Monday, August 4, 2014

MARKET UPDATE AND COMMENTARY
August 3, 2014


It has been a number of weeks since my last Market Update and Commentary and it is time to get back to my regular schedule. First, I would like to say that during part of my writing absence I traveled to Ireland and Scotland with my wife, Virginia, and some of my dearest friends Toliver and Jeanette. A trip to the land of my ancestors has always been on my bucket list. I was thrilled to make the journey and I came home with some fabulous memories and impressions. First, Ireland and
Scotland are countries of immense beauty. Both countries are rustic, green, and lush. Irish communities are very different than other European countries I have visited in that the Irish did not build village clusters, rather their homes are scattered throughout the countryside. Dublin was actually a Viking settlement not Irish; and I learned that Irish redheads, like my daughter, all have their origins from the Vikings. Second, the Irish are fiercely independent. Irish independence is not yet 100 years old and the struggle to gain their autonomy from England is still very much in the public discourse. Third, the food was not nearly as bad as I was told it would be, not fabulous, but not bad. This leads me to my final observation and that is the Irish, and Scottish, people are every bit as friendly as you hear. Everyone we encountered was genuine and welcoming. All in all a great trip.

For the first part of the summer, the markets have been indifferent. This has followed a theme that has persisted through much of the year. The financial media has been obsessed with the notion that the markets were at the top of a bubble and we are poised for a major correction. Last week certainly felt terrible with the Dow Jones Industrial Average (DJIA) losing 467 points (-2.75%) and the S&P 500 falling 53 points (-2.69%). The weekly performance was the second worst week of the year for the DJIA and the worst week for the S&P 500. However, when you stand back and put all of this into perspective, the markets are flat to up slightly for the year. I have written many times in previous Updates that markets do not move steadily higher and that pullbacks are a very common aspect of investing. That 5% corrections have historically occurred between 2 and 3 times each year. This is fact and yet no matter how many times you might have experienced a small or large correction, it always feels terrible. Therefore it is imperative to not lose sight of the goal of most investors and that is strive for long-term gains to support a future lifestyle.

I would also suggest that the markets have actually done pretty well considering the unsettling turmoil that has gripped the world stage. Investors do not like the uncertainty global events can bring into markets and given the ever increasing connectivity of markets, seemingly isolated world events can have an impact on stock and bond prices here in the US. What I believe will have the greatest impact on future market performance in relation to the current global unease is whether or not investors believe the outcome of these key events (Ukraine and Israel/Gaza) will lead to a better business environment. Only time will tell on this point.

KEEPING IT ALL IN PERSPECTIVE

July was the second weakest month for the markets after January so far in 2014. January was, except for the Russell 2000, significantly worse than July. The DJIA was down -1.56% in July compared to -5.30% in January. The S&P 500 was down -1.51% in July compared to -3.56% in January. The Russell 2000 gave back -6.11% in July compared to -2.82% in January. For the year, the DJIA is has lost just 13 points (-0.08%) from where it started 2014. The S&P 500 is up 4.45%, the NASDAQ is up 4.63%, while the Russell 2000 has fallen 3.74%. Given the rather uninspiring results of the major equity markets both here and abroad, I find it interesting that so many pundits keep asserting the markets are in a bubble. Bubbles come when markets keep going up and up and up. I do not see that pattern here. Furthermore, I do not hear any clamor for investors to jump in and start buying stocks because they might miss the next big move upward. What I believe is happening is that the markets have paused and are reflecting the fifth year of sluggish growth in the economy.

The Gross Domestic Product (GDP) has averaged 2.1% growth over the past five years. This year is no different with the 1st Quarter registering in at -2.1% and the 2nd Quarter rebounding to 4.0%. The recovery continues to be the slowest in the modern era. It is also the longest, but that is due, I believe, to the very sluggish nature of the recovery. I also believe that the decline in workforce participation has also helped keep wages down. The markets recovered, in my view, in the previous years because US companies adapted to the post-recession economy and made money surprising many investors. I will concede that a very accommodative Federal Reserve keeping short-term interest rates at near 0% for five years has certainly helped companies. However, I do not believe that the Fed is primarily responsible for current market valuations as many bearish pundits suggest.

It is necessary, I believe, to keep the bond markets included in the discussion of markets and valuations. Keep in mind that the Federal Reserve does not control all interest rates. They set the overnight lending rate and they influence rates through monetary policy (overnight interest rate and the supply of money). The supply of money is extremely important because the more of anything will cause the price to go up (inflation) as you have more dollars chasing the same goods. I have noted previously that the supply of money is not expanding at an above average pace which has kept inflation expectations down.

