Wednesday, November 14, 2012


The 2012 presidential election is finally behind us.  What lies ahead is the prospect of significantly higher taxes and drastic cuts to government spending (the fiscal cliff) unless the President and Congress can find ground to compromise and diminish the potential setbacks to the US economy.  If you look at the market’s performance since the election, I believe investors are signaling that they do not have a lot of confidence that such compromise will be forthcoming.

The Dow Jones Industrial Average (DJIA) fell 278 points (-2.1%) last week including a 312 point loss on the day following the election.  The S&P 500 lost 2.4%, the Russell 2000 fell 2.4%, and the NASDAQ gave back 2.6%.  These losses have helped take some of the luster off what has been a good year for US stocks.  For the year, the DJIA is now up 4.9%, the S&P 500 has risen 9.7%, the Russell 2000 has gained 7.3%, and the NASDAQ is up 11.5%. 

The major economic sectors here in the US were all negative this past week.  Utilities lost just over 4% to lead all sectors to the downside.  This sharp negative move pushes Utilities into an overall negative return for the year.  Telecom, Financials, and Consumer Discretionary were the next three poorest performing sectors behind Utilities losing between 3.5% and 2.4%.  Materials, Industrials, Consumer Staples, and Health Care were the best performing sectors and all lost between 1% and 2% for the week.  For the year, Consumer Discretionary, Financials, Health Care, and Telecom remain the best performing sectors and all have outperformed the NASDAQ.  The top three sectors that lost ground last week are also some of the highest dividend payers of the eleven major sectors.  With the looming tax increases on capital gains, dividends, and interest payments ready to go into place on January 1st, I believe that investors are adjusting their expectations for the after-tax value of the income they receive from their investments in these sectors.

International markets were also down last week.  The MSCI (EAFE) index fell 2.1% and the European-only STOXX 600 lost 1.7%.  While I believe some of the weakness in markets abroad is a sympathetic sell-off with US markets, European markets were also hurt by the riots in Greece and concerns that Greece may run out of money before European leaders approve the next round of bailout funds even as the Greek Parliament passed a new round of austerity measures.  The European Union (EU) has also seen its unemployment rate surge to new post-WWII highs and European Central Bank (ECB) President Mario Draghi warned last week that the European economy would remain “weak” through next year.

Bonds were the beneficiary of investor worries about stocks last week as the Barclays Aggregate Bond index gained nearly 0.2% and is now up over 4.5% for the year.  Extended duration US Treasuries and corporate bonds were the best performing bond sectors as investors’ purchases pushed the US 10-year and US 30-year yields down to 1.614% and 2.747% respectively.  The one-week drop in interest rates was the largest in seven weeks.  High yield, preferreds, and high quality corporate bonds were the weakest sectors.

The US Dollar index gained 0.5% last week and this index is now up for the third consecutive week.  The Euro fell just over 1% to close at $1.271.  This was the largest one-week loss in two months.  I believe the challenges facing the EU are overwhelming currency traders who also see continued weakness in the US Dollar due to the expectation for continued outsized budget deficits in Obama’s second term.  I think the US Dollar’s strength can be equated to PIMCO’s Bill Gross’s worldview that the US is the “cleanest dirty shirt” in the closet.   

The Dow Jones UBS Commodity index gained a slight 0.3% last week primarily on the strength of precious metals.  Gold added $55.70 (3.3%) to close Friday at $1730.90 per ounce.  This gain is, I believe, primarily due to the increasing likelihood that the re-election of Mr. Obama will result in the continuation of a highly accommodative monetary policy to help finance the large deficits his administration may run in his second term.  Since many see gold as a hedge against weak paper currencies, gold and silver purchases were strong and reversed a recent trend of weakness.  WTI Oil gained $1.21 per barrel (1.4%) closing Friday at $86.07.  The Bloomberg news service said that the bump in oil prices was attributable to a higher-than-expected jump in the Consumer Confidence index released this past Friday.  Another story in the Wall Street Journal reported that daily oil consumption in the US has fallen by two million barrels of oil from its high of 20.8 million barrels in 2005 to just 18.8 million barrels today. 


LOOKING AT THE REST OF THE YEAR AND BEYOND

I like clichés.  I like them because they have their roots in some truism of human behavior.  My cliché today is, “the only certainty in life is death and taxes.”  However, I am going to add one more caveat, and that is “media pundits telling all of us what this presidential election means.”  I will humbly add my name to the list of people commenting about the election and what it means to us.

As I have said repeatedly, I generally avoid all attempts at making predictions because I believe the effort is a fool’s errand.  Instead, I prefer to focus on data, and specifically the data provided by Dorsey Wright & Associates.  My belief is that most economic circumstances that impacts what happens in markets both here and abroad are beyond our control so we must focus on making the best decisions given the circumstances at the time we make a decision and then revisit those decisions as events evolve.  However, I am going to make some general observations about where things stand after the election and how they might affect all of us going forward.

The most pressing of issues is the fiscal cliff.  The law currently on the books says that unless Congress and the President act to change existing law, a nearly $600 billion tax increase will go into effect on January 1st along with $500 billion in spending cuts—half aimed directly at Defense.  The spending cuts are referred to as “sequestration.”  A number of different analysts have stated that the fiscal cliff, if enacted as is, would reduce the nation’s Gross Domestic Product by about 4%.  Through the first three quarters of this year, the GDP is growing at an overall rate of 1.7%, and the most optimistic estimates of further growth are no higher than 2%.  This means that the fiscal cliff will put the US squarely back into a full recession with a net GDP growth rate of -2%.  I cannot fathom any scenario where the President and Congress would knowingly and willingly not take bipartisan action to reach a compromise on this matter and reach an agreement.  I believe the markets will remain nervous and this nervousness translates into increased volatility until an agreement is reached.

