Tuesday, August 7, 2012

As has seemingly been the case for 2012, markets careened from one news story to another last week leaving most stock indexes slightly higher and bonds a bit lower. Following reports on July 26th that quoted the European Central Bank President, Mario Draghi, saying he would, “do whatever it takes” to save the Euro, markets generally rallied and interest rates for Spain and other weak European countries fell sharply. This past Thursday, Mr. Draghi delivered a speech that failed to deliver on expectations and markets sold off only to rally Friday on a “positive” US employment report.


The Dow Jones Industrial Average (DJIA) added 22 points (0.16%) last week while the S&P 500 gained 0.36%. The Russell 2000 fell nearly 1% and the tech-heavy NASDAQ added 0.33%. If not for Friday’s strong markets, every stock index would have been in negative territory for the week. July’s muted returns mirrored the past week’s performance. For the month, the DJIA was up 1.0%, the S&P 500 was also up 1.3%, and the NASDAQ added 0.2%. The small and mid-capitalization-heavy Russell 2000 was down 1.4%. For the year, the DJIA is up 7.2%, the S&P 500 is up 10.6%, the Russell 2000 has gained 6.4%, and the NASDAQ has posted a leading 13.9% gain.

Five of the eleven major economic sectors outperformed the DJIA. Information Technology led with just over a 1% gain last week followed by Real Estate, Financials, Consumer Staples, and Industrials. Health Care was the weakest sector losing just under 1% followed by Utilities, Consumer Discretionary, and Materials. The bottom four sectors all posted slightly negative returns for the week. For the year, Real Estate remains the best performing sector posting a nearly 16% gain followed by Information Technology, Financials, and Consumer Technology. All but Energy, Utilities, and Materials have outperformed the DJIA so far in 2012, and all sectors are positive through the 31st week of trading.

The European-heavy MSCI (EAFE) index fell sharply on Thursday following Mr. Draghi’s remarks, but rallied alongside US indexes on Friday to finish 1.5% higher for the week. To summarize what has happened with Mr. Draghi over the past week I would simply say he over-promised and under-delivered. After pronouncing that the ECB would do whatever it takes on July 26th, investors implied (rightly or wrongly) this to mean he would immediately begin buying the bonds of Spain, Italy, and the other struggling European countries. Investors were expecting Mr. Draghi to announce details about how he was going to save the Euro at his press conference last Thursday. When he failed to deliver, European markets sold off sharply and interest rates on sovereign bonds jumped in the weaker countries. I believe that Germany’s continued resistance to more aggressive ECB monetary policy prevented Mr. Draghi from announcing new bond purchases and curtailed his plans. Even so, the European Union may have been given an August reprieve to continue their efforts to enact serious fiscal and political reform.

The employment data coupled with the US Federal Reserve Chairman’s recent remarks indicating the Fed will not take any immediate steps to further stimulate monetary policy in the US pushed the US dollar down for the week. The US Dollar Index fell 0.4% last week and is now down three of the past four weeks. The Euro managed a very modest 0.5% gain last week to close Friday at $1.238 rallying on the US employment report.

Bond markets were flat following the equity markets’ rally Friday with the Barclays US Aggregate Bond index up just 0.1% for the week. The Spanish 10-year yield jumped to 7.17% on Thursday following Mr. Draghi’s comments but rallied on Friday to close at 6.85%. Friday’s risk-on trade in turn pushed down US bonds with the 10-year and 30-year Treasuries dropping for the week as interest rates rose to 1.57% and 2.65% respectively. I understand this may be a bit hard to follow so I will try to simplify. US bonds are a “safe haven” place for investors to place their money when they are nervous. Buying US bonds pushes up the price of bonds (more demand equals higher prices) and thus drives down the interest rate. Spanish and Italian bonds are very risky assets today. When investors are nervous about their money, they sell riskier assets (including Spanish and Italian bonds) to invest their money in “safer” investments. This has the effect of driving prices down on risky assets and interest rates higher on Spanish and Italian bonds. Friday, when investors were feeling more secure, they returned to buying riskier assets and the prices of Spanish and Italian bonds rose causing their interest rates to fall.

