Monday, December 24, 2012

Markets have become laser-focused recently on the ebb and flow of negotiations in Washington over the fast approaching fiscal cliff.  Although markets are up slightly in December, positive reaction has been muted to several recent important economic announcements including the upward revision of the 3rd Quarter Gross Domestic Product (GDP) from 2.7% growth to 3.1%, and that the Federal Reserve would extend its massive bond purchases indefinitely.  Friday’s 121-point sell-off was prompted by investors spooked by the apparent impasse between the House Republicans and the White House when the “Plan B” option failed to come to the floor for a vote.  Uncertainty has gripped the markets.

The Dow Jones Industrial Average (DJIA) gained 56 points (0.4%) last week despite the 122-point drop on Friday.  The S&P 500 added 1.2%, the Russell 2000 jumped 2.9%, and the NASDAQ gained 1.7% last week.  For the year, the DJIA is up 8.0%, the S&P 500 is positive by 13.7%, the Russell 2000 has gained 14.4%, and the NASDAQ is up 16.0%.

Financials and Real Estate were the best two performing major economic sectors last week easily beating the S&P 500.  Consumer Staples and Telecom were both down more than 3% and were the weakest performers last week.  For the year, Financials, Consumer Discretionary, and Health Care are the top three performing sectors followed by Industrials and Real Estate.  Utilities and Energy continue to bring up the rear, but as has been the case for most of the year, have posted positive total gains for 2012.

International markets maintained their consistent performance.  The broad MSCI (EAFE) index was up 1.3% last week and is now up 13.7% for the year.  The European STOXX 600 index was up 0.6% and is now up 14.9% for the year.  As I noted last week, the EU is still economically a mess with virtually no growth, 13% unemployment, and crushing debt levels that are sucking the life out of the economy.  However, the European Central Bank (ECB) has stepped forward and is offering to make massive bond purchases like the Federal Reserve and this has quelled the immediate panic and given political leaders some time to fix their broken economies.  The recent strength of international stocks has pushed this major asset category up to the number three position on the Dorsey Wright & Associates (DWA) ranking system ahead of Currencies, Cash, and Commodities.  It is my belief that international stocks do not provide the degree of diversification they once did, but they do give you exposure to some truly excellent global companies not based in the United States.

The bond market has shown some weakness the past few weeks as yields on US Treasuries have crept upwards.  Yields on US Treasuries have risen from 1.612% and 2.806% for the 10-year and 30-year respectively at the end of November to close Friday at 1.770% and 2.936%.  Friday saw investors return to US Treasuries as a safe haven investment, but not enough to boost the Barclays Aggregate Bond index into positive territory for the week.  The Barclays index was down 0.1% for the week and is now down each of the three weeks in December for a cumulative loss of -0.2%.  For the year the Barclays is up 4.4%.  Spanish and Italian bond yields continue to fall as investors in Europe understand that the ECB will ultimately be there to prevent any major losses.  As expected, the Italian Prime Minister, Mario Monti, resigned late Friday evening ushering in a potentially contentious election in the EU’s third largest economy this spring.

The US Dollar index is down 0.8% for the month of December.  The Euro has found renewed strength as the EU and ECB continue to sort out the Greek debt crisis and make progress on an EU-wide banking oversight agency.  The banking oversight agency proposition remains an important component for the financial unification of the EU, however, significant issues remain to be worked out before passage and implementation.  The Euro closed Friday at $1.319 up 1.6% for the month and 2.6% for the fourth quarter.  The US Dollar did rebound Friday as nervous investors returned to the US Dollar as fear prompted “risk-off” trading in the markets.  The Japanese Yen has come back into the headlines as the newly elected Prime Minister, Shinzo Abe, has called for the Japanese Central Bank to resist efforts by the United States and Europe to weaken their currencies at the expense of the Yen.  The Yen has been strengthening against the US Dollar for most of the year, but with Mr. Abe’s recent comments, the Yen has weakened.  Abe is one of the first significant political leaders to openly talk about currency manipulation even though the US, EU, China, and Switzerland have all been doing so via monetary policies for some time now.  This will be a story to watch in 2013.

The Dow Jones UBS Commodity index fell 0.9% last week marking the fourth straight weekly decline.  This broad-based commodity index is now down 2.5% for December and 6.2% for the fourth quarter.  With one trading week left to the year, the index is down 1% for 2012.  Gold fell $43.10 (-2.5%) last week to close Friday at $1652.70 per ounce.  This was the worst weekly percentage decline since late June.  For the month, Gold has fallen 3.5%, and is down 6.9% for the fourth quarter.  Gold is still up 5.5% for the year.  Gold, in my opinion, has not moved upwards in the face of continued monetary weakening by the Fed and ECB because investors have been shifting from gold into more risky assets with the belief that the fiscal cliff will be resolved.  WTI Oil jumped $2.23 (2.6%) per barrel to close Friday at $88.96, but this key commodity remains essentially unchanged (+0.02%) for the month as investors appear to be sitting on the sidelines as Washington tries to sort out the fiscal cliff.  WTI Oil is now down 3.4% for the quarter and down 10.0% for the year.  Coffee, Silver, Wheat, and Soybeans have all fallen at least 10% during the current quarter contributing to the overall weakness of commodities.


