Wednesday, August 15, 2012

Markets were up slightly around the world this past week on no particular theme. Economically, 2nd quarter productivity in the US came in at a higher than expected 1.6% increase indicating that workers are producing more for each hour worked. Productivity growth is an important indicator about the competitiveness of the US economy and growth is clearly positive. China reported flat (+1%) year-over-year growth in exports disappointing investors who had been expecting exports to grow by 7% or 8%. Slowing exports from China serves to confirm concerns that the global economy has slowed and continues to slow.


The Dow Jones Industrial Average (DJIA) added 112 points (0.85%) last week while the S&P 500 gained 1.1%. The Russell 2000 gained 1.7% and the tech-heavy NASDAQ led the major indexes posting a 1.8% gain. For the year, the DJIA is up 8.1%, the S&P 500 is up 11.8%, the Russell 2000 has gained 8.2%, and the NASDAQ is up a strong 16.0%.

All but one (Real Estate) of the major eleven economic sectors was positive for the week with six sectors out-performing the DJIA. Energy, Materials, and Information Technology were the best performing sectors while Real Estate, Utilities, and Consumer Staples were the worst. For the year, all sectors are clearly positive led by Information Technology, Telecom, Consumer Discretionary, and Financials. Utilities, Energy, and Materials are the weakest sectors to date, but all are up at least 4%. This continues to be a year where the difference between the best and worst performing sectors is smaller than usual. The difference between the best performing sector (Information Technology) and the worst (Utilities) is about 13% while the average from 2003 to 2011 has been 38%. Reviewing the data shows that this year, the best performing sector is not significantly out-performing the market while the worst performing sector is doing relatively well. I would not read too much into this analysis other than the recognition that sector weighting, which can be an important driver of good portfolio returns, has not provided much benefit to investors this year.

The MSCI (EAFI) posted a 1.82% weekly gain marking the first time this broad but European-weighted index bettered the DJIA in four weeks. I do not read much into this positive return since most of Europe is on vacation in August and investors are expecting little movement until the all-important European Central Bank meeting occurs on September 6th. The Asian/Pacific region led all major global areas last week with a gain of 2.9% while the Americas region trailed at a 1.4% gain.

The Barclays US Aggregate Bond index was down a slight -0.1% for the week leaving the index essentially unchanged over the previous two weeks. US Treasury yields, however, rose for the week (pushing down bond prices) with the 10-year closing at 1.658% compared to the previous week’s close of 1.569%. The US 30-year yield increased to 2.747% from 2.649%. German, Italian, and French 10-year yields all fell with only Spanish 10-year yields rising last week. I point this out because this is the first time since the week of May 25th that the US and German yields did not move in the same direction. The Spanish 10-year settled Friday at 6.907% indicating much concern remains with the Spanish. I do not believe you should read too much into last week’s bond yield movements only because there is so little news moving the markets right now. The more equity-sensitive bond sectors such as preferreds and high yields were the best performing bond sectors last week while extended duration Treasuries and corporate were the weakest on the modest interest rate rise.

Currency movement has also been muted. The Euro fell less than 1 cent (-0.7%) to close Friday at $1.229. The US Dollar Index closed up 0.2% for the week with little conviction in the currency markets. I believe that many currency investors, like their stock and bond counterparts, are in a wait and see mode for a while.

Overall, commodities were up very slightly. The Dow Jones UBS Commodity index, which is a broad basket of commodities, gained 0.2% for the week. The best performing commodity sectors were the oil and timber sectors. Among the worst performing sectors were sugar, coffee, and livestock. Corn prices were relatively stable even as the drought worsened. WTI Oil gained nearly $2 per barrel (2.2%) to close at $93.39. Gold gained $13.80 per ounce (0.9%) to close Friday at $1623.10. I will remind everyone that oil tends to trade more on supply/demand fundamentals and the strength or weakness of the US dollar while gold is a measure of investor sentiment regarding central bank policies regarding central bank willingness to print money. The gold jury is leaning towards the US Federal Reserve engaging in another round of quantitative easing (printing money) with some doubters holding the gold bulls back for now. Look for more activity to pick up as we approach the end of August meeting of the Federal Reserve at Jackson Hole, Wyoming. Investors believe the Chairman, Mr. Bernanke, will signal the likelihood of the Fed taking more measures in the future to boost growth (i.e. print more money) going forward and that will probably boost stocks and gold prices. If he fails to deliver a monetary stimulus message, I believe the stock markets could come under some short-term pressure and gold prices would fall as well.

