Tuesday, May 10, 2011

Markets changed course and drifted downwards this past week following a sharp sell-off in the commodity markets. The US dollar gained strength upon mixed economic data and then was further buoyed by a report Friday in the German publication of Der Speigel that Greece was considering withdrawal from the EU (the report was flatly denied by the Greek Prime Minister).

For the first week in May, the Dow Jones Industrial Average (DJIA) lost 172 points (-1.34%) to close at 12,639 and the S&P 500 lost 23 points (-1.72%) to close at 1340. On Thursday the markets reacted very negatively to the weekly first-time jobless report which saw claims surge only to reverse course on Friday with a solid private sector jobs report for April. For the year the DJIA is now up 9.17% and the S&P 500 is up 6.65%. The Russell 2000 lost 3.69% for the week and is now up 6.34% for the year.

Among the broad economic sectors, Health Care, Telecom, and Utilities were the best performing sectors while Energy, Materials, and Real Estate were the worst. With the price of oil tumbling, it was not surprising to see the energy sector take a sizeable hit and it has now fallen to the second best performing sector for the year behind Health Care and just ahead Real Estate. Financials, Materials, and Information Technology are the bottom three sectors so far in 2011. Health Care, Energy, Real Estate and Industrials are all above the yearly performance of the DJIA.

The MSCI (EAFE) World Index lost 2.32% for the week and is up 5.88% for the year. Europe, particularly Eastern Europe has been the strongest performing region so far in 2011. The Middle East and India dominate the bottom performers. For the week developed markets slightly outperformed emerging markets and that relationship also extends for the entire year. Both categories have underperformed the United States.

The Euro lost 5 cents (-3.38%) against the US dollar marking the worst drop in US dollar terms for the year closing Friday at $1.431. For the year the Euro has gained 9.4 cents (+7.04%) on the US dollar. Two factors contributed to this drop, first concerns over Greece's debt situation started the sell-off, and second, investors who "shorted" the US dollar (shorting is when investors sell a security or currency-in this case the US dollar--in anticipation of continued losses) had to buy back the US dollar to prevent further losses. These two immediate issues overwhelmed more fundamental issues facing the dollar such as lower interest rates and fears of US policy makers failing to make tough decisions on the US deficit. The sudden strength of the US dollar also helped exacerbate the commodity sell-off.

Commodities suffered a steep drop last week. West Texas Intermediate (WTI) oil closed Friday at $97.18 losing $16.75 (-14.70%) for the week. This one week drop sliced off nearly 75% of oil's gains in 2011 and was the largest one week drop in US dollar terms in history. For the year, WTI oil is now up 6.53%. A report in the Wall Street Journal this past weekend highlighted the fact that many of the sell orders last week came in as a result of automated trades rather than from floor traders. Like the Euro sell-off, investors who placed bets (in this case that oil would continue gaining in price) began to sell to cover their losses once the selling started that contributed to the large drop. It is uncertain if this is the start of a full correction of oil prices or just an overreaction by oil speculators. I will discuss more about the technicals of commodities shortly.

Gold lost $65.40 per ounce (-4.20%) to close at $1491.00. Although not as severe as oil's losses, this drop represented a loss of nearly 48% of the year's gains. The sell-off in gold was precipitated by a correction in silver as this metal lost nearly 27% of its value. Clearly the speculators and short-term investors ran to the sidelines as precious metals sold-off. To keep this sell-off in perspective, silver is still up nearly 15% for the year.

Collectively the broad basket of commodities was down about 9% for the week and for the year remains up nearly 2% which reinforces two facts that I believe: first, investing in commodities is volatile, and second, for most investors it makes more sense to invest in a diversified commodity investment rather than focusing on just one or two commodities.

