Monday, September 10, 2012

European Central Bank (ECB) President, Mario Draghi, announced this past Thursday that he was prepared to initiate an unlimited amount of bond purchases in order to stabilize borrowing costs among European Union (EU) countries and protect the very existence of the Euro. Markets, both here and abroad, moved sharply upwards on the news. The weak August Employment Situation Report on Friday dampened investor’s spirits and greatly increased the expectations that Federal Reserve Chairman, Ben Bernanke, would undertake further monetary stimulus referred to as quantitative easing (QE).

For the week the Dow Jones Industrial Average (DJIA) added 216 points (1.6%), the S&P 500 gained 2.2%, the NASDAQ increased 2.3%, and the small and mid-capitalization dominated Russell 2000 surged 3.7%. Thursday was the key day as the DJIA jumped 245 points, and (Source: Wall Street Journal) without it, the DJIA would have been down 39 points for the week. Encouragingly, the DJIA and other indexes all managed gains on Friday in the face of the lackluster employment report. For the year the DJIA is up 8.9%, the S&P 500 is up 14.3%, the Russell 2000 is up 13.7%, and the NASDAQ is up 20.4%.

All eleven major economic sectors were positive last week led by Materials, Financials, and Consumer Discretionary. Only Consumer Staples, Utilities, and Real Estate underperformed the DJIA. For the year, the sectors ranked by performance: Consumer Discretionary, Information Technology, Financials, Health Care, Real Estate, Telecom, Materials, Consumer Staples, Energy, and Utilities. Only Utilities and Energy have underperformed the DJIA.

International stocks rallied on the ECB announcement last week with the MSCI (EAFE) posting a 2.8% gain. The European STOXX 600 index gained 2.3%. Developed markets (2.6%) led the major regions of the world followed by the Americas (2.6%), Emerging markets (2.5%), and Asia/Pacific (1.0%). The Far East continues to be hobbled by sluggish and disappointing growth numbers coming from China and Japan’s economic and political paralysis.

The Barclays US Aggregate Bond index posted its first weekly loss (-0.3%) in three weeks as US Treasury yields pushed higher for the week. The 10-year US Treasury yield closed Friday at 1.668% up from the previous Friday close of 1.543%. The 30-year yield also gained to close the week at 2.819% compared to last week’s close of 2.667%. Yields did fall slightly on Friday after the lackluster employment report and increasing expectation that the Fed will institute QE3, but uncertainty about how the Fed will implement QE3 and the move to riskier bonds following the ECB’s announcement dominated trading strategies for the week. Spanish 10-year yields fell sharply last week closing Friday at 5.36%. The yield on Spanish 10-year notes has now fallen over 1.9% from the July 20th close of 7.27%. Italian debt also pulled back. German sovereign debt yields, like the US, increased sharply as bond traders left “safe haven” debt and rushed to higher-yielding countries like Spain and Italy with the confidence that the ECB will step in and protect their bond purchases. Short duration international was the best performing bond sector last week while long duration US Treasuries and Corporates were the weakest.

The Euro jumped the past week to a four-month high against the US Dollar to close Friday at $1.281 up over two cents (1.83%) from last Friday’s close. The US Dollar weakened on investors leaving the safety of the US currency for riskier ones and because the poor employment report has increased the likelihood of another round of quantitative easing and the low interest rates this policy is expected to bring. The US Dollar index lost 1.2% for the week and is now down for the third consecutive week.

Gold and precious metals in general did very well this past week on expectations of QE3. Gold gained $52.90 (3.1%) per ounce to close Friday at $1740.50. Gold is the primary hedge against weakening currencies that are potentially devalued by easy monetary policies announced by the ECB and anticipated by the Fed. Commodities were generally higher last week with the Dow Jones UBS Commodity index gaining 0.8%. WTI Oil dropped negligibly to close the week at $96.42 per barrel. Corn was the biggest commodity loser of the seventeen I track losing over 11% for the week. Commodity prices tend to be very volatile week over week making it difficult to draw any hard conclusions about short-term fluctuations.


