Monday, October 1, 2012

The 3rd quarter provided investors solid returns despite consecutive weekly losses to close out the quarter and growing concerns about a global economic slowdown.  The Dow Jones Industrial Average (DJIA) gained 4.3%, the S&P 500 was up 5.8%, the Russell 2000 added 4.9%, and the NASDAQ led all major US indexes with a 6.2% gain for the quarter.  The gains over the 3rd quarter illustrated just how difficult it is for investors to place their faith in such maxims as, “sell in May and go away.”  The last two years following this maxim would have helped, but not this year, and over the longer-term, empirical evidence has not supported this somewhat popular view.  For the year, the DJIA is now up 10.0%, the S&P 500 is up 14.6%, the Russell 2000 has gained 13.1%, and the NASDAQ is up a solid 19.6%.

Telecom led all sectors in performance in the 3rd quarter and is now the second best performing sector for the year.  The major phone companies (AT&T and Verizon) have benefited by our obsession with phones, and I believe we will continue to do so as phone technology continues to improve.  Telecom was followed by Energy, Consumer Discretionary, and Information Technology.  Real Estate, Utilities, Industrials, and Consumer Staples were the weakest sectors during the quarter and all underperformed the DJIA.  For the year, Consumer Discretionary, Telecom, Information Technology, Health Care, and Financials are the top performing sectors and all bested the S&P 500’s return.  Utilities, Energy, and Industrials are the bottom three performing sectors through the first three quarters of the year and only Utilities and Energy have not outperformed the DJIA.  All sectors are positive for the year. 

International stocks rallied last quarter with the MSCI (EAFE) index posting a strong 7.2% gain.  Looking at the various regions around the world, Europe (STOXX 600) led with a gain of 6.9% followed by Emerging Markets which added 6.5%.  The Asia/Pacific region lagged all others with a gain of 4.5%.  I believe Europe, which had been hard hit over the debt crisis, rallied off lows as the European Central Bank (ECB) stepped forward promising to provide support via a bond-buying program, while the Far East has been hurt by a slowdown in Chinese manufacturing. 



US Treasury yields pulled back sharply the last two weeks of September after rising on news that the ECB and US Federal Reserve pledged to make sizeable bond purchases.  The 10-year yield closed Friday at 1.628% compared to a yield of 1.863% two weeks earlier.  The 30-year has traded similarly and closed Friday at 2.823%.  I believe that Treasury yields at this level reflect significant pessimism among bond investors who do not see robust growth for years to come.  European investors have renewed bond purchases of European Union (EU) sovereign debt now that the ECB has said they would also purchase bonds.  Spain, the most significant risk in the EU, has seen its 10-year yield fall from 6.857% on August 31st to 5.938% at last Friday’s close anticipating ECB purchases.  However, in order for the ECB to begin purchasing Spanish debt, Spain must make a formal request to the ECB.  To date, this has not happened and there is great internal political pressure to avoid such a request.  Spain’s debt problems are growing and I would expect bond investors to start getting nervous waiting on the Spanish government to make a formal request.  I believe it is just a matter of when, not if, a formal request will be made.  As I have said before, watch the sovereign yields, the yields reveal how markets are thinking about the economic future of countries.  The Barclays US Aggregate bond index gained 1.7% in the 3rd quarter and is now up 4.2% for the year.  Emerging Market debt led all bond sectors in performance over the past quarter with gains matching the major US stock indexes.  International treasuries and quality corporate bonds also did well.  Extended duration US Treasuries and corporate bonds were the weakest bond sectors.  For the year, Emerging Market bonds, Preferreds, and High Income are the best performing bond sectors while short duration bonds of all types are the weakest.

The US Dollar index fell 2.0% in the 3rd quarter and is now down 0.3% for the year.  The US Dollar’s weakness, I believe, is due to the Federal Reserve’s commitment to easy monetary policies expressed in terms of ultra-low interest rates and indefinite bond purchases.  Pumping dollars into the economy increases the supply of US Dollars and the more of anything you have, the cheaper it becomes--Economics 101.  However, as doubts are increasing over the effectiveness of the latest round of stimulus, the US Dollar gained strength and the US Dollar index was positive the last two weeks in September.  I believe currency traders are very unsure about how the next few months are going to play out.  The Euro gained 2 cents (1.5%) against the US Dollar in the third quarter and closed Friday at $1.285.  For the year, the Euro is down about one cent (-0.7%) to the US Dollar.   