Investors determine the yield on bonds based upon credit risk, growth expectations, and inflation expectations. US Treasuries are unique in that they are considered to be risk-free because no one expects the Federal government to default. Therefore, when looking at the current yields on Treasuries investors consider just growth and inflation expectations over the period of the bond. That is why I routinely refer to the 10-year and 30-year US Treasury yields as the bond markets’ view of future growth and inflation. Today, the 10-year yield is 2.50%. When you factor in inflation and growth, it does not offer a very optimistic view of future growth rates but it also does not imply that inflation will be running out of control anytime soon.

Another important consideration is what impact low interest rates have on investors. With interest rates historically low for so many years, investors who are seeking income may have been forced to invest in securities that might be considered too risky in normal interest rate periods. Examples of this behavior include investments in high yield bonds, real estate, and utility stocks--equity or equity-like investments by investors who would rather invest in a good old-fashioned boring bonds. As demand for these securities increases, so do the prices. If rates do start jumping upwards, conservative investors may sell higher risk assets in favor of more traditional bonds causing prices in the higher-risk assets to fall.

So as I look across the investment landscape I see a view virtually unchanged in 2014, and I believe the markets are seeing the same. Economic growth is continuing at a very modest pace, inflation remains under control (this can always change and must be watched carefully), monetary policy is expected to be the same for at least the next 9 to 12 months, and I believe there is virtually zero likelihood that the fiscal policy coming out of Washington will change this year. So put the recent moves of the market in proper context as part of the natural ups and downs found in typical markets.

LOOKING AHEAD

The recent sell-off in the markets has pushed down a number of key technicals that I follow. The New York Stock Exchange Bullish Percent (NYSEBP) fell from a very bullish 69.25 to a more moderate 62.35 in July. The first trading day of August saw the NYSEBP fall another 2 points to close at 60.35. This key DorseyWright indicator is also in a defensive posture indicating the potential for some weakness ahead. I believe that if the markets continue their recent pullback, I would expect the reading (and markets) to fall a bit further.

US Stocks continue, however, to be favored on a long-term basis followed by International Stocks. These major asset categories remain the #1 and #2 of the six asset classes I follow. Bonds are third, Currencies and Cash are tied at fourth and fifth, and the Commodity asset class remains in last position.

Looking more closely at US Stocks, the S&P 500 is currently 35% oversold. Anything closer to 100% oversold and beyond would make an attractive entry point for new cash. According to The Wall Street Journal, the trailing 12-month S&P 500 Price/Earnings (P/E) ratio is currently 18.80 with a dividend yield of 1.93%. The 18.80 P/E level is slightly elevated over the long-term average of 15.7.

The International stock asset class ranks number two of the six major asset classes. The European-heavy STOXX 600 lost 1.72% in July putting its loss slightly greater than the DJIA and S&P 500. The Emerging Market region gained 1.67% while the Developed Market region lost 1.25%. The Emerging Market region has been the best performing International sector that I track gaining 6.81% year-to-date. I like this sector, however, not all emerging markets are the same and great care must be taken in gaining exposure in this area.

Bonds continue to fall below stocks on a relative strength basis, however, most bond sectors have performed well so far in 2014. The Barclays US Aggregate Bond Index is up 3.91% for the year as interest rates have generally fallen throughout 2014. Falling interest rates pushed longer maturity bond returns higher making long-term bonds the best performing bond category so far in 2014 (long maturities are also more vulnerable to rising interest rates). The High Yield and Bank Loan bond sectors are currently the most oversold standing at -159% and -173% respectively. Even with the recent sell-off, nearly all bond sectors are positive for the year.

Commodities have lost a lot of strength in the past couple of months. The Dow Jones UBS Commodity index (a broad basket of different commodities) has fallen 5.6% since the end of June and is now up just 1.1% for the year. Oil and Gold tend to be the most reported commodities on the daily news and WTI Oil is down 0.7% for the year while Gold is up a healthy 7.6%. What investors should keep in mind is that Gold is currently $657 (-33.7%) below its all-time high of $1952 reached in August 2011. I do not believe Gold will see a return to the 2011 prices as long as the Federal Reserve keeps the supply of US Dollars within an appropriate growth rate (about 6%) as it transitions into a new era of monetary policy next year. It is important that investors keep in mind that commodities typically trade in a supply and demand environment and if demand falls or supply grows, prices are likely to fall as well.

While I am going to approach the next couple of weeks with caution, I am not going to start selling stocks for selling’s sake. I will be looking very closely at the various DWA technicals that I use to make buy and sell decisions and I would anticipate that some of the weaker relative strength ranked securities will be trimmed. I have learned over the years not to get to heavy handed in trading on down markets, but rather be selective and thoughtful in selling decisions. This time is no different.




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.