Wednesday, September 19, 2012

Quantitative easing is once again part of US monetary policy following Thursday’s announcement by Ben Bernanke that the US Federal Reserve would begin another program to buy mortgage-backed securities.  Some form of easing was anticipated following recent statements by Mr. Bernanke indicating he was in favor of intervention; however, many economists did not expect the unlimited duration of this new policy.  This third round of easing (referred to as QE3) had an immediate and positive impact on stock markets and “Risk On” assets, and rippled through the remainder of other markets both here and abroad.  The net effect of the Federal Reserve’s action will be to pump more and more money into the economy, which, I believe, will push prices for nearly everything higher, and exert influence over the markets near term.  As I review the past week, you will see this QE3 theme affecting every major market and asset category.

For the week the Dow Jones Industrial Average (DJIA) added 287 points (2.2%), the S&P 500 gained 1.9%, the NASDAQ increased 1.5%, and the small and mid-capitalization dominated Russell 2000 led US indexes for the second week in a row adding 2.7%.  Historically September is the weakest month for stocks, but that has been anything but the case so far.  For the month, all of the major stock indexes are up led by the Russell 2000 that has posted a 6.5% gain in just two weeks.  The S&P 500 is up 4.2% followed by the DJIA and NASDAQ which are each up by 3.8%.  For the year the DJIA is now up 11.3%, the S&P 500 is up 16.6%, the Russell 2000 is up 16.7%, and the NASDAQ continues to lead with a 22.2% gain.

Utilities was the only major economic sector negative this past week as the “Risk On” theme hurt the more defensive sectors.  The other weak sectors last week were Consumer Staples and Health Care.  Energy, Materials, Financials, and Industrials were the best performing sectors and exceeded the DJIA for the week.  For the year, Financials is now the best performing sector followed by Consumer Discretionary, Information Technology, and Real Estate.  Utilities, Energy, and Consumer Staples are the weakest.  The Utilities sector, although positive for the year, has significantly underperformed the other sectors so far.

International stocks continued to rally this past week led by the Emerging Markets region that posted a gain of 4.3% for the week.  The “Risk On” theme sponsored by the Federal Reserve’s and European Central Bank’s (ECB) monetary policies has given a strong boost to international stocks both in terms of overall risk tolerance by investors, but also by weakening the US Dollar which helps international investment valuations here in the US.  The MSCI (EAFE) gained 3.7% and the European STOXX 600 index gained 1.3%.  In addition to the Emerging Markets region, the Asia/Pacific region also did well gaining 3.6%. 

The Barclays US Aggregate Bond index posted its second consecutive loss last week losing 0.43% as “safe haven” bonds were sold in favor of riskier assets.  The 10-year and 30-year US Treasuries were especially hard hit with yields jumping dramatically for both bonds.  The 10-year yield increased from 1.668% to 1.863% and the 30-year yield moved north of 3% to close last week at 3.089%.  This is the first time since May 4th that the 30-year US Treasury yield closed above 3%.  As with stocks, the key theme in the bond markets was “Risk On.”  For those who may not be aware of the diversity of the bond market, it is important to realize that the bond market is anything but a homogenous pool of like-style investments.  I track over 13 different bond sectors on a weekly basis from the ultra-conservative US Treasuries to riskier high yield bonds and preferreds.  Some bonds are sensitive to credit risk (the ability of companies to pay back their bonds) while others are sensitive to interest rates (the upward or downward movement of interest rates).  Still others are not even bonds.  The floating rate sector is not comprised of bonds at all, but rather bank loans that are made by banks to companies.  This past week the “Risk On” theme affected bond markets as safe-haven bonds like US Treasuries significantly underperformed for the week while corporate high-yield and preferreds did very well.  Bond sectors that provide investors some protection against rising rates like Treasury Inflation Protection Notes (TIPs) and floating rates also did well.  International bonds did well with the weakness in the US Dollar.

The US Dollar came under considerable pressure after the Fed announced the terms of QE3.  As I have said, the net result of QE3 will be an increase in the supply of cash, and the more cash you have in the economy, the less valuable it becomes.  The US Dollar Index fell 1.8% this past week and was the worst weekly performance by the index in 2012.  The Euro gained 2.5% against the US Dollar to close last Friday at $1.313.  This was the largest weekly percent gain in 2012 and marks the highest Friday close for the Euro since late April.

A weak US Dollar drives commodity prices higher and this was certainly the case last week.  The Dow Jones UBS Commodity index gained 3.2% and is now up 4.1% in September.  Gold added another $29.50 (1.7%) per ounce to close Friday at $1770.00.  Gold is up $82.40 (4.9%) this month as central bankers around the world have announced they will print more money.  Oil also increased $2.66 (2.7%) to close Friday at $99.03.  Worries over escalating tensions in the Middle East are partially responsible for the increase in oil; however, the weakening US Dollar is also a major factor in rising oil and commodity prices.  For the year, the Dow Jones UBS Commodity index is up 8.1%.


I will attempt in a limited space to explain QE3 and the ramifications it may have on investors.  I have already spent time recently discussing central banks and their role in setting monetary policy and thus influencing economic policy both here and abroad.  If you did not read the past three or four Weekly Updates, I would encourage you to go back and review the middle sections.

So what exactly did the Federal Reserve do with QE3?  Three things actually.  First, Chairman Bernanke said that the Fed would keep the Federal funds rate low (0.0% to 0.25%) until mid-2015 (an extension of another year); second, the Fed is continuing Operation Twist (buying longer-duration Treasuries as short-term Treasuries mature) until the end of 2012; and third, the Fed is going to begin purchasing $40 billion of mortgage-backed securities per month indefinitely until the job market improves.  The Federal Reserve’s statement on Thursday said this move “should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.” The net result of this extremely accommodative monetary policy is to push cash into the economy with the expectation that all of this money will help stimulate economic activity and ultimately drive down unemployment.

