Monday, October 15, 2012


Investors turned cautious this past week shifting money away from stocks and into safe-havens like US Treasuries and the US Dollar.  A report issued by the International Monetary Fund (IMF) and the downgrade of Spanish sovereign debt by Standard & Poor’s refocused concerns about the effectiveness of the European Union’s (EU) efforts to deal with the on-going debt crisis in Europe.  While here at home, the consensus is growing that earnings for the 3rd quarter will not be as robust a previous quarters due to the slowing global economy.  I believe that companies have trimmed every bit of fat out of their budgets and therefore, if any real growth is going to emerge in profits, it will have to come from revenue growth, not spending cuts.

The Dow Jones Industrial Average (DJIA) fell 281 points (-2.1%) last week for its worst weekly loss since the week ending June 1st some 19 weeks ago.  The S&P 500 lost 2.2%, and the Russell 2000 gave back 2.4%.  The technology-heavy NASDAQ lost 2.9% as Apple fell 3.5%.  Let me take a brief moment to describe how the NASDAQ Composite index is constructed.  The NASDAQ is like many indexes and is a capitalization-weighted index.  This means that the weighting given to Apple and other companies within the index is in direct proportion to the market size of each company.  Apple is the largest company in the world in terms of market capitalization (total number of shares outstanding multiplied by the current share price) and makes up just over 9% of the NASDAQ, so the performance of Apple greatly influences the performance of the NASDAQ. 

For the year, the DJIA is up 9.1%, the S&P 500 is up 13.6%, the Russell 2000 has increased 11.1%, and the NASDAQ has gained 16.8%.

Not a single major economic sector was positive last week.  Real Estate and Utilities were the best performing sectors losing less than 1%.  Energy, Financials, Consumer Staples, and Industrials followed in order of performance and all outperformed the DJIA.  Information Technology, Consumer Discretionary, and Telecom were the weakest and all lost more than 2%.  For the year, Consumer Discretionary, Health Care, Financials, and Telecom are the strongest performing sectors while Utilities, Energy, and Industrials are the weakest.

The protests that greeted German Chancellor Merkel in Greece early in the week or Wednesday evening’s downgrade of Spanish sovereign debt to one notch above junk by S&P failed to shake European markets.  This leads me to believe that some of the obvious bad news is already discounted into European stocks.  The STOXX 600 fell a modest 1.7% for the week while the MSCI (EAFE) index fell 2.1%.  The Emerging Market region was the best performing region losing just 0.5% for the week while the Asian/Pacific region fell 1.5%.  I remain, as I have all year, skeptical about international markets and European markets in particular.  I remain skeptical first because the technical indicators provided to me by Dorsey Wright & Associates in Richmond, Virginia, have placed international equities either in last or next to last place relative to the other four major asset categories in 2012.  Second, I do not believe that the EU is progressing quickly enough to alter fiscal policies anchored in bloated government-dominated economies toward more robust private sector-based economies.  Therefore, I believe the risk/reward attributes of European stocks are not attractive. 

I mentioned at the top of the Update that US Treasuries regained some popularity last week as a safe-haven investment and that was reflected by the 10-year and 30-year yields falling over the past week.  The 10-year yield fell from 1.737% to close Friday at 1.660%, while the 30-year yield fell from 2.965% to 2.833%.  The latest move in Treasuries marks the third time in six weeks that their prices have risen (yields down).  What I see, especially in the 30-year yield, is that each successive high has been higher than the previous high, and that each successive drop in yield has been higher than the previous drop.  Higher highs and higher lows in yields provide a longer-term upward trend to interest rates, and I will be watching this closely to see if a trend is developing.

The rally in longer duration US Treasuries helped bonds outperform stocks last week.  The Barclays US Aggregate Bond index was up 0.4% for the week and is now up 4.4% for the year.  The best performing bond sectors last week were the long duration US Treasuries and corporates along with high quality corporate and emerging market sovereign debt.  Treasury inflation protection notes (TIPs), mortgage-backed bonds, and short duration international treasuries were the weakest performers losing less than 0.5% for the week.  Yields on Spanish, Italian, and French sovereign debt all fell like US Treasuries.  The drop in Spanish debt may be perplexing in light of S&P’s downgrade, buy yields did drop.  I will attempt to explain the market’s reasoning shortly.

