Tuesday, November 1, 2011

Global markets reacted to the news from European leaders that they had reached a broad consensus on dealing with the debt crisis with a strong rally on Thursday and an October for the record books. The US showed signs that a second recession was not imminent (US 3rd Qtr GDP +2.5%), and perceived risk in the market shrank as the Chicago Board Options Exchange Volatility Index fell to below 30 for the first time in three months.

The Dow Jones Industrial Average (DJIA) had another strong week gaining 3.58% (422 points) last week while the S&P 500 gained 3.78% and the Russell 2000 added 6.82%. With just one trading day remaining in October, the month is poised to be one of the strongest in the past quarter century. As of market close on Friday the DJIA is up 12.07% for the month, the S&P 500 is up 13.58%, and the Russell 2000 has returned 18.14%. As welcomed as October's rally has been, the indexes remain relatively flat for the year. For 2011, the DJIA is up 1.20%, the S&P 500 is up 2.18% and the Russell 2000 is still down 2.89%.

Every major US economic sector was positive last week with the strongest performances turned in by the generally weakest sectors in 2011. Materials, Real Estate, Financials, and Energy were the best performing sectors while Consumer Staples, Utilities, Consumer Discretionary, and Telecom were the poorest. Looking at the inconsistent sector returns this year reveals unsettled traders moving in and out of defensive sectors depending on their perceptions of risk on a nearly daily basis. This "Risk On" and "Risk Off" nature of the markets is emerging as the one consistent theme for 2011. For the year Utilities, Consumer Staples, Health Care, and Energy are the top performing sectors with Financials, Materials, Telecom, and Industrials the worse.

Europe posted strong gains with the MSCI EAFE adding another 6.27% last week but remains down 5.88% for the year. Europe has been the best performing region in the world for October followed by the Americas, Africa, and the Pacific Region. All but the Pacific Region posted double-digit gains. For the year, the Americas is slightly negative but leading all other regions. Africa, weighed down by the Middle East, and the Pacific Region are the two weakest regions.

The Euro continued to rebound against the US Dollar. On Friday, the Euro closed at $1.415 marking its best close to the US Dollar since September 2nd. For the week, the Euro gained $0.026 (1.87%) and has rallied $0.075 (5.60%) against the US Dollar in October. The US Dollar has fallen steadily against most major currencies since October 4th as investors shifted away from the safe-haven US Dollar to riskier currencies.

The commodity rally remained in place last week as the US Dollar continued to weaken and expectations that the global economy would not dip into another recession (primarily because of US economic data). The Dow Jones UBS Commodity Index gained 4.09% last week and is up 7.67% for the month. West Texas Intermediate (WTI) oil gained $5.60 (6.41%) per barrel this past week to close Friday at $93.00. Gold gained $110.70 (6.77%) per ounce for a Friday close of $1746.80. Gold and precious metals lead all commodities in 2011. For gold investors this is good, but I am cautious about this trend. As I have said many times, gold is a hedge against uncertainty. If investors are concerned about the overall value of paper currencies, they buy gold. If they are confident in global leaders' ability to manage their debt and currencies, then the price of gold would be expected to pull back or at least pause. Investors are showing confidence in a growing global economy but hedging their bets on global leadership.

US Treasuries pulled back with interest rates rising for the fourth time in five weeks. Longer duration US Treasuries were the worst performing bond sector this past week while higher risk bonds such as preferreds, high yield, and inflation protection bonds-along with international bonds, were the best performers. The weakening US Dollar is helping international bonds. The 10-year interest rate on the 10-year US Treasury increased from 2.25% a week earlier to close Friday at 2.33%. The 30-year rate also increased from 3.24% to 3.38%. The Barclay's Aggregate US Bond Index gained 0.16% last week and remains up 6.68% for the year.


Much has been made of the progress by European leaders in their efforts to address the credit crisis in Greece and preventing a spillover into Italy. October so far has followed the old trader adage, "buy on the rumor, sell on the news," as stock investors have bought heavily into the current European agreement. The question is will they sell on the news?

I have cheered the recognition of European leaders that some default on Greek debt was inevitable, and the reported agreement to reduce the value of existing Greek bonds by 50% is clearly a step in the right direction. However, a lot of work remains towards resolving this debt crisis.