Central bankers are doing their part to bail out spendthrift politicians. With Mario Draghi’s announcement on Thursday that he was prepared to enter into unlimited bond purchases in the secondary market to keep interest rates in check and preserve the Euro, he has bought politicians an undetermined amount of time to get the EU’s fiscal house in order. Since his initial comments in July supporting the Euro and his willingness to take action to preserve the Euro, interest rates have fallen sharply for the most at-risk countries in the southern sphere of the EU. Mr. Draghi’s announced policy was supported by every ECB Governing Council member except Bundesbank President, Jens Weidmann; but even German Chancellor Angela Merkel did not renounce the move. However, Germany was able to wrestle some important concessions from the ECB. First, a country will be required to formally request that the ECB begin purchasing its bonds in the secondary market. Second, there will be strict austerity requirements imposed as a condition for the ECB to buy a country’s bonds, and third, the ECB will buy only bonds with less than three-year maturities. These may prove to be important concessions wrestled by the Germans. Angela Merkel warned that the ECB’s unprecedented monetary accommodation could not take the place of political leadership (fiscal policy) to correct the imbalances between members of the EU.

Now it appears to most pundits that Mr. Bernanke will step forward and offer additional monetary policy accommodation following the weak jobs report for August. The Federal Reserve, unlike the ECB, has a dual mandate for price stability (inflation control) and full employment. It is the employment mandate of the Fed that makes most observers believe Mr. Bernanke will take action now. There is uncertainty concerning just how he will act. Will the Fed start a new round of bond purchases, will it talk down rates by promising to hold interest rates at near zero level for another year or two, or a combination of these and other measures?

Assuming Mr. Bernanke does act and Mr. Draghi begins to buy bonds, the ultimate question is will these policies be effective or will their efforts do little more than postpone the inevitable and do more harm in the long run? In other words, are we experiencing a sugar high or is the beginning of the end to the economic crisis gripping Europe?

The challenges are great—especially in Europe. Europe lacks monetary control over the countries within the EU and this issue is at the heart of a lawsuit challenging the constitutionality of German’s involvement in the permanent bailout facility known as the European Stability Mechanism (ESM). This Wednesday the German Federal Constitutional Court is expected to rule whether German leaders can give control over budgetary matters to the EU which the plaintiffs say is currently unconstitutional and precisely what would happen if Germany signs the ESM treaty. On the same day, the Dutch go to the polls for national elections. The outcome is being interpreted as a referendum in the Netherlands, for support of the Euro and of continued bailouts. If the Europeans are ever going to stem the current crisis and retain the Euro, I believe like many economists that there must be a fundamental reorganization of the EU focusing on fiscal and monetary centralization, the requisite loss of sovereignty by all countries in the EU, and approval of all these measures by the citizens of Europe. This must be done as Europe slips back into a second recession and unemployment reaches historical highs.

How much time the markets are willing to provide the political class is a critical unknown. Indicators such as European swap spreads and interest rates tell me that there is a cushion right now and that politicians have been given plenty of room to maneuver. Interest rates have plummeted in Spain and Italy, and it is expected that the private sector will step in and continue buying bonds as long as the ECB is buying as well. I believe that interest rates will remain the canary in the cave and will tell us if the private market approves or disapproves of monetary or fiscal policy initiatives, and I will continue to report that information each week. Much has yet to be done both here and abroad and the outcome is clearly in doubt.


As I previously noted, the Europeans have several major events happening this week that are of real interest to investors. Here in the US, the 2012 presidential campaign is now in full swing and Congress is expected to be back in session. With vital issues facing the government, I am expecting nothing to happen in Washington until after the election. The Federal Reserve Open Market Committee (FOMC) will be meeting during the week and all eyes will be on Chairman Bernanke and whether or not QE3 will or will not begin and how it will be implemented if it is launched. The outcome of the FOMC meeting is very, very important to the markets and the economy in general.

