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Tuesday, September 2, 2014

MARKET UPDATE AND COMMENTARY
September 1, 2014


Key US stock market indexes finished up nicely in August despite the continued global turmoil. The Dow Jones Industrial Average (DJIA), S&P 500, and NASDAQ indexes posted their second best monthly returns of the year gaining 3.2%, 3.8%, and 4.0% respectively in August. The struggling small capitalization-heavy Russell 2000 had its best monthly gain (4.9%) helping to push this beleaguered index into positive returns for the year. Eight months and 35 trading weeks into 2014, the DJIA is up 3.1%, the S&P 500 has gained 8.4%, the NASDAQ leads with a 9.7% gain, and the Russell 2000 is up 0.9%.

I believe a number of factors contributed to August’s performance including continued growth in corporate profits, a 4.2% quarterly growth rate in the Gross Domestic Product (GDP), and flagging economic growth elsewhere. With concerns of political instability abroad and a very modest sustained economic recovery here, more and more investors appear to be “buying American.”

August was a positive month for most international indexes led by a 4.0% increase in the Americas region and a 2.5% improvement in the Emerging Markets region. The Asia/Pacific region and the European-dominated STOXX 600 indexes were the weakest in August with returns of 0.3% and 1.8% respectively. For the year, the Emerging Markets region leads my international indexes with a 9.8% gain followed by the Americas region with a gain of 8.4%. The STOXX 600 lags other international indexes with a yearly gain of 4.2%. European economic performance is starting to sag yet again, and coupled with the troubles in the Ukraine, I believe further weakness may lie ahead for the Euro Zone.

Interest rates continue to fall leaving economists and pundits scratching their heads. Both the US 10-year and 30-year Treasury yields fell almost a quarter percent in August closing Friday at 2.34% and 3.08% respectively. It was widely anticipated at the beginning of the year that with the Federal Reserve purchasing fewer bonds and an economy forecast to grow above 3% in 2014; interest rates would have to rise. This has led to a new debate among the chattering financial press: how can stock investors and bond investors’ view of the markets/economy be so opposite? Stock indexes are at or near all-time records while low interest rates signals pessimism. In my opinion, they may both be right given their frames of reference. I will address this further below.

Weakness in commodities continues. The Dow Jones UBS broad commodity index fell 2.1% in August reflecting the continued pullback in commodity prices. Natural Gas posted a 6.4% gain as WTI Oil fell 2.0% and Corn fell 0.6% but for now seems to be stabilizing. Another factor contributing to growing commodity price weakness that I have not discussed in sometime is the impact of a strengthening US dollar on commodity prices. All else being equal, the stronger the US dollar, the lower commodity prices; and the US dollar has gained against most other currencies recently.

THE THREE GOLDEN WORDS

When I was studying for my MBA at the University of Cincinnati, I was compelled to take several courses in macroeconomics. I say compelled, because I never found sitting through multiple 3-hour lectures in grad school discussing graphs like the ones to the left particularly enjoyable. This does not mean that I did not understand or diminish the importance of such topics as monetary policy, GDP, the differences between real and nominal data, and the interaction of government fiscal policies on labor and the economy, I did. However, I grew to understand that macro economists, in my opinion, were trying to use very advanced mathematics to predict something that in the end was unpredictable — human behavior.

I believe simplicity is the foundation of understanding the complex, and frequently the complex can be broken down into very basic and understandable truths. Macroeconomics is no different. The foundation of all economics can be summed up into three words, my “golden words” of economics: SUPPLY AND DEMAND.

Any product bought or sold has a value. The perceived value is determined by the buyer and seller based upon their own criteria of value. Let me use an example to explain.

I am a big fan of Pawn Stars on the History Channel. If you watch the show for more than five minutes, you will see the value of articles such as books, guitars, autographs, cars, and even a 1920’s-era drink mixer negotiated. It is particularly intriguing when a seller walks into the store with an object they believe is worth a great deal of money because of age or of because of research they did on internet only to be told by the store’s owner, Rick Harrison, that the object is worth far less than the seller’s perceived value. Rick uses his experience to assess how much demand he can expect for the object, at what price that demand exists, and what profit margin he must make for the risk he is assuming with the purchase. Rick has a different set of criteria by which he values items compared to the sellers. Ultimately, the value of the object is determined when Rick and the seller reach an agreement on price, and that price becomes the value of the item at that moment in time.