Like it or not, it now looks like Obamacare will now become a way of life in our economy.  I am not going to debate the argument about whether this legislation is good or bad, but rather focus on the economic impact this sweeping legislation will have on businesses.  If the early headlines are any indication, the news is not positive.  John Schnatter, President and CEO of Papa John’s Pizza (and a Romney supporter) was quoted by WPTV.com saying that Obamacare “would add 10-14% for customers buying a pizza,” and that it “was likely that some franchise owners would reduce employees' hours in order to avoid having to cover them,” referring to the requirement that any worker who works more than 30-hours per week must be covered by health insurance.  A franchisee for Applebee’s has been excoriated on Twitter for suggesting on the Fox News Channel that with Obamacare going into effect he would be forced to consider a hiring freeze or slowing expansion.  Again, I am not taking a position pro or con on Obamacare, I am just saying there are consequences to every law and regulation that the government places on businesses, and in the end, the economic data will give us some idea of the true costs of such legislation and regulations.

I also believe that the chances of reducing the federal deficit in a meaningful way will be muted.  President Obama has shown little inclination to actually do something about the budget deficits (and raising taxes on the upper income earners will not close the gap in a meaningful way) so expect more of the same.  I believe the surge in gold prices following the election was an indication that gold traders see it the same way.  As I have said in previous Updates, my view is that the price of gold is a referendum on how much money the Treasury must print to fund these deficits.  The bigger the deficits, the more money the government prints,  the weaker the US Dollar will eventually get, and the greater the possibility gold will be purchased as a store of real value.

Interest rates will also be an important indicator of how the markets grade the President and Congress’ ability to manage the economy.  US Treasury rates fell sharply this past week signaling bond investors’ belief that the economy is not going to grow in a meaningful way for a very long time.  Remember, that with inflation currently at 1.99%, anyone who buys a US Treasury note with a maturity of 10-years or less is actually losing money in real terms for the duration of owning the note.  Now I recognize that there is a great deal of debate about the future course of interest rates.  Most analysts believe, and I share this belief, that interest rates will eventually go higher.  The question no one really can answer is when this will happen.  I believe that interest rates will rise sometime during the next four years and they will rise because either the government works well together and real growth kicks in (good higher interest rates), or because the private sector loses patience with the political class and forces interest rates higher because of concerns over repayment of funds (bad higher interest rates).  Either way, investors must pay attention to interest rates closely to avoid the possibility of taking significant losses in their bond portfolios.

I believe we are in for some challenging times over the next several quarters.  However, I do believe there are some notable and very positive factors that will be working on the economy in the next four years that will help mitigate the mess we have in Washington.  I will address those factors in my next Commentary in two weeks.


LOOKING AHEAD

The New York Stock Exchange Bullish Percent (NYSEBP) turned negative Friday in response to market actions during the week.  This move by my most important technical indicator suggests that supply (or selling pressure) is now the dominant theme in the markets.  US equities and Bonds still remain the top two favored major asset categories, so I will be looking at reducing some of the risk in my portfolios but not moving away from stocks on a whole—for now.  The value of the NYSEBP is 59.91.  Not a bad number overall, but it has been slowly weakening over the past couple of months.

The S&P 500 has violated its key long-term support level of 1380.  This support line (trend) has been in place since Thanksgiving of last year and is an important signal to investors.  This does not mean that stocks are ready to fall off the cliff, but it does suggest that there is greater downside risk in the markets and all investors should pause and evaluate their portfolios at this time.

We have a number of important economic reports coming out this week.  The biggest, in my view, is the October Retail Sales report scheduled for release at 8:30 AM on Wednesday.  Consensus is expecting a drop of 0.1% compared to an increase of 1.1% in September.  This report is always important because of the importance consumer spending is to our GDP.  The October Producer Price Index report on Wednesday morning and the October Consumer Price Index report on Thursday will give investors a sense of the rate of inflation in the country.  Expectations are that price increases will be muted compared to September’s numbers.  The weekly Initial Jobless Claims number on Thursday is expected to increase from 355,000 the week before to 376,000, and October’s Industrial Production report on Friday is expected to show an increase of 0.2% following September’s increase of 0.4%.

The Dorsey Wright & Associates analysis of the markets remains unchanged as it has for most of the year at this point (other than the NYSEBP reversal).  Data indicates 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.  On a relative strength basis, the top three major economic sectors remains unchanged: Consumer Discretionary, Health Care, and Financials.  Consumer Staples has pushed into the number four position while Real Estate slipped to number five.  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 Commodity category.

In honor of Veteran’s Day I would like to ask everyone to take a moment to thank a a soldier, sailor, marine, or airman for their service.  I am blessed to have a step-grandfather who served in World War I, another grandfather who served in WWII, a father who served in Korea and Vietnam, and a step-father and father-in-law who also served in Vietnam.  I am always mindful of their service to this great nation and we should never forget the sacrifice that these, and millions of other, men and women have made for our great country.

After much thought and consideration, I have decided to reduce my Market Commentaries to every other week rather than weekly for now.  The holidays are a welcome distraction for all of us and the time we spend with our families is important, and I have some additional writings I want to complete regarding individual investors and their retirement plan investing.  You will be able to find those writings on the NTrust Facebook page (as you can all of my market commentaries), as well as on LinkedIn, and on blogger.com.  So going forward, please look for my market commentary every other week.

Sincerely,






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.