Tuesday, March 1, 2011

The past week was dominated yet again by the turmoil in the Middle East with the focus turning away from Egypt and on to Libya. In response to the turmoil there, oil and gold prices jumped, the stock market fell, and interest rates dropped.

Stock markets around the world posted losses last week as investors struggled to gauge the new risks posed by the unrest in Libya. The Dow Jones Industrial Average (DJIA) lost 261 points (-2.10%) to close the week at 12,130 and the S&P 500 gave back 23 points (-1.72%) to close at 1320. For both indexes it was the largest percentage drop since the week of November 12, 2010. For the year, the DJIA is up 4.78% and the S&P 500 is up 4.95%. The Russell 2000 lost 12.27 points (-1.47%) and for the year is up 4.89%.

Among the broad economic sectors in the US economy, only Energy posted a positive gain last week, however, the next two best performing sectors: Utilities and Real Estate were off just marginally. Industrials, Materials, and Consumer Discretionary were the bottom three sectors for the week. Year-to-date Energy, Information Technology, and Industrials are the top performing sectors while Telecom, Consumer Staples, and Utilities are the worst. Only the Telecom sector has a negative return so far for 2011.

The MSCI (EAFE) World Index lost 1.56% for the week and is now up 4.42% for the year. Developed Markets, predominantly European countries, have outperformed so far in 2011. As I have highlighted in previous Weekly Updates, the best performing countries this year were last year's dogs. Greece, Spain, and Italy are all up double digits while France and Portugal are also well above the MSCI (EAFE) World Index return. Emerging Markets are continuing to struggle. India, the largest of the emerging market countries, is down 15% so far in 2011. Chile and Turkey are also down double digits. The international space continues to challenge investors.

The Euro continued its gains against the US dollar last week adding 0.41% closing at $1.3754 compared to the previous week's close of $1.3698. For the year, the Euro is up 2.88% compared to the US dollar. The Euro ended 2010 at $1.3369. The strength or weakness of the US dollar recently remains fixed to investor expectations regarding interest rates with the notion of the US dollar serving as a "safe haven" as a secondary driver. Here in the United States, the Chairman of the Federal Reserve, Ben Bernanke, has continually reinforced his commitment to an accommodative monetary policy (low interest rates and growing money supply) which continues to hold US interest rates down and lowers the demand for US debt. With lower yields, foreign investors have less interest in US debt and will look elsewhere for higher yielding debt thus lowering demand for US dollars, keeping our currency cheaper compared to other currencies.

There are enormous geopolitical consequences to a weak dollar both here and abroad. We are seeing some of this played out today as food inflation is helping to foster the unrest we are seeing in the Arab world. Emerging market countries are dealing with new inflation pressures and are resorting to tightening monetary policies to stem the impact of cheap US dollars flooding the world contributing in part to their recent under-performance.

Gold closed Friday at $1409.30 after another week of strong gains. Gold is now up 5.66% for the month and is just below the close of 2010 of $1419.70. Investors will continue to use gold as a hedge against uncertainty around the world. Compared to stocks, gold has not been a great investment this year, however, when stock markets suffer under the weight of political unrest; gold has served as a hedge against this uncertainty. I hold gold today for this reason.

Oil was the biggest mover in the commodity space last week. With worries of a disruption of Libyan oil supplies, oil gained $11.88 per barrel (13.81%) for West Texas Intermediate. At one point during the week, oil jumped to $103 per barrel before pulling back on the news that Saudi Arabia would step up oil production to make up for the loss of Libyan oil. Gasoline prices have jumped dramatically at the pump here at home as I know everyone is aware. I recently paid $3.49 per gallon which is the most I have paid since oil prices shot up to $147 a barrel in 2008. I will discuss the impact of oil prices on the economy in a moment.

Bonds rallied for a second week with the Barclays Aggregate Bond Index gaining 0.73% and is now up 0.22% for the year. The 10-year Treasury yield closed Friday at 3.415% down from the previous week's close of 3.634%. This was the largest drop of the 10-year yield so far in 2011. The 30-year Treasury yield also fell last week to 4.497% from the previous Friday's close of 4.716%. With oil prices rising dramatically, and with it inflationary expectations, you may be wondering why longer-term interest rates fell. I will offer an explanation below.

GLOBAL UNREST, OIL PRICES SURGE, AND INTEREST RATES DECLINE--WHY?

Oil prices surged last week over concerns that the Middle East oil supply was at risk of interruption. Prices pulled back somewhat when Saudi Arabia said it would make up any supply shortfalls from Libya calming investor worries. Nonetheless, oil still gained nearly 14% and for a time reached $100 per barrel. Why did the equity and bond markets react the way they did?

Stocks pulled back for several reasons. For starters, stock markets hate uncertainty, and the unrest abroad makes investors nervous. The worst possible scenario would be for the unrest in the Middle East to spread to Saudi Arabia. If that should happen, then you would see a major correction of stock markets all over the world. As of this moment, it is too early to tell what the final outcome of all of this will be. I do believe the face of the Middle East, for good or bad, will be significantly altered. Second, higher priced oil serves as a drag on global economies. For every extra dollar or euro spent on oil, there is one less to spend on other items. And this anticipated effect is what has had the greatest impact on the US stock market. Let me put it another way, for every $10 increase in the price of oil, the US will spend another $75 billion for oil and not on clothes, furniture, electronic gadgets, or other items. Goldman Sachs has published a paper that suggests that for every $10 increase in the price of a barrel of oil it will shave 0.2% off the US Gross Domestic Product (GDP). This major diversion of US dollars away from other sectors and industries at a time when the fragile US recovery is still in doubt will hurt family budgets and corporate profits.