Commodities were among the best performers last quarter.  The Dow Jones UBS Commodity index posted a 9.7% gain on the strength of precious metals, natural gas, and oil.  Gold gained $170.30 (10.6%) per ounce for the quarter and is now up 13.3% for the year.  Gold is a hedge against weak currencies and I believe these gains reflect investor worries about easy global central bank monetary policies.  WTI Oil also did well this past quarter gaining 8.4% to close Friday at $92.10 per barrel but is down 6.8% for the year.  Brent Oil gained 14.7% last quarter reflecting more concerns about the Iranian problems than WTI, I believe.  Brent is up 4.5% for the year.

UNCERTAINTIES ABOUND HEADING INTO THE 4th QUARTER

As we start the last quarter of 2012, I sense a great deal of unease.  One does not need to look far to see what investors are worried about.  The upcoming US elections, the looming fiscal cliff, a European debt crisis that is hitting its third anniversary, and slowing manufacturing in China are among the biggest concerns.  US economic data has not provided any inspiration either.  Last week the final revision of the 2nd quarter Gross Domestic Product (GDP) was revised downwards from 1.7% to 1.25%.  Most talking heads on TV pushed that report aside insisting that number was “old news.”  Durable goods orders plummeted in August, and unemployment is holding steady at just over 8%.  More worrisome is that job creation is barely keeping up with demographic increases in the work force (100,000 new workers every month).  Housing appears to be bottoming and that is a positive signal, however, unless the economy grows at something more than 2% GDP, I do not see the prospect of more robust housing growth.  In short, economic signals are weak.

Yet the S&P 500 is up nearly 15% so far in 2012.  How can that be you might ask?  The answer is simply that the stock market is a forward-looking economic indicator.  If investors believe that the current price of stocks relative to future growth and value is cheap, then they will buy stocks and the market will go up.  This has been the message the markets have been signaling all year—stocks are cheap relative to future growth. 

I am not suggesting that all is well and we can push blindly forward.  Quite the contrary.  I am saying that investors must be aware of what is going on around them and invest smartly.  The Motley Fool website recently published a story (Dangerous Denial—September 20, 2012) citing a study released by Franklin Templeton Investments that found 56% of investors thought the US stock market had fallen each of the past three years.  In fact, the S&P 500 is up nearly 60% since the start of 2009 without a single down year.  I was shocked when I saw this, but then again not surprised when I stopped and thought how negative financial media coverage is of current events.  The media cannot help themselves.  It sells papers and gets people to tune in.

So we head into the last quarter of 2012 with a lot of worry.  Legitimate worries.  Situations that must be monitored.  October is a month that carries with it the memories of crashes in 1929, 1987, and 2008.  What October also has delivered are 51 monthly gains in the DJIA out of the past 84 Octobers (going back to 1929).  In other words, October has been up 60% of the time.  Going back just 10 years, October has been positive 70% of the time.  Will this October be positive?  I have no idea.  What I do know is that diligence and the tools to monitor markets are important to investment decision making.  It is also necessary not to let maxims or adages or even headlines throw us off sound investing practices.  Pick strong technical investments, watch the general trend of the markets, and be prepared to adjust as necessary.

LOOKING AHEAD

There are some key reports this week that might influence the markets.  The September ISM Manufacturing Index will be out at 10 AM Monday morning.  It is expected that this timely report will show that manufacturing has contracted for the third consecutive month.  The September Employment Situation report will be released on Friday morning.  Consensus expects 17,000 more jobs created in September than were created in August for a total of 113,000 new jobs.  The unemployment rate is expected to hold steady at 8.1%.  These two reports will provide a relatively current look at the state of the economy and may have even more importance given their proximity to the presidential election.  

The New York Stock Exchange Bullish Percent (NYSEBP) ended the 3rd quarter at 65.96 down 2.3% from the previous week’s close.  This drop is the worst weekly performance for this critical technical indicator since the first week in June.  However, one week does not make a trend, and with a reading of nearly 66, it means that two-thirds of stocks are still on a point and figure buy signal—demand for stocks remains firmly in control.  It will take a drop to 61.37 to reverse this reading.   After the pullback in US markets over the past two weeks, the overbought reading of the S&P 500 has dropped to 33% indicating that markets are not significantly overbought at this time.  Should the markets begin to correct, the key support level for the S&P 500 is 1350.  This would reflect a drop of 6.3% from current levels.

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.

I would like to finish up this weekend by telling everyone that my daughter’s wedding in Richmond on the 22nd was a huge success.  Thank you all for your warm wishes and thoughts.

RIP Taylor.  You were a great companion on Saturday and Sunday mornings as I worked at my desk.






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