Tuesday, July 19, 2011

US and global markets sagged under the weight of the European debt crisis and the fiscal uncertainty here at home.

The Dow Jones Industrial Average (DJIA) lost 177 points (-1.40%) last week as the S&P 500 gave back 28 points (-2.06%) and the Russell 2000 fell 24 points (-2.79%) pushing July returns back to near zero indicating that markets are struggling to digest and trade on the uneven news coming from Washington in the form of the debt ceiling debate and continued weak economic news. For the year the DJIA is up 7.79%, the S&P 500 is up 4.65%, and the Russell 2000 is up 5.76%.

Turning to specific sectors, only the Energy sector posted a positive gain of approximately 0.40% last week with the best performance found in the exploration and production sub-sector. Utilities and Consumer Staples outperformed the DJIA followed closely by Health Care. Financials, Industrials, and Telecom were the bottom three performers for the week. For the year, Energy, Health Care, and Real Estate lead while Financials, Information Technology, and Materials rank as the bottom three. Beyond the strong performance of the Energy, Health Care, and Real Estate sectors, every other of the eight remaining sectors (except Financials) have performed adequately and have not been a drag on portfolios. Financials continue to perform very poorly and I continue to avoid this sector completely.

International markets continue to struggle. The MSCI (EAFE) index was down 2.71% last week and is up just 0.17% for the year. On a regional basis, Europe has underperformed so far in July with Greece, Portugal, Italy, Spain, and France holding five of the bottom six positions globally for the month of July. Europe owns the bottom 14 country spots (out of 64 that I follow) so far in July as investors express doubts about the financial health of this region. Asia continues to lead building on early momentum this month. For the year, the United States ranks a respectable 17th out of 64 countries. Among the BRIC countries, Brazil, Russia, China, and India, only Russia is solidly positive for the year while China is off nearly 3% and Brazil and India are each of about 9%. This underperformance highlights the challenges that emerging markets have had this year coping with surging commodity prices and local inflation. Most emerging market governments have had to implement policies to curb economic growth to fight inflation and this in turn has hurt equity markets.

The US dollar weakened slightly and the Euro also gave back about a penny closing last week at $1.416. The US dollar has been on a generally positive trend since mid-April and this has helped hold back commodity prices, however, recently the US dollar has shown weakness especially after Fed Chairman Bernanke expressed his support for low interest rates and indicated a willingness to step in with another round of bond purchases (QE III) should conditions warrant.

Commodities have been bolstered this month by a surge in gold prices of nearly 6% in July along with almost a 2% increase in oil prices. Gold jumped $48.50 an ounce (3.15%) last week to close on Friday at $1590.10. WTI Oil added $1.04 per barrel to close Friday at $97.24. The impact of new supply provided by the Strategic Oil Reserve has done little to curb prices. Gold prices reflect uncertainty in investors minds while oil prices indicate a combination of demand and currency movements. The Dow Jones UBS Commodity Index has gained 2.8% for the week on the strength of precious metals (silver has also been performing well recently) and is now up 1.30% for the year.

The Barclays Aggregate Bond Index had its best weekly performance (+0.97%) so far in 2011 as investors continue to see a mountain of sub-par economic data, a continued accommodative Fed, and a firm belief that Washington will not default on its obligations. For the year, the Barclays is now up 3.99%. The 10-year Treasury yield closed Friday at 2.905% which is off lows reached earlier in the week. Longer duration bonds and inflation protection notes (TIPs) were among the best performers while International, preferreds, and high yield bonds were the worst. For the year, International, municipals, and TIPs have been the best performing general category of bonds while very short-term treasuries have been the worst.

UNCERTAINTY MOUNTS

For those of you who have been reading my Update regularly you know that I have consistently said that the price of gold is a measure of uncertainty in the markets. Looking across the global landscape one only sees uncertainty and worry. Uncertainty and worry are not new to financial markets, just look at American history over the past 100 years. This country has fought two world wars, numerous smaller conflicts, survived the Great Depression, an unprecedented oil embargo, and a cowardly terrorist attack on our nation. We have lived under the cloud of nuclear annihilation for nearly 70 years and yet the United States and world economy has expanded. So a little perspective helps now.

