Tuesday, March 15, 2016

MARKET UPDATE AND COMMENTARY
February 28, 2016


US markets have posted two consecutive positive weeks as oil prices improved by 11% over the same period.  Recent economic reports continue to signal a slow growing economy with inflation remaining under the Federal Reserve’s annualized target of 2%.  Nothing exciting, but certainly not recessionary in my view.


Time Period
Dow Jones
Industrial Average
(DJIA)

S&P 500

Russell 2000

NASDAQ
Feb 1 - 5
-1.6%
-3.1%
-4.8%
-5.4%
Feb 8 - 12
-1.4%
-0.8%
-1.4%
-0.6%
Feb 15 - 19
2.6%
2.8%
3.9%
3.5%
Feb 22 - 26
1.5%
1.6%
2.7%
2.3%
Month-to-Date
1.0%
0.4%
0.2%
-0.5%
Year-to-Date
-4.5%
-4.7%
-8.7%
-8.3%
Source:  The Wall Street Journal (Past performance is not indicative of future returns).  February 26, 2016

US small capitalization stocks (Russell 2000) and technology stocks (NASDAQ) continue to be more volatile than the Dow Jones Industrial Average (DJIA) and the S&P 500.  The stronger gains in the small cap and tech stock indexes these past two weeks has not been enough to catch up with the DJIA or S&P 500, however, it does show some renewed faith in investors in these volatile stock indexes in my view.

Growth stocks have underperformed value stocks across all market capitalizations.  This is a fairly normal scenario during market pullbacks when investors tend to seek the perceived safety in more mature, stable companies most often found in Morningstar’s definition of a value stock.  The chart to the left shows the returns by market capitalization (large, middle, small) and style (growth, blend, value) according to Morningstar®.  Additionally, value stocks also are more likely to pay a dividend, and with dividend payouts on stocks generally exceeding bond returns, value stocks can offer an even greater incentive to own for some investors.  The current dividend yield on the S&P 500 is 2.2% compared to the 1.8% yield on the US 10-year Treasury bond.  Looking back over history, Standard & Poor’s reported in 2013 that dividends contributed about one-third of this key index’s return since its founding in 1926.  During bear markets, that percentage can be even higher and helps explain the attractiveness of value stocks today.


Turning to sectors, Utilities (+6%), Telecom (+4%), and Consumer Staples (+1%) are the only three out of eleven basic economic sectors I track that are positive so far in 2016.  Financials (-10%), Health Care (-8%), and Information Technology (-6%) are the three worst performing sectors this year.  Energy (-5%) has pulled itself out of last position and is now eighth out of eleven.  The theme among sectors is the same as I highlighted in my discussion about market capitalization and stock style—defensive sectors (typically value, dividend paying stocks) are outperforming the more risky/growth stocks.  This trend can reverse quickly, but it is too early to tell if the recent positive market moves will continue.

International stocks continue to lag the US.  The challenges facing international companies continues to weigh heavily on foreign stocks.  Growth concerns in Europe and China are holding markets in these regions back.  The strong US Dollar helps in their ability to export to the US by making the price of their goods cheaper, however, a strong dollar can also have serious consequences to the economies in emerging markets.  Emerging markets are also heavily dependent on commodity production and with the collapse of oil prices, many emerging market economies are struggling.


Time Period

Global Dow xUS

STOXX 600
Dow Jones
Devel Mkt Region
Total Stock Market
Dow Jones
Emerg Mkt Region
Total Stock Market
Feb 1 - 5
-1.1%
-4.8%
-2.4%
-0.6%
Feb 8 - 12
-4.6%
-1.1%
-2.7%
-3.5%
Feb 15 - 19
4.4%
1.2%
3.6%
4.4%
Feb 22 - 26
0.2%
1.6%
1.1%
0.0%
Month-to-Date
-1.2%
-3.1%
-0.4%
0.0%
Year-to-Date
-8.2%
-9.4%
-6.7%
-7.3%
Source:  The Wall Street Journal (Past performance is not indicative of future returns).  February 26, 2016

As I noted in my opening, oil prices have climbed 11% over the past two weeks, however, this masks the continued weakness in this critical commodity.  For the year, oil prices remain down 11.5% and down 2.5% for the month of February.  The recent strength in oil prices has been attributed to talks between Saudi Arabia, Russia, Venezuela, and Qatar to cap production with the goal of stabilizing oil prices.  Here in the US, oil rigs in production continue to decline and the rig count is now 400 compared to 1609 at its peak in October 2014 according to the Wall Street Journal and Baker Hughes.  While I see all of this as the natural reaction to the current sharp decline in oil prices (-65% since July 2014), the potential for more volatility (further declines) remains very real in my view.  Agreements are very fungible and I question how effective this deal might be.  One thing these four countries have in common is that they are hemorrhaging money and need to stabilize their countries’ economies so they are certainly motivated to make a deal, however, there are many other forces/factors aligning against them that could undercut any deal.  I remain very optimistic, however, that the United States is uniquely capable of surviving this downturn in prices and exploiting its superior technology to produce oil at ever-lower costs.  It will be rough going for now, but the outlook for energy is bright in my view for the US.

