Thursday, October 13, 2011

US and global markets managed to rally this past week on less bad US economic news and speculation that Europe may be considering a plan to recapitalize European banks.

The Dow Jones Industrial Average (DJIA) gained 1.74% (190 points) last week while the S&P 500 gained 2.12% and the Russell 2000 ticked up 1.87%. US markets rallied Friday morning after the September jobs report showed a net increase of 103,000 jobs when an increase of 65,000 was anticipated. The unemployment rate of 9.1% remained unchanged reinforcing worries that the US economy will continue to lag for some time. For the year, the DJIA is now down 4.10%, the S&P 500 is off 8.12%, and the Russell 2000 is down 16.26%.

Seven of the eleven major economic sectors were positive for the week led by Materials, Consumer Discretionary and Industrials, while Real Estate, Telecom, and Utilities performed the worst. Traditionally defensive sectors, Utilities, Consumer Staples, and Health Care remain the only positive sectors for 2011. Financials, Materials, Industrials, and Energy are down more than double digits and are currently underperforming the DJIA and S&P 500.

The MSCI EAFE gained 2.00% and has now rebounded 5.22% in the past two weeks driven by investor optimism that European leaders were looking at a coordinated plan to recapitalize the region's banks. Additionally, the European Central Bank (ECB) announced that it would continue to provide unlimited funds for European banks by purchasing certain categories of bonds for the next year. The move is viewed as a way to give the political leaders more time to make banks healthier in the event of a Greek bankruptcy. For the year, the MSCI EAFE is now down 15.52%.

The Euro remained essentially unchanged against the US dollar last week but continued a six-week pullback against the Japanese Yen. The ECB's decision to hold interest rates at 1.5% helped maintain the Euro's strength to the US dollar. For the year, the Euro has given back all its gains against the US dollar and closed the week at $1.3380 compared to opening 2011 at $1.3369.

Commodities in general rallied over the past week on the "less bad" economic data coming out of the US. The Dow Jones UBS Commodity Index, a broad basket commodity index, gained 1.21% helped primarily by the 4.8% increase in WTI crude oil. Oil is particularly sensitive to perceived global supply and demand adjustments and with the improved jobs report in the US, traders raised their bets on oil. Base metals, those used primarily in manufacturing such as copper, tin, and nickel, were the best performing commodities last week. This is consistent with the strong weekly performance in the Materials sector. Natural gas and platinum were the worst performers. Gold also gained $13.50 per ounce (0.83%) as investors shifted money away from US Treasuries and into gold. WTI oil is now down 9.03% for the year and gold is up 15.22%.

Bond markets pulled back for the second consecutive week as US Treasury interest rates continued to rise pushing down bond valuations. The 10-year interest rate increased from 1.91% a week earlier to close Friday at 2.08%. The 30-year rate also increased from 2.91% to 3.02%. Emerging market sovereign debt, high yield, and inflation protection notes were the best performing sectors within the fixed-income asset category while extended maturity bonds (greater than 20 years) were the worst performers. The Barclay's Aggregate US Bond Index closed down 0.63% last week but remains up 6.40% for the year. It is too early to tell if the two-week pull back in bonds is the start of a longer-term trend or just a brief aberration. It does warrant on-going monitoring.

DOES EUROPE FINALLY GET IT?

German Chancellor Merkel stated last Wednesday that Germany supported the recapitalization of banks if the situation warranted. While it remains to be seen if other leaders support her, it does mark a critical shift in the conversation among European leaders. It is also important to keep in mind that most European banks have substantial holdings in the debt from many countries, not just Greece...making debt stability in the Euro Zone such a vital issue.

Implied within her remarks is a tacit admission that Greece is likely to default on its sovereign debt-a view already reached by the private sector and confirmed by the ratings agencies. By acknowledging that Greece is unlikely to repay its debt, it may be possible for European leaders to take the first step in dealing with this crucial problem. Protecting banks is essential, but ultimately the EU must deal with member countries that are not growing fast enough to keep up with their spending. The English edition of Der Spiegel has an outstanding series of articles titled "What Options Are Left for the Common Currency?" that deals with this problem in depth: http://www.spiegel.de/international/europe.

