Thursday, January 19, 2012

As expected, Standard & Poor's (S&P) Rating Services cut the sovereign debt ratings of nine European countries including France, whose AAA rating was cut one notch to AA+, Friday evening after US markets closed. Word that an S&P announcement would be made on Friday did not surprise markets and the French finance minister went on live television in France before the announcement in
the US to assure the French people that the downgrade was not "catastrophic" and that, "it is not the ratings agencies that dictate the policies of France." Besides France, Austria's AAA rating was cut one notch, while Italy, Spain, and Portugal were each cut by two notches. Portugal's debt rating is now BB meaning its debt is now junk status and considered speculative.

Global traders were aware of the pending downgrades during most of the European and US trading sessions Friday pushing markets lower, but not significantly so.

The Dow Jones Industrial Average (DJIA) fell 49 points (-0.39%) Friday but closed the week up 62 points (+0.50%). The S&P 500 added 11 points (0.88%) for the week, and the Russell 2000 posted a strong 1.93% gain indicating that investor tolerance for riskier assets is increasing for now. Two weeks into the year the DJIA is up 1.67%, the S&P 500 is up 2.50%, and the Russell 2000 is up 3.14%.

Materials, Financials, and Industrials were the top three performing sectors this past week while Energy, Utilities, and Consumer Staples were the weakest. For the year only Utilities and Consumer Staples have a negative return.

The on-going troubles in Europe have hurt that region. The Euro-centric MSCI EAFE index posted a 0.60% gain last week and is up just 0.19% for the year. Looking around the world, emerging markets have led all international sectors posting a 2.94% gain last week with most of that strength coming from the Asia-Pacific region. For the year, emerging markets are up a collective 4.5% while developed markets are up 1.76%. Two weeks does not make a trend, but it will be important to see if this relationship of out-performance is maintained or expanded.

For the week the broad basket Dow Jones Commodity Index was down 1.43% and pulled the index into negative territory (-0.12%) for 2012. Gold added $14 (0.87%) an ounce closing Friday at $1630.80 and is now up $64.00 (4.08%) an ounce for the year. WTI oil fell $2.86 (-2.82%) to close the week at $98.70. Oil prices were hurt by the continuing weakness of the Euro and expectations of weakening demand from a slumping European economy.

The Euro continued to struggle this past week following a trend that has been in place since early September 2011. For the week the Euro lost 2 ½ cents to the US dollar to close at $1.268 its lowest level since September 2010. The threat (and realization) of a sovereign debt downgrade and an overall slump in economic growth has pushed investors away from the Euro and into the US dollar and Japanese Yen. For the week the Brazilian Real and Indian Rupee showed the greatest strength, but it should be noted that both of these currencies are coming off significant lows. Two weeks does not make a trend, and I will monitor this development as well.

Bonds have carried on their strength from 2011 into 2012. The Barclays Aggregate US bond index posted a 0.57% gain for the week and is now up 0.42% for the year. The US 10-year yield dropped to 1.868% from the previous week's close of 1.957%. The US 30-year yield fell to 2.913%. Low US Treasury rates are attributable to the Federal Reserve's stated policy of keeping all rates at very low levels and the Federal Reserve's Open Market Committee's action of purchasing longer dated bonds in the open market-a ready buyer keeps rates down. For the week, long Treasuries benefited and was the best performing sector within the bond category. Municipal bonds also did well. Emerging market debt was the weakest performing sector, however, its performance was only slightly negative.

THE EUROPEAN DOWNGRADE VS. THE REAL PROBLEM

The well-telegraphed downgrade finally hit Europe Friday evening. The Euro fell a bit. Stock markets fell a bit, and US Treasury yields fell a bit. But in the end, not much really happened. Nothing happened because the downgrade is not really the story. First, Standard & Poor's responsibly gave the markets plenty of warning that they were going to downgrade many European countries. Second, whether France is AAA or AA+ really doesn't matter. Just look at how the US Treasury prices and yields reacted to our downgrade. Third, the real issue is not about downgrades but rather how the European Union continues to deal with their multi-year debt crisis. The downgrade was an important reminder to European politicians that they must move decisively to resolve the crisis, but ultimately what matters is still being debated in Brussels and Greece.