The Barclays Aggregate Bond Index posted its fourth straight week of increases gaining 0.60% for the week. This broad-based US bond index is now up 2.43% for the year. The US 10-year Treasury yield fell from 3.283% to 3.155% last week. The 10-year Treasury yield is now at its lowest level this year (pushing bond valuations upward). The bond market benefited by the rise in the US dollar (safe haven as the Euro faltered) and fears stemming from the commodity markets which in their own way signaled that inflation may not be an immediate problem. In turn this takes pressure of the Federal Reserve to raise rates further comforting bond investors. Long-duration bonds were the best performing sector in the bond market followed by emerging market bonds, and high quality corporates. International sovereign debt bonds, preferreds, and high-yield bonds were the worst performing bond sectors. For the year, international sovereign bonds, Treasure Inflation Protection Notes (TIPs), preferreds, and high-yield bonds are the best performing bond sectors with short-duration bonds, emerging markets, and agency bonds the worst.


Everyone is asking, "is this the beginning of a full scale route on commodities?" As I scanned the flood of articles written on the subject in the financial media over the weekend I have to say most pundits simply don't know. So what do we know and how do we use that knowledge?

To start, we know that in some cases we had historic corrections. What we also know is that the commodity market acted as it has in the past. Commodity markets have always been subject to speculation. I do not mean speculation in a negative way, but rather in the sense that historically investors have had to make bets about the expected future direction of prices. What are investors speculating? In the case of agriculture, investors have worried about droughts, floods, famine, and fires. Sounds a bit biblical, but the challenges of farmers have really not changed over history; and investors who buy and sell farming products are making prices certain today while dealing with the uncertainty of tomorrow. This basic concept applies more or less the same to all commodity classes. I am greatly simplifying the process, but in general this is how commodity investing works.

Much of the speculation you see in commodity markets today is more akin to betting on the direction of prices by buying and selling commodity contracts (typically known as futures contracts) by investors who have no intention to own the commodity itself. These investors can magnify the gains or losses on commodities and create greater volatility in the day-to-day trading in commodities. I am not implying that these current day speculators are bad or that they should not be making commodity investments, rather I believe that there are very legitimate reasons for many of us to invest some part of our portfolios in commodities as a hedge against inflation. Any investment, commodities or not, can be overblown and behaviors can create bubbles when all value concerns are tossed aside in the name of getting in on a good thing.

I would argue that in the case of silver, this was a speculative bubble that has burst, for now. However, I would also say that when looking at the broad basket of commodities, the 9% drawdown was actually fairly typical. Since commodities bottomed out in December 2008, there have been six corrections of between 8% and 11% as commodities have risen to these current heights. So to invest successfully in commodities, you must be prepared for such volatility.

Getting back to the fundamental question, "what do I do now?" Do I sell my commodity holdings and take my profits, or hang on?

What I see is the overall trend for the broad basket of commodities remains positive. I also see that commodities have gone from being over-bought to over-sold. When comparing commodities to my five major asset groups (US stocks, international stocks, fixed-income, currencies, and commodities), commodities still rank #2. However, commodities also fail what I call the cash bogey. In other words, cash is now favored over commodities on a relative strength basis. In the past, this action alone would have knocked out commodities from my two favored asset categories, but recent adjustments to my methodology offers greater flexibility. So the answer to the question is: if you are risk averse, you should consider selling all or part of your commodity investments until commodities pass the cash bogey check. Otherwise, stay the course for now.

Let me expand on the adjustment to my methodology. When using relative strength as the primary tool to make buy and sell decisions, I must recognize this tool's limitations. One of the major limitations is that we can get into a situation like we are today where failing the cash bogey was always grounds to sell our holdings even though the investment is still in a long-term positive trend. This hard and fast rule work poorly when the markets quickly correct as they did during much of 2010. Likewise, this worked perfectly in 2008 when the markets tumbled and kept tumbling during the year. So I will look at your risk tolerance before making the decision to sell an investment while that investment is still in a long-term positive trend. If an investment gives a long-term sell signal, it will generally be sold.


As those of you who have regularly read my Weekly Update know I have never let the debt problems in Europe stray far from my gaze. I monitor Europe because if the European Union (EU) and Euro rise or fall dramatically it will impact us here in the United States. The situation in Greece is reaching an important interim climax in how the EU will ultimately deal with their debt crisis.