We are, however, confronting what I believe to be the crisis of our lifetimes. Spending and debt are at record levels in nearly all of the developed countries not just here. I recently saw a chart in the Wall Street Journal that illustrated US debt as a percentage of Gross Domestic Product (GDP). The chart shows that in the history of this country, we are at levels seen only during World War II when debt to GDP exceeded 100%. What the chart also shows is that the nation's debt was cut drastically in the years immediately following the war when 12 million servicemen and women were discharged from the military and military budgets were slashed. Looking forward from here, there is no such option. We cannot "discharge" the millions and millions of Americans living on social security or using Medicare. These numbers are only going to grow.

Europe is confronting an economic system that can only be described as flawed. Germany, France, and the Netherlands are supporting the spendthrift countries found in the southern regions of Europe. Reports that politicians are at least acknowledging that Greece has no chance of repaying its debt is helping reshape discussions to a more realistic outcome. For the first time leaders are looking at more than just kicking the can down the road.

A recent editorial on Bloomberg.com by Carmen Reinhart and Kenneth Rogoff (Too Much Debt Means the Economy Can't Grow: Reinhart and Rogoff) postulated that if debt to GDP ratio exceeds 90%, countries are increasingly unlikely to be capable of growing their way out of debt and suffer slow growth until the debt is retired either through default or inflation. The article also discusses that in developed countries, interest can rates remain relatively low as governments use financial repression to help pay off debt (interest rates are below real rates of growth). They also point out that higher interest rates generally do not signal a problem until very late in the game if at all. Japan continues to be the most recent example of this.

So how does this information translate to gold at $1600 per ounce? It signals a lack of confidence. A lack of confidence that the US political leadership will be able to lead our nation to a sustainable conclusion of the current debt burdens, that the Europeans will continue to struggle with unruly member nations, and that it is better to hold a tangible asset than the paper promises of countries that are growing increasingly fiscally unsound. So as you try to make sense of all of the macro economic data that is discussed in the media, just watch the price of gold and the rate on the US 10-year Treasury note. High gold prices and low interest rates signal pessimism while lower gold prices and higher interest rates would signal optimism.

LOOKING AHEAD

Last week's economic data was not good. First time unemployment claims remained above 400,000, consumer confidence is at very low levels, industrial output is anemic, and inflation is a little better but creeping upwards. Yet the DJIA is up over 9%, the United States is outperforming most countries around the world, and corporate earnings continue to come in strong.

US Stocks remained favored over Commodities, International Stocks, Bonds, and Currencies. Commodities, International Stocks, Bonds, and Currencies is trending weaker while US stocks continue to hold. Stocks are still favored over bonds, small and mid-capitalization stocks favored over large. Growth over value, and equal-weighted indexes over capitalization-weighted. Large capitalization stocks have shown signs of life and while I continue to prefer small and mid-capitalization stocks, I believe that large growth stocks will not be a drag on portfolio returns.

I maintain my comments about sectors. While I have no significant preference within the various broad economic sectors other than avoiding Financials, I am concentrating more on Health Care, Consumer Staples, Real Estate, and Energy. Utilities have proven to be a good bond-alternative option within the equity space.

International investments should be carefully considered. The strength around the world has been weak at best and any holdings should be evaluated with only the strongest technical holdings kept in the portfolio. From a relative strength basis, I continue to prefer Emerging Markets over Developed Markets.

Commodities have rebounded recently. Gold and silver are especially strong. Oil remains in a negative trend so I am less committed to oil in the near-term than I have been; however, I read a recent observation in the Wall Street Journal that said oil will win regardless of what the economy does. If economies falter, the Fed is likely to maintain a weak dollar policy (favors commodities) and if the economy strengthens demand will grow favoring oil. I am not initiating new positions in oil at this time, but I am not pushing to sell existing ones for now. Please keep in mind that commodities is a highly volatile asset class and entering positions in this category should be done so with the understanding that you are likely to experience greater volatility than with many other investments.

Bonds have been a stable investment so far in 2011. With the pullback late in June, bonds are not nearly as overbought as they had been and I believe remain attractive for now. I prefer high quality corporates, emerging market debt, and TIPs.

All eyes will remain on Washington and Brussels as the US and Europe will be working on their debt problems. Based upon US interest rates and the strength of the Euro, investors believe resolutions are coming; however, the rising price of gold show that they are hedging their bets!

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 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 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.

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, 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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