The most important story from Europe this past month has been the move by the European Central Bank (ECB) to significantly increase liquidity within the financial system much like the US Federal Reserve did during the height of the 2008 financial crisis. The ECB introduced the Long Term Refinancing Operation (LTRO) in which banks can borrow funds for three years at very low interest rates. Banks need only to put up average quality bonds in order to access this nearly unlimited supply of money. The ECB's expectation is that bankers will borrow heavily at 1% and reinvest into sovereign debt from countries like Italy and Spain in order to make significant profits on the higher yielding sovereign debt. Based upon the results of early bond auctions in those countries, the strategy is working as good demand has pushed yields down sharply from earlier highs. This takes considerable pressure off the political class and continues to buy them time to do whatever they are doing. The dark lining to this silver cloud is the ECB is loading up on riskier assets that could blow up their balance sheet if demand does not keep up with the large amount of debt that must be rolled over. Additionally, this policy only addresses the liquidity part of Europe's problems and much work remains to deal with countries that are hopelessly in debt.

In the meantime, Greece is teetering on bankruptcy as negotiations between private bondholders and banks stall. A key qualification for the payment of the next bailout from the Europeans and International Monetary Fund is the willingness of private lenders to agree to a 50% reduction in the value of their investments. This voluntary "haircut" is critical to avoid an uncontrolled meltdown of Greece and the possibility of a panic extending into the other weak, but sizeable, countries like Spain and Italy. Talks are expected to re-start this week, but there is a lot of uncertainty about a successful outcome.

So we find ourselves in limbo watching and waiting for the next European summit (January 30, 2012) and some breakthrough from the political class-a wait that has occurred numerous times before in the past year or so. I sincerely hope the Europeans find a way out of their crisis because the ramifications of failure extend globally. A successful outcome remains very much in doubt.

LOOKING AHEAD

The markets will certainly be watching the developments in Europe this week, but some focus will return to the US. Fourth quarter 2011 earnings announcements have begun and will continue for the next several weeks. JP Morgan's quarterly earnings announced last week were indifferent at best and are raising concerns about the overall prospects of the US banking industry. Investors will be looking for confirmation of growth that some of the early governmental statistics have signaled across the major economic sectors. Putting a twist to President Regan's famous view of the former Soviet Union I suggest investors will trust the government's data but will verify with corporate profit announcements.

I remain cautious about the markets due to the uncertainty and risk in the world. The Europeans may well find a way to continue kicking the can down the road, however, I do not have much confidence in the Euro Zone's economic prospects for the next few months. The recent jump in emerging markets is worth noting, but I am not prepared to recommend buying emerging markets at this time.

US equities continue to be the strongest markets and I do favor investment in high quality, dividend-paying investments. I also favor some investment in riskier assets such as small and mid-capitalization stocks, however, I suggest under-weighting these investments within your equity allocation. Balance and quality should characterize equity investments today.

I believe that the current global slowdown, which is underway, coupled with the strengthening US dollar, makes commodities less attractive at this time; and I am recommending a reduction in broad commodity investments.

The bond market remains attractive and my recommendations for this asset category include international bonds, inflation-protection bonds, and a mix of high-yield and high-quality bonds. I am also watching senior bank loan bonds and am considering these as part of my bond portfolio recommendation.

There are a large number of government economic reports coming this week. The Producer Price Index and Industrial Production data will be released on Wednesday. Thursday brings Jobless Claims, Consumer Price Index, Housing Starts, and the Philadelphia Fed Survey. The week closes on Friday with Existing Home Sales. Investors will be looking for signs of economic strength in terms of better production numbers, homes sales, or a continued falling of unemployment. Nervous markets, like the one we have today, seek validation in every headline and economic report. We are just continuing the theme of late 2011 into 2012.

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.

Securities and Advisory Services offered through Commonwealth Financial Network(R), Member FINRA/SIPC, a Registered Investment Adviser.