Tuesday, October 28, 2014


MARKET UPDATE AND COMMENTARY
October 26, 2014


Just as quickly as the economic storm clouds gathered over stock markets earlier in the month, they cleared and key US indexes posted their best weekly returns for the year. For the week, the Dow Jones Industrial Average (DJIA) gained 2.6%, the S&P 500 rose 4.1%, the Russell 2000 added 3.4%, and the NASDAQ jumped 5.3%. Other than the Russell 2000 (+1.6%) which is now positive for the month, the DJIA (-1.4%), S&P 500 (-0.4%), and the NASDAQ (-0.2%) still remain in negative territory for October. For the year, the DJIA is up 1.4%, the S&P 500 is up 6.3%, the Russell 2000 is down -3.9%, and the NASDAQ is up 7.3%.

The turn in markets coincided with 3rd quarter earnings announcements that have been decidedly positive overall. Current projections suggest that US corporations will exceed last year’s 3rd quarter profits by roughly 10%. Ebola fears have subsided for now. Both Dallas nurses are now Ebola-free, and the case of the Brooklyn doctor does not appear, at this time, to be a concern to the markets.

International markets also rebounded last week. The broad MSCI EAFE index added 2.4% with the European-heavy STOXX 600 gaining 2.6%. The Emerging Markets region lagged with a 0.8% gain. For the month, however, the Emerging Markets region has outperformed the key international indexes I follow with a loss of -1.6%. The STOXX 600 remains down -4.6% in October, and the MSCI EAFE is down about -3.0%. European leaders continue to seek solutions for their economic woes; however, I believe they face significant, self-imposed obstacles.

Bond yields edged slightly upwards this past week for the first time in six weeks. The US 10-year Treasury yield rose nearly seven basis points (a basis point is .01%--similar to a penny to a dollar) to close Friday at 2.263%. The slight rise in interest rates pushed the broad Barclays US Aggregate bond index down 0.3% for the week. For the month, however, this index is up 1.3% and 5.7% for the year.

Commodities in general continue to struggle. The Dow Jones UBS Commodity index lost -0.8% last week as Gold (-0.7%) and WTI Oil (-2.1%) continued their recent slides. Grains are the notable exception to general commodity weakness. Corn and Wheat have risen in price about 10% since October 1st. Coupled with high meat prices, these increases could lead to higher food prices in the next few months.

THE TROUBLE WITH EUROPE

I wrote in my previous Update and Commentary that I had lost confidence in Europe, and despite the recent jump in key European indexes, my view remains. Let me explain.

Several recent events illustrate my concern. First, the German economy has slowed exposing economic weakness in other countries most notably France and Italy (second and third largest countries in the European Union (EU) by Gross Domestic Product--GDP). France is growing at just 0.4% and Italy is contracting -0.2% in 2014. Growth forecasts for 2015 by the International Monetary Fund show the EU growing at an anemic 1.3%, France 1%, Italy 0.8%, and Germany 1.5%.

Second, the ability of the EU to oversee member nations and enforce rules is facing its most important test to date. In response to all of the recent economic troubles, the EU strengthened its Stability and Growth Pact. Under the terms of this pact, member nations are required to reduce annual borrowing to 3% of GDP. France submitted its 2015 budget to the EU projecting borrowing of 4.3% of GDP. The French government currently spends approximately 56% of the nation’s GDP each year. Tax revenues have improved, but spending continues to grow as well. Violating the borrowing levels set by the EU subjects France to an €800 million ($1.01 billion) fine. The EU has forced smaller countries to undertake unpopular austerity measures, so the question confronting the EU is whether they will impose such a fine on France. France has indicated they will not cut spending. If the EU fails to enforce its rules on larger members, there will be no incentive for other countries to adhere to the unpopular austerity measures demanded by the EU, and call into question the viability of the EU. Investors are watching this development very closely.

Third, the EU has just concluded stress tests on 125 of the largest banks in the EU. Results just released show 25 banks failed, an increase of five banks over the last test. Initial reaction to the test results has been mixed. I think this is a negative development and shows continued weakness in the EU banking system.

Fourth, unemployment within the EU remains at high levels. According to Eurostat, unemployment throughout the EU sits at 10.1%. France’s unemployment rate is 10.5%, Italy’s is 12.3%, Spain’s is 24.7%, and Greece is 26.4%. These high unemployment rates are likely to be a drag on any economic growth long-term. Reform-minded leaders such as Italy’s Matteo Renzi have been unable to pass meaningful changes in the face of entrenched self-interests that protect existing, older workers, leaving the unemployed to settle for temporary, poor paying work. Many EU leaders face similar challenges—assuming they want to address labor reform at all.

Finally, the outlook for population growth in the EU does not bode well for the future. A growing population is necessary for economic growth. According to the Population Research Institute (PRI) European countries combined had 10% of the world’s population in 1985. By 2025 that percentage is expected to decline to just 6%. Current birth rates are about 25% below where they need to be just to replace the existing population. A large influx of immigrants into Europe from Africa/Middle East and Asia is helping to mitigate this decline, but at this time, it is uncertain to be enough to counter the trends of the past 30 years.

While population decline is a longer concern, the political dysfunction within the EU is a real and present problem. I have highlighted just a few of the problems facing the EU today. Pressure is mounting on Germany to come to the rescue once again with large public spending projects or to support the European Central Bank’s own quantitative easing program. Germans, for now, do not appear to be receptive to taking on more debt to finance such projects. Even if the Germans do change course and support some version of quantitative easing, I believe the EU will continue to postpone meaningful fiscal policy choices (cut government spending) and limp along. Better growth opportunities, in my view, will continue to be found here in the United States.

LOOKING AHEAD

Earnings season is still underway. With 70% of reporting companies exceeding profit forecasts, I would anticipate this trend to continue and help stocks.

The first case of Ebola reported in New York is certainly a cause for concern, but I believe for now this threat of an Ebola-driven sell-off has declined. As Ebola continues to challenge Africa, I believe that the medical community will improve its tactics for dealing with this deadly disease and reduce the threat there and here.

Among the key economic reports due out this week, the first estimate of 3rd quarter GDP will be released on Thursday morning. Consensus is expecting a 3.0% growth rate, and if this number is met or exceeded, I believe it will calm many investor nerves. Additionally, on Wednesday afternoon the Federal Reserve will report on its current meeting. The Federal Funds rate is expected to remain at the 0% range. Investors will be focused on the language regarding the timing of future increases in this rate. The Federal Reserve is also expected to announce the end of bond purchases officially ending this round of quantitative easing. Initial jobless claims will be announced on Thursday morning, and consensus is calling for initial claims of 280,000. This would be another positive for the markets and reflect an improving employment situation. The final report that I want to draw your attention to is the Personal Income and Outlays report of Friday morning. Consensus expects income to remain steady at 0.3% and outlays to also remain steady at 0.5%. These numbers are very important because increasing income and spending bodes well for future growth.

The mid-term elections are just nine days away. While it is difficult to determine the market impact of election results, they may certainly have some influence.

Overall the economy is slowly and steadily improving, and the likelihood of sharp correction is, in my opinion, unlikely in the near term.

If you have any questions or comments, please reach out to me.





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.

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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.

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