The US Dollar index gained 0.4% last week marking the third week out of the past four that the US Dollar has strengthened against a basket of foreign currencies.  The Euro lost almost a penny (-0.6%) against the US Dollar to close Friday at $1.295.  Worries about the European debt crisis continues to keep currency traders off balance and unsure about the success of the EU, European Central Bank (ECB), and the IMF in dealing with the current situation on the ground.  I believe the recent US Dollar weakness over the past several months was influenced by the Federal Reserve’s decision to engage in another round of Quantitative Easing (QE III), however, the effect of that policy on currency traders has lessened and most attention is now focused on the EU.  Traders can be a finicky lot, so next week may bring an entirely different story (think US elections and fiscal cliff) and an entirely different set of behaviors.

Commodities pulled back for the second week in a row with the UBS Dow Jones Commodity index falling 0.6%.  Natural gas and oil prices were both higher last week.  Natural gas because of lower than expected inventories.  Oil, according to reports, because of fears over political uncertainty in the Middle East coupled with the increasingly hostile activities on the Turkey/Syrian border.  The Organization of Petroleum Exporting Countries (OPEC) went to great lengths to reassure markets and told the IMF at its meetings last week that OPEC was prepared to insure adequate supplies for world consumers.  Despite OPEC’s efforts, WTI Oil still jumped $1.94 per barrel (2.2%) to close Friday at $91.86.  Gold fell $21.10 per ounce (-1.2%) to close at $1759.70.  I believe that anytime the US Dollar strengthens, as it did last week that helps push down or hold gold prices steady.  There were also reports that China had slowed gold imports over the past few months, and China’s activities have a huge influence over commodity prices, including gold. 

IS SPAIN PLAYING A GAME OF CHICKEN WITH THE EU?

Oh boy.  Here I go again writing about Europe and the debt crisis.  For those of you who read my Updates regularly know how tired I have become writing about Europe and their economic and debt mess, yet events in Europe compel me to pick up my pen and address this subject once again.  My focus this week is on Spain and the dangerous game of chicken I believe that country is playing and what it means to us.

The game of chicken takes on many forms from benign games little kids will play to the more serious life-and-death games countries play with each other.  The one thing all players have in common is that they try to outlast their opponent even in the face of perceived or real doom.  Each  player believes the other will flinch first and victory will be to the steely-nerved one, but if neither makes a move, both players will suffer.  This is precisely the game, I believe, that Spanish President Mariano Rajoy is playing with the EU.

Before the Olympic Games in London this past summer, ECB President, Mario Draghi, assured the world he would do “whatever it takes,” to keep the euro together.  A couple of days prior to Mr. Draghi’s comments on July 26th, the yield on the Spanish 10-year sovereign bond reached 7.69% and Spain was on the verge of economic collapse.  When markets closed just a day after Draghi’s comments, the yield on Spain’s 10-year had fallen to 6.74%.  Not perfect, but clearly much better than earlier in the week.  Since then, Mr. Draghi has outlined a specific plan for any EU country to obtain aid and the EU has formalized its bailout mechanism now known as the European Stability Mechanism (ESM).  The Germans, who have never been enamored with bailouts, were able to drive one key concession in the structuring of the ESM, and that concession was that a government would have to formally request the bailout.  Now you might think that is a rather innocuous concession, but just look at the three previous countries that sought and received bailouts:  Greece, Portugal, and Ireland.  The political parties in power at the time of the bailouts were all voted out of office at the first national elections following the bailout.  The political price to pay for seeking a bailout can be extremely high.