Friday’s market jitters and sell-off resulted from investor disappointment in the political class.  The failure of Speaker Boehner to bring “Plan B” to the floor for a vote was seen as a sign of the dysfunction in Washington and shaking the confidence of investors that an agreement on the fiscal cliff would be reached.  As I have noted previously, there is nearly unanimous consensus among economists, pundits, and money managers that the politicians will find common ground and forge a compromise to avoid falling off the cliff.  While I still hold out hope that there will be at least a small compromise to get us past the end of the year, I remain unconvinced that a grand bargain will be reached in the near-term.  I am also growing skeptical that any deal will provide a meaningful solution to the ever-growing Federal deficit that is the real problem with Washington and our nation’s economy.  I believe we have seen the first shot across the bow from the financial markets.

I would like to devote this week’s commentary to a review of what I believe are some of the key market basics that will help you understand what is happening all around us as the politicians push this country right up to the fiscal cliff.

Economic Policy = Monetary Policy + Fiscal Policy.  This is the key economic equation we must all keep in mind as our political leaders debate the fiscal cliff in Washington.  Economic policy is the collective action taken by governments to influence the economic behavior of a nation’s citizens, businesses, and governmental agencies.  The Gross Domestic Product (GDP), which is a measure of all economic activity within the country, is the report card on economic policy.  Successful economic policy is essential for the long-term strength and success of any country.  Monetary policy is the use of the money supply to support economic growth.  Money supply is controlled by government agencies that have the power to print money, set interest rates, and buy or sell debt (a key tool of influencing money supply).  In the United States, that government agency is the Federal Reserve.  The Federal Reserve has been extraordinarily accommodative using oceans of cash to keep asset prices growing in the face of a generally weak economy.  Fiscal policy is the use of taxation and government spending to influence the economy.  I believe most would agree that the White House and Congress have failed to take responsible action regarding revenues and spending policies for years and this has resulted in the recent spike in US debt.  It is this failure of maintaining a sound fiscal policy that is the focus of the fiscal cliff.

Markets are Forward Looking.  The value of financial markets today, which is reported through key indexes such as the DJIA or the Barclays Aggregate Bond index, represent the belief of investors about the future growth of assets.  If enough investors believe that the future of a company is strong, for example, they will move to buy that company and drive up its stock price.  If enough investors believe in the overall strength of the economy, they will bid up prices across a broad array of companies lifting indexes even at a time when circumstances may be bleak.  Bond investors generally work from a different perspective.  When bond investors believe that the future growth of the economy will be weak or even negative, they are attracted to the interest income and perceived security of owning debt.  Just as demand pushes up the values of individual companies through stock prices, bond investors can push up the price of bonds when pessimism is prevalent.  The one caveat I would add is that the Federal Reserve’s massive intervention has potentially skewed traditional relationships in the free market by flooding the system with cash and artificially driving up the prices of all assets.

Falling Off the Fiscal Cliff Will Result in Higher Taxes and Spending Cuts.  Most analysts will say that the economy’s recovery has been weak and tentative.  The impact of raising taxes and simultaneously cutting spending could cut GDP output by as much as 4% in the first half of 2013 and push the country back into a recession.  It is this reason why most observers believe some agreement will be forthcoming, but a complete failure by our political leaders, I believe, will have an immediate and negative impact on the general economy.

Higher Taxes on Dividends Can Hurt Stock Prices.  Stock prices, just like other assets, are driven by demand, and if taxes go up substantially on dividends, demand can weaken and push down stock prices.  Let me use a simple example to illustrate.  Altria (MO) currently pays a dividend of approximately $1.76 per year for each share of stock.  On Friday, Altria closed at $31.86.  The current dividend yield ($1.76/$31.86) is 5.5%.  The average tax on most dividends is 15% meaning that the after-tax yield on MO is 4.7%.  Investors will buy MO at its current price if they feel that a 4.7% after-tax dividend yield is an adequate return for the risk of owning MO.  If the tax rate on dividends increases to 39.6% under current fiscal cliff law (as it would for many top earners) then the after-tax yield on MO would drop to 3.3%.  Now MO at $31.86 may not look so attractive.  For top earners to receive the same after-tax yield of 4.7% with a new 39.6% tax rate, the stock price of MO would have to fall to $22.64, a drop of 28.9%.  There is no evidence that investors will suddenly sell MO or any other high dividend paying stocks with a dividend tax increase, however, there still remains a real economic consequence to a dividend tax increase and the potential for many dividend paying stocks to adjust prices under a new tax.