The initial plan to deal with Greece's debt was for the EU to come in and purchase €110 billion ($157 billion) of Greek debt to stabilize the government's balance sheet. The price for that bailout was Greece's adherence to strict austerity measures including spending cuts. It was thought that this initial bailout would set the conditions for Greece to come into the private bond market (as the Federal Reserve does each week) and issue another €30 billion in 2012 to meet expected needs. However, with two-year Greek notes yielding more than 23%, it is apparent that Greece will not be able to go back into the private bond market anytime soon.

The EU must decide how to deal with this. The Germans have quietly been pushing for a plan to extend the maturities on Greek debt by as much as five years, but the European Central Bank President, Claude Trichet, and the French among others are strongly opposed. Their fear is that by extending the maturities it would create a serious outflow of capital from the EU and put increasing pressure on Ireland and Portugal. The Germans do not want to restructure the debt because bondholders would receive less than face value on the bonds, and with the German government being the largest Greek bondholder in the EU, German taxpayers would be stuck with the bill.

Further meetings are scheduled and at some point this issue will be dealt with. What I do not believe will happen is Greece leaving the EU and returning to the drachma. That action would make Greek insolvent overnight and plunge the country into financial chaos.


This coming week promises to be especially interesting. All eyes will be on the commodity and currency markets. I will be one of those watching these markets closely and if there are changes to be made, I will be on the phone with my clients.

I have not changed my overall guidance regarding US stocks and Commodities. However, it is important to review each commodity position in relation to your risk tolerance. Commodities did try to rise on Friday after the release of the positive US private sector jobs data, but the troubles in Europe muted that rally. Europe will continue to be volatile given the challenges with Greece, so I continue to suggest that international investments should be made in the most technically strong securities.

I continue to favor equal weighted indexes over capitalization weighted ones. While small cap investments have slightly underperformed recently, small and mid cap investments are still the strongest on a relative strength basis. I am aware of some improvement in the large capitalization space; however, good performance is mostly found in US corporations with strong earnings abroad.

When looking at broad economic sectors, the recent volatility has made it difficult to really favor one sector over another; however, I believe that Health Care, Energy, and Industrials are strongest and Real Estate and Consumer Discretionary are solid. To make it simple, the only sector I truly do not like right now is Financials, especially the banking sector.

I have already said enough regarding the commodity sectors. Investments here are volatile and investors must be prepared to react if this asset class continues to deteriorate.

Bonds have continued to make steady and unspectacular returns. Long term, I do not like US Treasuries and I would encourage you to read Bill Gross's recent monthly commentary titled "The Caine Mutiny (Part 2)"about why he does not own US Treasuries. I continue to like preferreds, high yield, floating rates, and corporates. International bonds, although a bit battered last week, remain an important investment alternative to US dollar denominated bonds. Treasury Inflation Protection Notes offer some protection against higher interest rates for now. Although long-duration bonds outperformed again last week as interest rates pulled back, I generally do not like this bond sector in the face of an expectation of rising rates at some point in the future.

I would like to make one final comment about last week. As everyone knows, our US special operations forces killed the worst terrorist since World War II. Over the 21 years I served in the US Army I had the privilege to witness the birth of the Special Operations Command and to work directly with a number of "operators" in several positions I held. Without a doubt, these men are the finest, best trained, and dedicated soldiers, sailors, marines, and airmen our country has to offer. Their success in a far-off land was not luck but the product of the attributes found in each of them and the resources our country gives to them. I stand in awe and admiration of these special men who dedicate their lives to our benefit. God Bless America!

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.

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.

Emerging market investments involve higher risks than investments from developed countries and also 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.

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.


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, this is a market capitalization weighted index, meaning the largest companies in the S&P 500 have a greater weighting than smaller companies. The S&P 500 Equal Weighted Index is determined by giving each of the 500 stocks in the index the same weighting in 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 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. The Russell 2000 Index is comprised of the 2000 smallest companies within the Russell 3000 Index, which is made up of the 3000 biggest companies in the US.

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