Spanish President Rajoy certainly understands this.  He also understands that with the S&P’s downgrade of his country’s debt, it is more clear than ever that his efforts to stabilize Spain and turn things around has either not worked, or are not working quickly enough.  Spain has the highest unemployment rate (25.1%) in the EU, and Spanish banks require over 100 billion ($129.5 billion) of recapitalization.  The economy is in recession and shows no sign of improving.  Demands on the government treasury are increasing, not decreasing.  Yet the yield on Spanish 10-year debt fell following S&P’s downgrade.  Are investors mad?  No.  They believe that Rajoy will be forced sooner, rather than later, to formally request a bailout.  With the ESM in the mix, Spanish bond investors believe they have downside protection on their investments and are willing to buy Spanish bonds.  Rajoy also understands that without having to go to the ESM so far, his bond yields have fallen dramatically and he has been able to refinance most of the debt Spain has coming due in 2012.  Pressure has been relieved and all of this accomplished without approaching the EU and having conditions established over Spanish sovereignty that would certainly be part of any bailout from the ESM.

How long can this last?  This is the game of chicken Rajoy is playing.  He is betting that he can get things turned around in Spain before the markets turn on him and drive up borrowing costs thus forcing him to go to the EU and the ESM.  Critics say that Rajoy should go to the ESM now while the debt levels are still manageable and expectations were that the S&P downgrade would make him understand the necessity of that course of action.  If Rajoy does not tap into the ESM and he cannot turn the country around, the cost of the bailout will increase significantly hurting not only Spain but also the EU, and jeopardizing the entire global economic balance.  I believe that Rajoy should act now, and that the longer he waits, the more uncertainty will creep into the markets, and the more unpleasant the outcome will have on the global economy.

LOOKING AHEAD

The coming week is going to be busy in terms of new economic data which is certain to keep all the talking heads buzzing on TV.  Given the proximity to the presidential election, every economic data point is going to be scritinized and dissected ad nauseum.

September retail sales get things kicked off Monday morning.  Retail sales is an important number because two-thirds of the US’s Gross Domestic Product (GDP) is based upon consumer consumption.  Consensus calls for a slight decrease from 0.9% in August to 0.7% in September.  The September Consumer Price Index and Industrial Production numbers will be released on Tuesday.  Prices are expected to increase at a slightly lower rate (0.5% vs. 0.6% in August), and Industrial Production is expected to increase 0.2% after falling 1.2% in August.  This will be an especially politically sensitive number, I believe.  New Housing Starts will be released Wednesday morning and are expected to continue increasing over previous monthly numbers.  The annualized rate for new home construction in September is expected to be 765,000 compared to 750,000 in August.  The Jobless Claims report on Thursday will also be carefully watched for political reasons.  Last week’s number of 339,000 was an unexpectedly sharp improvement, but was quickly discounted after it was learned that the Bureau of Labor Statistics had not included California’s number in their data.  This week, a arge upward revision is expected on the previous week’s number along with 765,000 new claims for last week.  Friday will conclude with September Existing Home Sales.  This number is expected to decrease from an annualized rate of 4.82 million homes to 4.75 million.  As I noted, with the presidential elections so close, all of these number will come under extraordinary scrutiny, but as we have seen most of the year, there is really nothing newsworthy in the numbers other than what we already know—economic growth is stuck in slow-motion.

The New York Stock Exchange Bullish Percent (NYSEBP) fell 1.03 to close Friday at 65.33.  This marks the third down week in the past four following two very strong weeks in early September.  I sense that momentum is waning and that this indicator feels like a plane stalling at the apex of a climb.    For now, however, there appears to be enough power in the engine to keep the plane right where it is, but I will be watching to see what direction the bullish percent moves from here.  The CBOE Volatility Index (VIX) has increased slightly over the past couple of weeks, but remains at a subdued 16.14.  Finally, the Standard and Poor’s 500 index is now 3% oversold, meaning that the current value of the index is about neutral based upon the past ten weeks of activity.

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, Health Care, and Real Estate.  Information Technology has fallen from third position to sixth on a relative strength basis.  US Treasuries and International Bonds are favored in the Bond category, while US and Developed Markets are favored within the International stock category.  Energy and Agriculture are the favored sectors within the Commodities asset category.

Sincerly,






Paul L. Merritt, MBA, AIF®, CRPC®
Principal
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.