IS CAUTION WARRANTED?

Investing is never an easy task.  I have been a professional advisor for nearly 17 years now and understanding investing, financial planning, and economics has become an obsession for me.  One of the biggest challenges I face, besides dealing with the uncertainties of market ups and downs, is balancing risks with the financial needs of clients.  I rarely have a client who simply wants to swing for the fences—someone who is trying to beat the markets, rather I am tasked to provide an appropriate rate of return (near-term goal) combined with meeting long-term goals of producing a livable source of income.  Meeting both goals requires compromise and sometimes getting more conservative is necessary. 

The media exacerbates investor uneasiness by spinning economic data relentlessly in an effort to drive your time and attention to a particular news outlet, or to make one political candidate or party look good or bad.  I get frustrated when I read or hear some of these statements knowing they are deceitful or at best, an incomplete truth.  My response is to focus on analysis that is more technical than subjective and to watch the trends in markets.  What I see today is the need for caution but not panic.

Much, but not all, of my technical analysis is provided by DorseyWright & Associates (DWA) based out of Richmond, Virginia.  Tommy Dorsey, one of two founders, is an icon in the financial services industry and I have spoken with him on numerous occasions gaining insight from his 40+ years of investment experience. 

The starting point of my objective analysis is the Daily Level Asset Investing (D.A.L.I)® indicator.  I have been including this chart in my recent Updates due to the changes within this very broad indicator.  The D.A.L.I® provides an objective view of the relative strength between the six major asset categories most investors use to manage their financial wealth.  As a quick review, relative strength is calculated by comparing the performance of one security, index, or economic indicator against another or a collection of many.  The strongest of them rise to the top and provide guidance of where investors should start their investment process.  You can see the current D.A.L.I® status below:






With Fixed Income (Bonds) in the top category and the rise of the Cash/Money Market category into the second position, D.A.L.I® is signaling that caution is appropriate at this time.  The recent fall of Domestic Equities from the number one position it had held since 2011 to third place is also very notable and cautionary.  Besides showing what asset category is in what position, this chart also shows the number of tallies or relative strength wins within each category has compared to the others.  The percentage number is just the percentage of tallies, and the (+0) shows the change in tallies from the previous day.  This is a very slow moving indicator and when changes occur, it is important to stop and analyze what is going on.

The next indicator I use is the Asset Class Group Score rankings.  Another proprietary DWA tool is the scoring system to evaluate securities.  This report generally matches the D.A.L.I® report, but not exactly.  A security

can have a score ranking between 0 and 6 with 6 being the strongest.  Scores above 4 (blue) are considered the strongest groups followed by those greater than 3 (green).  Scores between 2.5 and 3 (yellow) are marginal, while anything below 2.5 (red) are showing considerable weakness.  The Asset Class Group Score is an average of all of the individual scores within a category.  The number under the “Ideas” column gives you an idea of how many securities comprise the group average. 

You can see from the excerpt (above) of this current chart that Bonds dominate the top of the list.  This particular chart view is only “macro” groups and does not list every one of the 133 different asset groups DWA measures. 

The “Direction” column shows the change in score over the past six months.  A rising score shows a group gaining strength while a falling score is a sign of recent weakness.  The “OBOS %” column shows the amount a group is overbought (+) or oversold (-) based upon a ten-week trading history.  If a group is overbought by more than 100, it is considered extreme and caution should be used when entering new positions within the group.  Likewise, if a group is oversold by more than 100, it may be a good buying opportunity. 

Today the Asset Class Group Score rankings is also in a cautionary position with the US Money Market (Cash) group score exceeding 96 (72%) of all other groups.  Furthermore, the All US Equity Diversified group registers a group score of 2.60 and is considered a weak marginal score.  Commodities barely show up on this excerpt chart, while International Equities make up the majority of bottom scoring securities.