Let's look at one of the three pillars of the new framework agreed to by the European Union (EU) leadership-expansion of the European Financial Stability Fund (EFSF)-as an example of how much work still remains. The EU has currently pledged some €440 billion ($623 billion) to fund the EFSF, but most observers believe that this amount will be inadequate to deal with not only Greece, but also Portugal, and ultimately Italy. With Germany resisting more direct funding, the EU leadership has decided to use leverage to boost the value of the fund to upwards of €1.4 trillion ($1.98 trillion). Leverage would be achieved by the EU using the existing EFSF funds to guarantee the first 20% or more of any losses incurred by new bond investors if further debt restructurings are required. However, to push the value of the EFSF upwards, the additional €1 trillion ($1.4 trillion) must come from somewhere, and that is the potential sticking point. Europe is looking at China and possibly Japan for the additional funding, but China in particular is sending very cautious signals to Europe about any expected help. So an agreement to leverage is a far cry of having outside investors ready and willing to provide the funding to achieve that leverage.

Stock markets are certainly an indication of investor confidence surrounding the efforts of the EU to stuff the bad Greek debt Genie back into its bottle, but I believe the bond markets will provide the true verdict of the success or failure of the EU. After all, the bond market has forced Europe into this crisis and bond investors will ultimately determine the fate of the debtor countries. The Italians are the biggest player by far in the European bond market with over €1.9 trillion ($2.7 trillion) of outstanding debt. The yield on the Italian 10-year Treasury bond increased last week to just over 6% indicating bond investors are growing less confident in the Italian government. A successful EU solution would reflect falling interest rates in Italy, not rising.


Markets in 2011 have been subject to heightened volatility in both directions. This behavior has led to inconsistent and unimpressive results, but what is becoming more predictable is what happens when the markets enter into either a Risk On or a Risk Off day. I believe for now this trend will continue. I will try and explain what this means and why it has occurred.

On days when Risk is On we generally see the following:

Stocks UP, US Bonds DOWN, International Bonds UP, Commodities UP, US Dollar DOWN

On days when Risk is Off we generally see the opposite:

Stocks DOWN, US Bonds UP, International Bonds DOWN, Commodities DOWN, US Dollar UP

The news from Europe has been dictating the Risk On or Risk Off sentiment in the markets. The market rally over the past month has been driven by speculation that the Europeans have finally realized that Greek debt must default in some fashion and that EU leadership will be forced to find a broad solution to stay one-step ahead of the bond markets. If the Europeans are successful in this difficult dance, there will be short-term comfort in the global markets followed by structural reforms designed to improve economic growth. If they do not, then we will see a full Risk Off scenario develop. The Europeans have their backs against the wall. They must act and I believe they will, but will their actions be enough to satisfy the bond markets? Watch the bond markets for answers.

Over the longer-term, I remain very cautious because I believe the real issue facing Europe is that of overspending and low- to no-growth. Failure to achieve a long-term solution will stress the Euro currency to

the point of possible dissolution of the currency in a worst-case scenario or the return to domestic currencies by some EU currency member countries in a less lethal scenario. To illustrate my point let me use a simple analogy. Picture 17 guys in a row boat each representing a country sharing the Euro currency...a couple of them, most notably the German rower, is working feverishly. Sweat is pouring down his face and his efforts are responsible for the boat moving forward. Somewhere else in the boat is the Greek rower. He is kicked back sipping on a glass of chilled ouzo watching the German row. Eventually the German is going to get tired of doing all the work and the Greek will put down his ouzo and start rowing or the German will toss him overboard to lighten the load. So this is where we are today, watching and wondering how much longer the German rower will tolerate the ouzo-sipping Greek. Oh, and the Italian and Spanish rowers are watching all of this very closely!

For now I believe that exposure to equities can be increased, but still underweighted from full allocations. I believe high yield bonds offer a good way to play the Risk On trade with less (but still present) potential downside risk if the Risk Off scenario returns.

US stocks have returned as the top Asset Category of the five I follow. Currencies are second with Commodities third, Bonds fourth, and International stocks last.

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

Within the Bond Asset Category, International bonds and Inflation Protection bonds are favored. Higher risk bonds such as preferreds and high-yield remain attractive options especially as stock markets rally.

I continue to like gold. Investors see gold as an important hedge against paper currencies that may be exploited by central banks to help get their debt problems under control. There is no indication that uncertainty will go away in the short-term.

Among the key economic data being reported next week is the Institute for Supply Management (ISM) survey (Tuesday), the Jobless Claims report (Thursday), and the October Unemployment report (Friday). Consensus data on each of these reports suggest little change to the current slow-growth economic environment.

I will not be writing a Weekly Update next week due to business-related commitment next weekend.

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.

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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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