I readily admit that a discussion of bank capitalization is a bit dull and technical, but I ask for your patience as I spend a few moments to review this important concept and explain the ramifications this has on the economy.

Banks are required by regulators to keep sufficient reserves on hand to deal with "unexpected" circumstances. Think of it like your own "emergency fund" that most households maintain in a savings account. Determining the appropriate size of the reserve is critical because funds held in the bank are not available for purchases in the case of households or lending in the case of banks. Regulators must set standards that ensure there is enough capital to keep banks solvent without hindering economic activity across a country or globally. Set aside too much cash and a recession can occur.

Most countries adhere to the capital requirements established by the Bank for International Settlements (BIS) located in Basel, Switzerland. Central bankers, like Fed Chairman Bernanke, work with the BIS to set guidelines

on banking that are subsequently adopted by individual countries. The capital requirement for a bank (and I am greatly simplifying) is determined by a complex formula that assigns various risk weightings for the types of assets owned by a typical bank. For example, cash and sovereign debt have a risk weighting of zero meaning that a bank does not need to set aside funds for these "riskless" assets while other loans may require reserves of up to 100% of the face value of the loan.

What makes the current situation in Europe so challenging is determining the appropriate risk weighting assigned to sovereign debt, especially the debt for Greece, Portugal, Spain, and Italy. Without an adjustment to reflect the growing risk of default in all of these countries, banks remain undercapitalized and therefore vulnerable to default by any of these countries. Assign too much risk and you increase the likelihood of recession. Chancellor Merkel's comments about bank capitalization will be meaningful only if coupled with a clear analysis of how much risk individual banks have by holding sovereign debt and a consensus by the EU members to provide assets to the banks to increase capitalization. By comparison, in 2008 US banks were initially supported by the Federal Reserve and have since raised capital through private investors (most recent example of this was Warren Buffett's $5 billion investment in Bank of America). This is exactly how Europe should proceed.

Europe faces additional risks because of the slow pace it takes to reach agreement on anything. If the private markets lose faith faster than European leaders can act, the situation could rapidly spin out of control bringing down many banks and pushing the world into a second major recession. The downgrade of Spain and Italy by Fitch Ratings on Friday will increase the pressure of European leaders to act quickly. I make no prediction about how this will unfold and anyone who does is merely speculating, but I am encouraged by this change in dialogue.

LOOKING AHEAD

After the sell-off in equity markets last Monday, October 3rd, US stocks fell from the number one asset category to the third. Foreign currencies moved to first followed by Commodities in second. Fixed-income remains fourth and International stocks remain firmly in fifth and last place. Within the foreign currency asset category, the Japanese Yen, Chinese Yuan, and US dollar are favored.

Even though the major US indexes all rose last week, the New York Stock Exchange Bullish Percent (NYSEBP) fell again from 23.98 to 23.09 with supply (selling) in control. The NYSEBP violated the August 8th low of 21.38 on October 4th reaching 17.47 before rallying to its current level. The NYSEBP indicates how washed out this market currently is and that a lot of risk has been removed. However, risk remains and with US stocks falling to the third of five asset categories and failing the cash bogey check, it would be premature to increase allocations into US stocks for all but the most aggressive investors.

I continue to recommend significantly underweighting international stocks, and I am not adding to my commodity allocations at this time.

Within the US stock category, mid-capitalization growth stocks are favored. On a relative strength basis, Consumer Staples, Utilities, and Consumer Discretionary are the strongest sectors while Financials, Industrials, and Materials are the weakest.

US bonds have come under pressure but most bond sectors remain positive year-to-date. International bonds rallied last week with the news coming from Europe. I do not recommend selling bond holdings and favor inflation protected bonds and international bonds at this time.

I continue to like gold. The recent selloff has come more from investors seeking profits rather than a reduction in the uncertainty factor in markets.

US markets are closed on Monday in observance of Columbus Day. The key economic events for the week will be the release of the Fed's Open Market Committee meeting notes on Wednesday afternoon, the regular initial jobless claims announcement on Thursday morning, and Retail Sales on Friday morning.

All eyes will continue to be on Europe. Will other European leaders endorse Merkel's call for recapitalization and if so, what plan will emerge for funding banks. The market's patience may come to a swift end if nothing substantive is undertaken.

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 generallyare 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 fi nancial 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.

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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