The last of the major three indicators I use in evaluating the current market condition is the New York Stock Exchange Bullish Percent (NYSEBP).  The NYSEBP is a broad indicator of whether stocks are generally on what I consider offense or defense.  The score can range from 0% to 100% and is determined by tallying all of the stocks listed on the New York Stock Exchange (NYSE) that are showing bullish demand and dividing that by the total number of stocks on the (NYSE).  When the NYSEBP is greater than 70% caution is warranted as stocks may be getting ahead of themselves, while a score below 30% is generally considered a buying opportunity.  The current NYSEBP score is 40.2% indicating a more defensive posture and supports a more cautionary approach to the markets today. 

I have been using these three (and other) indicators from DWA to help guide my investment decisions for over eight years now.  I have learned that having an objective set of criteria to evaluate securities, an asset class, a sector, or an index, is extremely valuable.  However, I have also learned that no one tool or set of data is a perfect indicator of how markets are likely to move.  Therefore, I have come to understand that a “soft touch” must be applied to making investment decisions.  I rarely take out an entire category, group, or sector simply based upon the quantitative data; rather I use the information to help alert me to underlying changes within the markets and begin taking action incrementally.  There is never one right or wrong answer to making investment decisions; however, I do believe that I can certainly get a sense of whether caution is warranted and where the stronger investment opportunities currently lie. 


LOOKING AHEAD

After walking you through a detailed discussion of how I have determined that caution should still be exercised in these markets, let me share some additional analysis.

First, because I do not believe we are headed into a recession and that we are experiencing what I would consider a more traditional market correction, I am not making any major adjustments to very long-term investment accounts like a 401(k)s.  As I see it, corrections like this are how those saving regularly for retirement years away actually make their money.  For some short-term accounts, or more risk-sensitive investors, I have certainly adjusted away from some of the more aggressive sectors (i.e. biotech, health care) and slipped into more conservative ones (i.e. telecom and consumer staples).

Second, I believe we are going to continue to struggle this year because of depressed corporate revenues and earnings.  FactSet Research Systems estimates that the S&P 500 revenue growth will decline by 3.6% for 2015 when all data is in, and will only grow at 1.9% in 2016.  The revenue and earnings collapse in the Energy sector has heavily influenced this data, but for now, all but Energy and Materials are expected to grow earnings this year albeit at a slower pace than most investors would like to see.  I believe that expectations of revenue and earnings growth is what propels markets up or down, and with modest growth expected for the year, it leaves little room for a robust rally in stock markets for now.  Job and wage growth could help improve this outlook and I will be watching these closely.

Translating this growth and earnings outlook into current relative strength, you can see where the DWA sector relative strength stands today:

 


Consumer Non-Cyclical, also referred to as Consumer Staples, and Utilities are considered defensive sectors and reflect the defensive nature of the markets today.  When I insert the Money Market category into the relative strength analysis, it falls into the #3 ranking reinforcing the current defensive nature of the markets.

Third, the Federal Reserve’s uncertainty over monetary policy hangs over the market creating unpleasantness much like being downwind to a cattle feeder lot—a reference to my childhood days in Nebraska.  As I said in my last Update we simply cannot get away from the influences of the Fed’s actions to raise or not raise interest rates.  It is not so much about the impact of a quarter percent increase in the overnight lending rate, but rather a critique over the strength of the markets here and abroad.  If jobs and wage growth continues, watch for worries about inflation to resurface.

Fourth, the Presidential elections loom large and may well contribute to investor anxiety as we approach the conventions this summer and the general election this November.  The Biotech sector, in my view, has been severely hurt by the campaign rhetoric by several of the leading contenders on both sides, and we may see more of the same in other sectors—good or bad.

Fifth, the energy sector has been closely linked to the stock market—not a normal condition.  The rise or fall of oil prices has, in my view, been a barometer of global growth expectations.  I believe the current rebound in oil prices has been a result of the talks by some countries to cap production.  I am doubtful that they will succeed, therefore, I do not expect to see the volatility in oil prices to stop.  I do believe that we will eventually find an equilibrium in production and demand which in turn will help stabilize prices.

When all of these considerations are put into one bundle it suggests, in my opinion, that we have the potential to see more volatility and no clear direction in the markets.  That being said, I am always watching the data for trends to develop.  I will certainly report what I see as we move through the year.

Finally, I encourage everyone to look at their investments wherever they are and assess your risk tolerance within the framework of what the investment objectives you have laid out and decide if portfolio is still consistent with those objectives.  If you are great, if not, make adjustments.

I am happy to help anyone who has questions so do not hesitate to pick up your phone 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.

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 sub indices, measuring both sectors and stock-size segments, are calculated for each country and region.

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.