This week has a number of important economic reports. The July International Trade figures will be released on Tuesday and consensus calls for a trade deficit of about $44 billion which is slightly higher than June’s $42.9 billion. Given the slowing global economy the export portion of this report will be viewed critically. Thursday is the weekly Initial Jobless Claims report and consensus is that 370,000 Americans will file first time jobless claims which would be up 5000 from last week. The August Producer Price Index (PPI) will also be reported Thursday morning. This report shows price increases to sellers of goods and services and thus reflects inflation momentum building within the economy. The PPI releases two sets of data, core and non-core with core stripping out food and fuel. I find the non-core most informative because food and fuel are key components to most of what the typical American buys each and everyday. Consensus expects the core rate to increase by 0.2% (0.4% in July) and the non-core rate to increase 1.4% (0.3%). If the non-core rate comes in anywhere near consensus, it could spell seriously higher prices for most goods and services in the fall. Friday has three important sets of data scheduled for release. First there is the August Consumer Price Index (CPI). The CPI measures the change in the average price level of a fixed basket of goods and services purchased by consumers. It is the measure of the rate of inflation. Consensus for a core basket is expected to increase by 0.2% (0.1% for July) while the non-core basket is expected to increase 0.6% (0.0% in July). The second report is the August Retail Sales figures. Consensus is for August to match July’s strong 0.8% increase. The last report is the August Industrial Production report. Consensus is for August to contract at a rate of -0.1% down from a good 0.6% increase in July.

The New York Stock Exchange Bullish Percent (NYSEBP) closed Friday at 62.56 up from 60.03 the previous week. This is the twelfth weekly increase of the past thirteen for this important technical indicator and has moved up from a low of 42.66 on June 4th. The overbought reading for the S&P 500 jumped last week and closed Friday at 65% up from last Friday’s reading of 35%. Still within a very acceptable range. I have consistently reported that bonds are overpriced relative to their values over the past ten weeks, but for most bond sectors, they are not extremely overbought. Except for corporate high yield which is currently overbought at 168%. This coincides with an article in the Wall Street Journal this past weekend reporting that high income bond yields are at their lowest point since this data was kept beginning in 1983. This translates to mean that investors are so starved for yield that their purchases have driven the price for high yield bonds to all-time high which in turn drives yields down (remember the inverse relationship between bond prices and yields). Exposure in this sector must be carefully watched for weakness.

The Dorsey Wright & Associates analysis of the markets indicate that US stocks and Bonds are the two favored major asset categories followed by Foreign Currencies, International stocks, and Commodities. Middle capitalization stocks are favored, as is growth over value, and equal-weighted indexes over capitalization weighted indexes. Equal-weighted indexes are those where each stock in the index is weighted the same, while in capitalization-weighted indexes the larger stocks have the largest weighting consistent with their size relative to the other stocks. The relative strength sector weightings favor Consumer Discretionary, Real Estate, Information Technology, and Health Care. US Treasuries and International Bonds are favored in the Bond category, while US and Developed Markets are favored within the International stock category.

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

P.S. If you think this type of analysis would be of benefit to anyone you know, please share this communication with them.

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.

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. The CBOE Volatility Index - more commonly referred to as "VIX" - is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500® Index (SPX) option bid/ask quotes. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.

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.

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 and is a capitalization-weighted index meaning the larger companies have a larger weighting of the index. The S&P 500 Equal Weighted Index is determined by giving each company in the index an equal weighting to each of the 500 companies that comprise 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 Russell 2000 Index Is comprised of the 2000 smallest companies of the Russell 3000 Index, which is comprised of the 3000 biggest companies in the US. The NASDAQ Composite Index (NASDAQ) is an index representing the securities traded on the NASDAQ stock market and is comprised of over 3000 issues. It has a heavy bias towards technology and growth stocks. The STOXX® Europe 600 is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 represents large, mid, and small capitalization countries of the European region.