For investors, I believe, this means that the “Risk On” trade is back and the risk of future inflation has been increased.

The concept of “Risk On” and “Risk Off” scenarios emerged as a dominant theme in the post-Lehman Brothers bankruptcy era and ensuing financial crisis.  This past April, HSBC published a paper authored by Stacy Williams, Daniel Fenn, and Mark McDonald titled, “Risk On – Risk Off, Fixing a Broken Investment Process.”  In their outstanding report, the authors conclude that long-standing investment principals used by most asset managers have been challenged by the extremely high correlation of asset classes in the past three years.  In the past, it was assumed that different asset classes had different correlations and therefore provided investors benefits through diversification.  Since the start of the financial crisis, the degree with which asset classes move together (correlation) has increased dramatically and securities trade, not on their own fundamentals, but on the market’s perceived levels of current risk.  According to the paper’s authors, the cause of this new phenomenon is primarily attributable to “a new systemic risk factor.”  They see this new systemic risk factor coming directly from “global intervention, QE and policy response of an unprecedented scale across many countries—and markets are pricing in the bimodal nature of consequences.”  In other words, massive intervention by central banks and governments in the global economy has distorted traditional economic relationships and there is great uncertainty about whether these interventions will achieve the desired outcomes.  When investors feel like policy actions are positive (at least in the short term), we see the “Risk On” trade emerge, while pessimism leads to “Risk Off” trades.

It is also important to note that another factor associated with the “Risk On – Risk Off” theme is that movements tend to be event driven.  The announcement of quantitative easing or the Greek financial crisis are just two examples of this and in each case, investors are making judgments about the levels of systematic risk in markets.  With the “Risk On” trade comes strength in riskier assets: stocks, commodities, and some bonds.  Not all stocks or all commodities or some bonds will benefit by the “Risk On” trade but most do.  Defensive sectors, higher yielding stocks (which are seen as more conservative) may lag, for example.  However, the general trend is up, up, and away with prices.  Safe haven assets such as US Treasuries and the US Dollar will pull back.  This is what we saw happen this past week.

If traditional investment principals no longer work as effectively in the current “Risk On – Risk Off” environment, then what are investors to do?  The authors of the HSBC article describe four approaches to investing in today’s world.  I want to highlight one of the approaches they refer to as “Seek unaffected active strategies.”  They go on to say, “some active strategies, such as momentum, have remained largely impervious to Risk On – Risk Off.”  I fully support this conclusion and have for some time.  This is why I use the relative strength (RS) research provided by Dorsey Wright & Associates.  RS is a form of trend following and trend following is tied to momentum.  I believe RS is a sound tool upon which to make investment decisions.  When old school concepts no longer work or are no longer as effective, then it is time to adapt and move forward and that is what RS analysis does.


Markets will continue to absorb the implications of QE3 and activities in Europe and elsewhere.  I agree with one of my favorite market observers, Scott Grannis (Calafia Beach Pundit), that the one thing for certain the Federal Reserve did last week was raise the probability of future inflation and make it more difficult for the Fed to step away from QE.  When inflation becomes a problem (and I believe it will some day), the Fed will have to pull money out of the markets and that traditionally requires unpleasant actions.  The more money into the market today the more that will be required to be removed and the more painful future moves will be. Offering a possible preview, Egan-Jones, one of nine nationally recognized statistical rating agencies announced last week that they were cutting the US’s credit rating for the third time from AA to AA- (the lowest rating among “high grade”bonds) citing the Federal Reserve’s continued monetary easing and debt purchases.  Eagan-Jones was the first ratings agency to cut the US credit rating back in July 2011.  It is too early to tell if any of the other rating agencies will follow, but it does provide some indication of how bond markets may eventually look upon the Fed’s latest actions.

After the busy week last week, this coming week has just a few economic reports due out.  Housing will be the focus on Wednesday as August Housing Starts and Existing Home Sales will be released.  Both reports are expected to show some modest increases from July’s data.  Initial Jobless Claims will be out Thursday morning.  Consensus is for 373,000 new claims, down from last week’s 382,000 increase.  The number remains too high and was likely one of the reasons that the Fed pushed for QE3.  The employment situation remains a real concern.

The New York Stock Exchange Bullish Percent (NYSEBP) closed Friday at 67.58 up from 62.56 up from 60.03 the previous week.  This important indicator about the general trend in US stocks has remained positive now for 14 weeks.  When the NYSEBP reaches 70, risk levels are becoming elevated.  It does not mean that a pullback is eminent, it is just that the risks of such an event are increasing.  Likewise, the S&P 500 is now overbought by 83% compared to last week’s 65% and the previous weeks level of 35%.  Corporate high yield, emerging market income, and US small cap stocks are the most overbought at this time exceeding 125%.  I believe that prices for these specific categories are high enough to hold off putting new money to work there.  After the past two weeks of gains, most categories (except bonds) are now overbought by 100% or more indicating caution.  Again, risk levels are elevated for now.

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.

Understanding how this market has become event driven and the potential for events to move markets, the next foreseeable “event” is the fiscal cliff.  Congress has just a week to do something before they go on recess prior to the November elections.  Much to do in so little time.  My guess is that we will just have to hope that a lame duck Congress can do something before we get into another fiscal crisis.  I do not think the Federal Reserve can do much more on the monetary side of the economic equation to save the politicians from themselves.

On a personal note, I will be taking next week off and not writing an update.  My daughter, LeeAnn, is getting married in Richmond on September 22nd and I will have the honor of walking her down the aisle.  I want to wish LeeAnn and her future husband, John Martin, great happiness and success.

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.