Tuesday, September 4, 2012

Federal Reserve Chairman Ben Bernanke delivered his much-anticipated speech at the Fed’s Jackson Hole conference Friday and markets reacted as would be expected.  His remarks made it clear that the Fed has its finger on the quantitative easing (QE) trigger, but that it was not ready to pull it just yet.  After a lackluster start to the week, Mr. Bernanke’s comments were enough to rally stocks, move bonds yields lower, weaken the US dollar, and push gold prices to a five-month high.  Investor attention will now turn to the European Central Bank (ECB) meeting next week where the ECB President, Mario Draghi, will address the very serious challenges facing the European Union (EU).

Friday’s rally was insufficient to push the Dow Jones Industrial Average (DJIA) positive for the week as this key index lost 67 points (-0.5%) and has now been down two consecutive weeks.  The S&P 500 fell by -0.3%, and the NASDAQ fell -0.1%.  The small and mid-capitalization heavy Russell 2000 posted a 0.4% gain.  The DJIA (0.6%), the S&P 500 (2.0%), the Russell 2000 (3.2%), and the NASDAQ (4.3%) were all positive in the month of August.  For the year the DJIA is now up 7.2%, the S&P 500 is positive by 11.8%, the Russell 2000 is up by 9.6%, and the NASDAQ leads all major indexes with a 17.7% gain.

Performance across the major economic sectors was generally muted with only four sectors posting positive returns.  Real Estate, Consumer Discretionary, Health Care, and Financials were the best performing sectors while Energy, Industrials, and Utilities were the weakest.  For the month of August, Information Technology was the best performing sector posting just over a 5% gain followed by Consumer Discretionary, and Materials.  Utilities, Consumer Staples, Telecom, and Real Estate were the negative sectors last month.  For the year, Information Technology, Consumer Discretionary, Financials, Health Care, Real Estate, and Telecom are all outperforming the S&P 500 while Utilities and Energy remain the worst performing sectors and the only two not exceeding the DJIA.

International stocks were notably lower last week with the MSCI (EAFE) losing -1.6% breaking six weeks of consecutive gains.  The heaviest losses came from Emerging Markets (-2.8%) and Asia/Pacific (-2.0%) regions.  For the month, the MSCI (EAFE) gained 2.4% and is now up 4.2% for the year.  The Emerging Markets was the weakest region in August losing -0.5% and is now up just 2.0% for the year.  Europe remains mired in crippling unemployment with a record 18 million (11.3%) of Europeans out of work.  Other economic indicators point to continuing slowdowns in the EU putting greater pressure political leaders and European Central Bank (ECB) President Mario Draghi.  Additionally, the growing concern about China slowing down along with the rest of the worlds’ major economies was punctuated last Saturday when the Chinese National Bureau of Statistics announced that the Purchasing Managers Index fell unexpectedly to 49.2 for August.  Any reading below 50 indicates contraction rather than expansion.

The Barclays US Aggregate Bond index stretched gains into a second week after gaining 0.5% for the week.  US Treasury yields fell again with the 10-year closing Friday at 1.543%.  In the past two weeks, the 10-week yield has fallen over a quarter percent from 1.814%.  The 30-year yield has followed a similar trajectory closing last week at 2.667% after closing at 2.932% just two weeks ago.  These drops in yields stem in part from two beliefs by traders.  First, Chairman Bernanke made it clear last Friday that he was still ready to intervene anytime to further stimulate the economy.  How specifically he would do this remains uncertain, but many economists believe buying more bonds is expected to be included in whatever steps he takes.  The Fed’s demand would push the price of bonds up and thus yields down.  Secondly, economic data here in the US has been flat and not improving thereby increasing the demand for bonds.  Low yields are the bond market’s forecast of slow economic times ahead. The cliché of a perfect storm is a bit overstated, but with the problems in Europe coupled with what is happening here in the US, bond yields have remained at historically low yields.  The same cannot be said for Spain.  Spain’s 10-year yield climbed up to 6.857% and is coming very close to the 7% level that most economists believe makes funding further Spanish borrowing unaffordable.  Not surprisingly, long-duration bonds—both Treasuries and Corporates—were the best performing of the bond sectors while low-duration bonds were the weakest.