The bond market's reaction may be the most curious of all. Bond investors hate inflation. They hate higher interest rates. With oil prices surging, the prevailing view should be that inflation is just around the corner. Yet bond yields fell. The 30-year Treasury yield is most sensitive to inflationary worries and that yield fell last week. The bond markets are signaling that inflation is not the problem, but a slowing economy is. Bond investors do well in weak economic times when inflation is tame. Additionally, as investors fear the stock market, they turn to the bond market and this additional demand helps push up bond prices and yields down.

So watch the 10-year and 30-year Treasury yields for inflation expectations. Watch the price of gold for the level of uncertainty in the world, and the stock markets for investor expectations of economic growth within their respective countries.

A BRIEF WORD ON EUROPE

Irish voters went to the polls this past Friday. The ruling party, Fianna Fail, is expected to be thrashed by voters after being in power for the past 13 years and overseeing the bank debacle and agreeing to the bailout by the European Union (EU) and International Monetary Fund (IMF). According to the Wall Street Journal this past weekend, the Fine Gael party (a slightly center-right organization) is expected to win the most seats; however, it is doubtful that it will be enough to form a ruling majority. If other, more liberal parties gain a solid position within the Parliament, the terms of the bailout may be called into question, and the Irish may renege on previous bailout terms hurting the credibility of the EU and the Euro.

I raise this point to highlight the difficulty the Europeans can expect to have as the EU finance ministers meet in March to craft new terms to the EU bailout fund. Remember that at the heart of the new terms being pressed by Germany and France is to require countries that take loans to become more compliant to the EU and the European Central Bank's terms. In other words, a country would be required to give up a portion of its sovereignty to the EU. The loss of power by Fianna Fail will serve as a strong warning to other politicians considering a bailout. Portuguese leaders have been adamant about rejecting a bailout, and the reason may be more for political survival than any other. When asked to give up their sovereignty, European leaders may try to find other alternatives to the EU's proposed heavy hand. Because it is not on the front page of the Wall Street Journal or Financial Times, it does not mean that the European debt crisis is over and all is good in Euroland. I suggest that it is imperative to not lose sight of what is going on in Europe.

Looking Ahead

Unrest around the world, particularly in the Middle East, continues. By the time this Weekly Update is published, Libya may have a new leader, or at least Gadhafi could be gone. There is no clear picture of whom or what would replace the dictator if he should fall. Let us all hope and pray that the transition can proceed with a minimal loss of life and without the country imploding into chaos.

I also have mentioned before that China is getting pressured by outside Chinese dissidents to become more democratic. China has many of the same problems that have contributed to the unrest in the Middle East: inflation, high food prices, growing unemployment, corruption by government officials, and growing disparity between the haves and have nots. I expect that the autocrats that run China to move quickly to quash all pro-democracy efforts as they have in the past. This will not, however, fix the problems that are affecting the economy. For the year, China's markets are off by over 2%.

The first week of the month brings important economic data. After the Department of Labor announced last week that the nation's GDP was revised downward from an annual rate of 3.2% in the 4th Quarter, to 2.8%, the data on January unemployment will be watched carefully (released at 8:30 AM on March 4th, Friday). The economic data is not all bad and there has been growth, but any sign of weakness would be problematic. Key data being released: Monday-Personal Income, Pending Home Sales, and the Chicago Purchasing Manager's Index; Tuesday-Construction Spending, and the ISM Manufacturing Index; Thursday-ISM Non-manufacturing Index; and Friday is the Unemployment Rate.

The New York Stock Exchange Bullish Percent fell to 76.37 last week. Not enough to reverse so demand for stocks remains in control. It will take a reading of 74.32 to cause a reversal. Small and mid-capitalization stocks remain favored. Equal-weighted indexes are favored over capitalization-weighted indexes. US and International stocks are favored over Commodities, Bonds, and Foreign Currencies. Emerging Markets remain preferred over Developed Markets (this relationship is under pressure right now).

My favored sectors are Energy, Technology, and Industrials. My views on bonds have not changed in 2011. Bonds will return bond-like returns. Nothing spectacular. On a relative strength basis, High Yield, Preferred, and Floating-Rate bonds are favored. Intermediate-term corporates continue to perform well.

Commodities are volatile. I continue to believe that oil prices are clearly sensitive to the uncertainty in the Middle East and any threats to supplies in any of the oil producing countries can cause a sharp increase in prices. A falling US dollar will also contribute to an increase in commodity prices in general. Gold is trying to get even for the year. I believe that if you own gold, keep it. Gold remains a hedge against the global uncertainties. I see no reason at this time to sell any commodities in portfolios.

On a personal note I want to thank all of you who have sent me kind notes about my involvement in last weekend's Wall Street Journal article titled "Boomers Find 401(k) Plans Fall Short." I was privileged to speak to the article's author, Jim Browning, a number of times about this important subject, and his article was extremely well received and picked up by nearly every major news outlet around the country. If you have not seen or read the article, please contact me and I will make sure you get a copy.

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.

As always, if you have any specific questions on your portfolio or wish to talk to me, please do not hesitate to call.

P.S. If you think this type of analysis would be of benefit to anyone you know, please share this communication with them.

Sincerely,

Paul Merritt, MBA, AIF(R). CRPC(R) Principal NTrust Wealth Management

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.

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. The Dow Jones Industrial Average is based on the average performance of 30 large U.S. companies monitored by Dow Jones & Company. The Dow Jones Corporate Bond Index is comprised of 96 investment grade issues that are divided into the industrial, financial, and utility/telecom sectors. They are further divided by maturity with each of the sectors represented by 2, 5, 10 and 30-year maturities. The Morgan Stanley Capital International (MSCI) Europe, Australia and Far East (EAFE) Index is a broad-based index composed of non U.S. stocks traded on the major exchanges around the globe.

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