD

My DorseyWright & Associates (DWA) technical indicators continue to favor small and mid-capitalization stocks over large cap. Growth is favored over value, and equal-weighted indexes are favored over capitalization-weighted indexes. US stocks are favored over all other major asset classes with International stocks remaining firmly in second position. Fixed income ranks third followed by Currencies, Money Market, and Commodities.

Money Market as an investment sector currently ranks 116 out of 132 of the sectors tracked by DWA meaning that the vast majority of sectors are outperforming cash. I cannot stress enough how important this ranking is in providing a key indicator of what is happening within the broad market. If Money Market begins to climb higher, it would be an important signal that more and more investments are beginning to weaken and caution will be warranted. This is one of my key risk indicators and I will certainly keep you informed of any changes to this important statistic.

Two major economic reports are due out this week. November Retail Sales will be released Thursday morning. This monthly report will take on added significance because we are in the all important holiday shopping season. The November Producer Price Index will be released Friday morning. This too will be an important data point because it will be a signal of the potential for increased inflation in the months ahead. Both of these data points will certainly be looked at closely by the Federal Reserve.

The Federal Reserve has one more meeting this year on December 15th and 16th. Guidance from the Fed will be released on Wednesday afternoon, December 16th. Economists and investors will be listening closely for clues of when tapering is likely to begin.

My next Market Update and Commentary will be published the last weekend in December.

I want to thank each of you for your support and feedback this year. I hope each of you have the opportunity to share this holiday season with family and friends.




Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
Principal
NTrust Wealth Management

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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. The Dow Jones Global ex-US index represents 77 countries and covers more than 98% of the world's market capitalization. A full complement of subindices, measuring both sectors and stock-size segments, are calculated for each country and region.