The Euro gained just under one cent this past week to close Friday at $1.258.  This is now the third consecutive week of a strengthening Euro to the US dollar.  The US Dollar index, a measure of the US dollar strength against six major currencies, fell another 0.5% marking the fifth down week out of the past eight.  Expectations that the Federal Reserve will resume quantitative easing and thus holding down interest rates, is the likely cause for the weakening US dollar I believe.  The ECB, with all of its difficulties, still pays more on debt than the US providing incentive for buyers to remain invested in ECB debt.

Commodities posted another positive week as the broad Dow Jones UBS Commodity index rose 0.5%.  WTI Oil closed the week with a 0.5% increase closing Friday at $96.47 per barrel.  Gold rebounded strongly on Friday following Fed Chairman’s remarks at Jackson Hole and finished the week up 0.9% closing at $1687.60 per ounce.  WTI Oil jumped 9.6% in August while Gold added 4.5% and contributed substantially to the Dow Jones UBS Commodity index’s 1.3% gain.   Cocoa, Silver, and Cotton were to top gainers last week while Orange Juice, Cattle, and Platinum were the weakest.  The recent rise in oil prices has moved to the pump with the national average for a gallon of regular gas at $3.83 up 8.5% in August. 


If asked what subjects were interesting and which they might like to study, I doubt economics would be high on most people’s lists.  I remember a conversation I had some years ago while studying for my MBA at the University of Cincinnati with a friend who was earning her PhD in Economics.  I told her I thought the Holy Grail of economics was to find a quantitative model that would predict human behavior and since that was an impossible task, economics was more junk science than science.  Looking back, I realize how naïve that statement was.  I still believe that economists will never find the perfect quantitative model, but I do recognize that economics is a critical field of study and that our very well-being is strongly influenced by the outcome of economic policy decisions made both here and abroad.  Economists in the form of central bankers are exerting more power over economic policy than they have in several generations.

Economic policy consists of monetary policy and fiscal policy.  Monetary policy primarily uses the supply of money in an economy to maintain economic stability.  Controlling inflation is seen a top priority for most policy makers and they do so traditionally by setting interest rates by both regulation and the purchase and sale of bonds on the open market.  Central bankers are responsible for monetary policy in most of the free world and typically fall outside the control of political leaders.  This independence allows central bankers to make unpopular decisions such as shrinking the money supply and causing interest rates to rise and economies to slow.  Obviously, politicians would not likely support a contraction of money supply especially in an election year even if it were the right thing to do at that time.

Fiscal policy consists of policies regarding government spending and taxation.  Political leaders are responsible for setting policy matters with regards to how much a government will spend and for what, and also how much it will levy in taxes.  Politicians in democratic countries are accountable to their populations and are thus strongly influenced by the will of the people.

Coupled together, monetary policy and fiscal policy work together to foster economic growth, strength and well-being for a country. When fiscal or monetary policies get out of sync imbalances and trouble can occur.  This leads my analysis of today’s mess.

The EU and the US have been operating for decades with fiscal policies that have resulted in ever increasing sovereign debt levels.  Make no mistake, spending and borrowing is a fiscal policy decision, not a monetary one.  As debt levels increase, as government spending increases, more and more of the productivity of the private sector is diverted to government and less productive uses.  Over time this becomes a drag on an economy, production slows, unemployment rises, tax revenue to governments contract, and we suddenly wake up to the prospect of a pretty bleak future…unless fiscal policies are changed.  This is precisely the challenge facing us today.  We must make very, very tough fiscal policy decisions in democratic countries where the voters must in a sense vote against their own self-interest.

I believe most politicians do not like making tough decisions, especially when those decisions are likely to upset the very people who elected them to office.  Politicians look for an easier way.  The easy way in this case is to turn to the central bankers, Mr. Bernanke in the US and Mr. Draghi in the EU, and get them to do the heavy lifting.  For the most part, the central bankers have complied and we have seen some of the most accommodative and easy monetary policies in all of our lifetimes.  But that has not been enough to stem the crisis, especially in Europe.  Mr. Draghi did not go to Jackson Hole this past weekend because he is facing enormous pressures in Europe.  The German publication, Der Spiegel, published an outstanding story on August 27th that summarized the problem by saying, “They (politicians) are feeling desperate because, after 17 monetary summits, they still haven’t been able to stop the crisis.  And now they are pleased to see Draghi doing the work for them.” (Italics added for emphasis.)  I believe that we have a similar situation here in the US, not quite as severe, but serious all the same.