What happens on Pawn Stars is happening millions of times each day when buyers and sellers in the financial markets come together to trade. What I think is important to put this discussion into context of today’s seemingly confused behavior in the stock and bond markets is to understand the criteria by which buyers and sellers bring into the financial “store.” Stock investors focus on corporate profitability and expected growth. I have noted a number of times that US companies are as profitable as ever and stock valuations have risen because of this profitability. Arguably, the US continues to be the most vibrant and growing entrepreneurial economy within politically stable boarders of any country in the world. The demand for US stocks remains strong.

Bond markets are also reflecting this same strong demand but due to a mix of similar and also different reasons. First, the stability of the US makes it the go-to place for international bond investors just as it does for stock buyers during periods of global uncertainty. With the political turmoil in the world today, investors are seeking the perceived safety of US bonds. Second, interest rates indicate slow, plodding growth going forward. However, when an investor has a choice between a German 10-year Bund yielding 0.98% or 2.34% on a US 10-year Treasury, which bond do you think an investor would buy today? Of course, the US 10-year. Finally, even though US growth is somewhat anemic, most other regions of the world are doing worse. Therefore, higher US interest rates are more likely than in other similar countries such as Germany or France, in my view.

Confirming international investor demand for all things US, the US dollar has risen sharply compared to other currencies. The US dollar index is up 4.9% since May 8th of this year, and if the European Central Bank (ECB) adopts more aggressive US-style Fed intervention, the Europeans may likely see even lower interest rates and a weaker Euro ahead.

The supply and demand dynamic affecting currencies has an interesting role on commodity prices. Over 90% of all commodity purchases in the world occur with US dollars. If the US dollar gains strength compared to other currencies, commodity prices increase for non-US dollar buyers. Higher prices tend to dampen global demand and with less demand come lower prices. Gold, a safe haven for a weaker US dollar, also tends to lose value as the US dollar strengthens. Watching currency exchange rates gives an indication of which currencies are in demand and which are not.

In summary, stock investors see profitability and bond investors see slow growth; US stocks, bonds, and dollars are in demand by both domestic and international buyers. The motivations and perceptions of value may differ between the investment asset categories; however, the net result is higher valuations for most US assets.


LOOKING AHEAD

September has traditionally been considered the weakest month of the year. My friends at DorseyWright & Associates put together some interesting historical data for the month of September.

Looking back 86 years, the S&P 500 has been positive 39 times (45.3%) in the month of September. Of the 39 positive months, the S&P 500 has gained an average 3.4% while it has lost 4.8% in the 47 down Septembers.

I share this information with you because I have seen a number of articles popping up in the financial media discussing the perils of September markets. Putting aside the noise, history suggests that having an up or down September has about the same odds of correctly picking heads or tails on a coin flip.

Here are some very general observations I will offer based upon my interpretation of what I have read and the data I have reviewed:

• Economic fundamentals remain positive. The economy is growing, albeit slowly.
• The S&P 500 is just slightly overvalued in comparison to long-term valuations, and on a ten-week average, it is overbought by 47% well within acceptable levels.
• Risk is personal. If you are uncomfortable with your stock exposure, make some sales and increase your cash for now.
• Small capitalization stocks are expensive relative to large cap stocks, so if you are going to sell any US stocks, I would suggest considering small caps first.
• European stocks are cheap relative to US companies, but I think they are cheap for a reason—their economies are weaker than the US. I like many companies found in Europe, but I would not rush out of US stocks and into European or Asian stocks at this time. I continue to underweight Europe to the US.
• The Federal Reserve may raise rates sooner than people expect, but I believe that this will be a positive sign over the long-run after some short-term turbulence as investors adapt to new monetary policies.

US stocks are still the preferred major asset class I follow. International stocks have strengthened slightly in the number two position followed by Bonds, Currencies, Commodities, and Money Market. Commodities and Money Market are taking turns deciding which major asset category will reside last in the rankings. The Money Market category score is presently 1.48 out of 6.0 and ranks 131 out of 134 DorseyWright categories indicating that nearly every DorseyWright category is outperforming the Money Market category on a relative strength basis.

Predicting major market moves is difficult at best and a fool’s errand at its worse. Stay focused on the underlying data and remain committed to your strategy over the long run.

If you have any questions or comments please reach out and give me a call.





Paul L. Merritt, MBA, C(k)P®, 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. 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.