Commodities had a good July. The Dow Jones UBS Commodity index, which measures a broad basket of commodities, gained 6.5% for the month on the strength of corn and other grain prices. Oil also contributed significantly to this positive return. The story of the drought and escalating grain prices in the US is well known by now and I believe that food inflation will be seen in higher grocery prices in the coming months. For the week, the Dow Jones UBS Commodity index fell 0.4%, however, grain prices remain high and oil jumped 1.4%. Oil prices rallied on the US employment report and brighter prospects for global economic growth. Oil was also helped by the weakening US dollar. Oil closed Friday at $91.40 per barrel. Gold retreated as it appeared that central banks were not going to ease monetary policy in the short-term. As I have said before, the price of gold provides an insight into the likelihood of monetary easing or contraction by central banks. For now, the printing presses have slowed and with that, the price of gold has pulled back just a bit.

HAVE WE BECOME FRANCE?

On a recent Saturday evening, Virginia and I were returning home from Stafford, Virginia, after spending a wonderful day celebrating our granddaughter’s 7th birthday. I was listening to Larry Kudlow on the radio and one of his guest speakers was one of my favorite economists, Brian Wesbury of First Trust Advisors. Brian made a statement I thought I would never hear in my lifetime. He said that the United States had become France! Ouch. He went on to say we had become France because we now have unemployment routinely greater than 8%, persistent economic growth of 2% or less, runaway government spending, and a shrinking defense budget.

Last Friday, the US grew private sector employment by a relatively paltry 172,000 while overall employment improved by 163,000 (the government sector shrank by 9000). Yet the DJIA rallied 217 points (1.7%). Why? Because we are now France. Investors were expecting an even more anemic jobs report, but were happily surprised by the larger number. Yet, the unemployment rate actually added an additional 0.1% to 8.3% overall. Forty plus months of 8% or greater unemployment—sounds a lot like France.

However, the employment report did another very important thing. Most economists believe that with average jobs growth somewhere in the 150,000’s to 170,000’s, it is becoming more and more likely that the US is not going into a second recession. This growth rate, as bad as it is, is still enough to keep our economy growing at a France-like rate. This in turn has reduced the chances that the Federal Reserve will step in with another round of monetary easing (quantitative easing—QE). While some investors would love the immediate “pop” the stock and bond markets would no doubt get, it would be—in my opinion—a very short-sighted policy and have long-term negative effects such as an even weaker US dollar and the potential for much higher inflation.

I do not expect anything significant to change in the near-term. With the President and Congress at a stalemate, there is zero expectation for any meaningful reform that will propel our economy forward to higher growth until after the election. Europe is also in a wait and see mode, although they are waiting to see how the power struggle between the ECB and the German Central Bank will play out. Will the spendthrift nations get more money to spend or will the tightfisted Germans force meaningful political, fiscal, and labor reforms on their neighbors? We will all be watching as these key debates unfold.

Have we become like France as Brian Wesbury suggests? Yes if you look at current economic data, but I believe most Americans do not have a European mindset. It was not that long ago that our ancestors got on boats for a dangerous trip here because they did not think like their fellow citizens. So no, I do not think we are like France today, but we have drifted very close to the French economically.

LOOKING AHEAD

August is here. Vacation time is here. I suspect most people will not be as focused on the markets as they might otherwise be during the rest of the year. There are relatively few economic reports in the coming week, and earnings season is pretty much over. Trading volumes are likely to be down and any significant market moves may come from the few rather than the many.

There are significant issues remaining and big events on the way. The unrest in the Syria and possible escalation by Russia (sending Russian troops to the region), and the ever-present worries over Iran and Israel remain. Both the Republicans and Democrats will have their nominating conventions. The Republicans will go first from August 27th-30th followed the next week by the Democrats, and the campaign for president will swing into high gear. We will have a spate of major economic reports during the middle of the month as we always do, and we will finish August with the second estimate of the 2nd Quarter GDP.

The Dorsey Wright & Associates (DWA) current technical analysis shows US stocks and Bonds as the two strongest major asset classes followed by Currencies, International stocks, and Commodities. Within the US stock asset class, Middle capitalization stocks are favored, growth is favored over value, and equal-weighted indexes are favored over capitalization-weighted indexes. On a relative strength basis, Real Estate, Consumer Discretionary, Health Care, and Information Technology are the four strongest sectors on a relative strength basis. Energy, Telecom, and Materials remain the weakest. Within the Bond major asset category, US Treasuries and International bonds are favored.

The New York Stock Exchange Bullish Percent (NYSEBP) closed at 53.77 up from 53.32 (0.8%) from the previous week. Not a definitive move, but a positive one none-the-less. Bonds in general and municipal bonds specifically remain very overbought indicating that prices have gotten very expensive in relation to prices over the past ten weeks. I would not initiate new positions here.

Sincerely,




Paul L. Merritt, MBA, AIF®, CRPC®
Principal
NTrust Wealth Management

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