So here we are.  Our political leaders, failing to do their jobs, continue to push central bankers to use monetary policy to compensate for terrible fiscal policies.  There are voices who challenge this application of monetary policy.  One of the most important is Jens Weidmann, the president of the Bundesbank, Germany’s equivalent to Ben Bernanke.  Mr. Weidmann has opposed most calls for the ECB to begin direct bond purchases of EU sovereign debt saying that such purchases violate the 1992 Maastricht Treaty (created the EU and the Euro ) and relieves pressure on European leaders from making tough fiscal policy adjustments.  However, Mr. Weidmann has come under increasing pressure from many politicians to relent and support Draghi’s plan for an American-styled QE by the ECB.  The Der Spiegel story concluded that it was just a matter of time before Mr. Weidmann is politically overwhelmed and forced to support direct bailouts or resign.  Mr. Bernanke is also coming under political pressure from both sides here.  The Democrats want Mr. Bernanke to do everything he can possibly do to continue providing essentially free money to keep the current administration in the White House while Republicans want Mr. Bernanke to cut off bailouts and force political leaders to make tough decisions about reducing spending and borrowing. 

The debate continues.  As you know, I try hard not to make predictions because no one really can say how events will unfold.  If you were to force me to take a position I would have to say that I believe both the ECB and the Federal Reserve will continue to use monetary policy to make up for the failings of fiscal policy.  I say this because both Draghi and Bernanke have publically stated they support such actions, and I believe the only thing that has held them back for now are the few but vocal voices of opposition who seek to shift responsibility back to elected leaders.  Mr. Bernanke and Mr. Draghi can hold off the day of reckoning for just so long, however, and if sound fiscal policy is not in place soon, two percent growth is going to feel like the good ole days.


Summer is officially over and I hope everyone enjoyed their Labor Day weekend holiday. Trades will get back to work and I suspect September is going to be an interesting month.

With Draghi’s absence at Jackson Hole, even more attention will be directed to his remarks following a meeting of the ECB on Wednesday.  Much has been made of his comment this past July throwing his full support behind preserving the Euro.  Traders are expecting Mr. Draghi to begin another large round of bond purchases (quantitative easing/QE) to help stabilize borrowing costs in such countries as Spain and Italy.  The news that Germany’s exports fell sharply in August (reported Monday morning, September 3rd) will put even more pressure on Draghi to act, and European markets holding firm on Monday reinforce this conclusion.  This will be an important speech and September promises to be an important month for the EU.

This holiday-shortened week has three major economic reports due out.  Tuesday morning is the Institute for Supply Management (ISM) Manufacturing Index August report.  The consensus calls for a reading of 50 which means manufacturing is neither growing or contracting.  Whether the number is a little above 50 or below, the manufacturing sector is not doing much.  Thursday has the weekly Initial Jobless Claims report.  Consensus is for jobless claims to come in at 370,000 the same expectation of the previous week.  The actual number last week was 374,000.  Again, this number is at such a level that a move a few thousand above or below doesn’t matter.  Unemployment seems frozen between 8% and 8.5%.  Finally, Friday has the official August Employment Situation report.  Consensus is calling for new non-farm payroll jobs to grow by 125,000 compared to July’s increase of 163,000, and the unemployment rate to remain at 8.3%.  All of these numbers have one thing in common…we are mired in a plow horse economy.

The New York Stock Exchange Bullish Percent (NYSEBP) closed Friday at 60.03 up from 59.79 the previous week.  This is the eleventh consecutive weekly increase for this important technical indicator.  I have noticed also that this is the third weekly drop in the rate of improvement meaning that the pace of improvement is slowing which typically happens before we get a drop in the NYSE Bullish Percent.  For now, however, positive momentum remains in US stocks.  The overbought reading for the S&P 500 continues to fall and closed Friday at 35%.  Looking back over ten weeks, the S&P 500 is getting less expensive and is clearly not in the extreme overbought range which I believe begins at 100%.  I have reported that fixed-income, bonds, has been the most overbought and therefore expensive asset class.  Even with the recent strength of US Treasuries, bonds as an overall asset class is now 77% overbought, high, but not extreme and well below the 120%+ readings of just a few weeks ago.  Only the Corporate High Yield bond sector is overbought by more than 100% at 125%.  Emerging market stocks have shown the greatest weakness and are now overbought just 14%, the lowest of any stock sector.

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.

The fiscal cliff is looming, but for now all eyes will be on Europe.

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

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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.