CAN CENTRAL BANKERS SAVE THE DAY?

Yes it is August, and yes many professional traders and investors here and abroad go on vacation in August, and yes markets tend to drift in August. The past two weeks have been a good example of the markets’ August indifference with little net movement in many stock and bond markets. So let me take this quiet time to ask the question, “Can the central bankers around the world help push us into more robust economic growth?”

To answer this question let me provide a very brief overview. Central bankers control monetary policy. They regulate the supply of money within their respective countries through various tools such as bond buying or selling in the open markets, setting certain interest rates (discount rate), and other less well-known operations. For most central bankers, their responsibility is to keep inflation in check through sound money policy. Here in the US, the Federal Reserve has a dual mandate: keep inflation in check and foster full employment.

The other side of the economic equation is fiscal policy. Fiscal policy is created and executed by political leaders. In most of the developed world that means democratically elected leaders are empowered by their citizens to pass laws regarding the structure and governmental tools to govern commerce. These policies are wide-ranging and very diverse and include issues such as labor laws, regulations governing business activities, taxation and levels of government spending. In well functioning capitalistic markets, central bankers compliment the work done by the politicians to help businesses and individuals succeed and grow. When either side gets it wrong, problems result and economies suffer. I think any objective person can look at our own recent economic past and find fault and blame on both sides of the economic equation, but can our current situation be fixed just by central bankers. The answer I believe is a resounding NO.

The tools of central banks are actually quite limited. Important but limited. I was having a discussion with friends recently about why inflation has not kicked in with such an expansion of money in our economy. The answer is pretty simple actually, banks are not lending to their capacity. There is $1.5 trillion in excess reserves in the banking system. This means banks could lend up to an additional $1.5 trillion but they are not. If they did, economic activity would likely soar along with inflation. So for now, the money is not in the producing economy and not pushing up inflation. But money supply is the big tool of central banks, they have used it, and not achieved a vibrantly growing economy and unemployment is still above 8%. So I again say, central bankers cannot fix the problem. Only our political leaders can fix the real structural problems in our economy, and until they do, central bankers will continue to try and find creative ways to buy time for our political leaders to fix our structural problems.

We are in a calm before the storm. This calm has been created by central bankers through massive monetary easing, but it is up to political leadership around the world to lead their economies to fiscal soundness before economic stresses punish everyone.

LOOKING AHEAD

I have heard a number of expressions to describe our economy. Muddling and plow horse are two of my favorite expressions. They all fit to some degree. Neel Kashkari of PIMCO funds wrote last month that there are two major downside risks to the markets today, 1) the sovereign debt crisis in Europe spinning out of control, and 2) the US falling off the fiscal cliff in 2013 with a major tax increase and massive federal spending cuts. On the positive side, Mr. Kashkari believes that if the Federal Reserve institutes another round of quantitative easing, the stock and bond markets would likely benefit. However, with so much uncertainty about which outcome we will see, markets, I believe, are likely to continue to muddle through.

So how to proceed? I believe Brian Wesbury, Chief Economist for First Trust Advisors, said it best last Monday (August 6th) when he stated, “In the end, the way for investors to avoid mistakes in this environment is to watch the data and avoid political spin.” I would add that investors should be wary of the spin financial media outlets put on news reports today. Rely on the data, not the emotion.

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 strenght basis. Energy, Materials, and Utilities are 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 57.37 up from 53.77 (6.7%) from the previous week. A solid showing. 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.

The most important economic report next week is July’s Retail Sales and will be released Tuesday morning at 8:30 AM. Consensus calls for an increase of 0.3% compared to the drop of -0.5% last month. This is such an important report because retail sales comprise 70% of our gross domestic product (GDP). Economists also look at this report closely for an idea of the health of the consumer. Other key reports include July’s Industrial Production and Consumer Price Index on Wednesday morning, the weekly Jobless Claims (365,000) and Housing Starts on Thrusday morning. A number of countries in Europe and Japan will be releasing their 2nd quarter GDP data. Do not expect any good news there.

Sincerely,



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

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Emerging market investments involve higher risks than investments from developed countries and 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 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. 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.

TIPS are U.S. government securities designed to protect investors and the future value of their fixed-income investments from the adverse effects of inflation. Using the Consumer Price Index (CPI) as a guide, the value of the bond's principal is adjusted upward to keep pace with inflation. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.

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 generally are 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 financial 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.

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