Uncertainty Can Increase Volatility.  Uncertainty makes it more difficult for investors to determine valuations on assets.  As facts/events change, prices will change to reflect this new information.  The more change, the more fluctuation.  Volatility causes most investors increased stress especially as they remember the pain inflicted by the financial markets in 2008.  This may help explain why, according to the Investment Company Institute (ICI), investors have withdrawn $137.2 billion from managed stock investments through December 5th of this year at the same time the S&P 500 had gained 12.1%.  Over the same period, the ICI reports that investors pumped $303.0 billion into managed bond portfolios.

As I said in my previous Market Commentary and Update, “failure in Washington would hurt stocks in the short term.”  I still believe this, and I also believe that if Washington delivers an unsound agreement, the joy of passing any agreement will be quickly replaced by the economic reality of a country saddled with unfunded spending for as long as we can all see.  By unsound agreement I mean one that only raises taxes, increases in near-term spending (to stimulate the economy), and does not effectively address the never-ending growth of entitlement spending.  If the nation is burdened with an anti-growth economic policy, then we will resemble Europe’s beleaguered economy that has virtually no growth and an unemployment rate of 13%.  So while I am anxious for an agreement, and I think at least a short-term fix will come, I am also mindful that our political class MUST implement sound and growth-oriented economic policy.

Depending on your perspective, you may or not agree with my assessment.  I admit that I have a conservative economic belief system; however, what really matters in the end is how we handle our investments in light of the economic realities of the world we live in.  I believe that there will always be investment opportunities, and the financial services industry has created many new investment tools to take advantage of those opportunities.  It is critical that you have a systematic process for evaluating markets and determining which major asset classes you should weight your investments, and to do so consistent with your ability and need to handle risk.  I believe my knowledge of the tools and information provided to me by Dorsey Wright & Associates helps give me the insight to navigate markets in these challenging times.  If you would like more information about these tools, I would be happy to share that knowledge with you.


The fiscal cliff negotiations will dominate the airways for the remainder of the year.  Event driven markets like the ones we have had since 2008 have the potential, in my opinion, to increase volatility and fray nerves.  With the key players in the fiscal cliff negotiations on holiday for the next few days, it is hard to say if Friday’s volatility will be repeated on Monday’s shortened trading day or even the first full day following the Christmas market closure.  However, I would anticipate more trading volatility associated with the fiscal cliff uncertainty in the last few days of the year and into the start of 2013.

My broad market indicator of trend and risk, the New York Stock Exchange Bullish Percent (NYSEBP) reversed last Thursday, December 20th, to a column of X’s meaning demand is back in control.  The NYSEBP has been in a positive trend since bottoming at 53.59 on November 16th, and closed Friday at 60.38.  I see this as a very positive signal, however, it will be extremely important to see if the NYSEBP can continue increasing.  I say this because the previous two highs—76.04 on February 17th and 67.38 on Septemer 14th have been getting sequentially lower. This series of decreasing highs is not a bullish trend.  Therefore, I will remain cautious until I see if the NYSEBP can push above 67.38 and create a higher high than the previous one. 

The CBOE Volatility index (VIX) has increased following the recent activity in the markets and closed Friday at 17.84 the highest close since November 7th.  The VIX has also moved slightly above its 100-day moving average suggesting higher volatility in the near term.  However, the VIX is well below its 5-year average of 25.64 and still below its long-term average of 20.47.  I believe this is suggesting that although volatility may be higher going forward, we are not facing the massive disruptions associated with 2008 and other recent economic shocks for now.

There are no signicant economic reports next week except for Thursday’s Initial Jobless Claims and November New Homes Sales.  Initial claims are expected to increase 4000 from 361,000 to 365,000, and new home sales are expected to increase from an annual rate of 368,000 to 375,000.  There is general consensus that the housing market has bottomed and is moving upwards.

The DWA analysis of the markets has seen a change in the overall ranking of the five major asset categories with International Stocks moving from fourth to third behind US Stocks and Bonds.  Currencies has moved to fourth position and Commodities remains in last place.  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 are unchanged: Consumer Discretionary, Health Care, and Financials.  Real Estate, Consumer Staples, and Information Technology are in positions four through six.  Energy and Utilities are the bottom two sectors.  US Treasuries and International Bonds are favored in the Bond category, while US and Developed Markets are favored within the International stock category.  India and China have been making some strong moves in the past month or so in the International stock category and I am exploring options in these regions.  Energy and Agriculture are the favored sectors within the Commodity category.
My next Market Update and Commentary will be published in two weeks.  No doubt it will be a very interesting time.  I hope everyone has the opportunity to celebrate this joyous holiday season with family and friends, and I wish you a very Happy New Year!

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 Eur