Monday, December 10, 2012

Markets have been drifting slightly higher the past couple of weeks on no real news—economically or politically.  Economic reports have reflected this indifference by providing a mixture of modest gains and declines, and it is becoming increasingly clear that Washington is going to push negotiations on the fiscal cliff right up to end, if not beyond.  News from Europe was also mixed as German officials indicated that economic growth in this critical country has slowed significantly while Greece appears to be nearing completion of an important bond buy back operation clearing the way for another round of bailout funds.

The Dow Jones Industrial Average (DJIA) gained 130 points (1.0%) last week and is now up 7.7% for the year.  Gains in the other major US indexes were less robust last week.  The S&P 500 added just 0.1%, the Russell 2000 was essentially unchanged, and the technology-heavy NASDAQ fell 1.1% as Apple shares fell nearly 9%.  For the year, the S&P 500 is up 12.8%, the Russell 2000 is up 11.0%, and the NASDAQ is up 14.3%.

Real Estate, Financials, and Energy were the top three performing sectors last week gaining more than 1%, while Materials, Information Technology, and Consumer Discretionary were the weakest losing between a modest -0.2% to a little more than -1%.  For the year, Consumer Discretionary leads all sectors with more than a 23% gain followed by Financials and Health Care.  With just 15 trading days left in the year, six of the eleven major economic sectors have outperformed the S&P 500.  In addition to the top three, Telecom, Industrials, and Consumer Staples have returns exceeding the S&P 500.  Utilities, Energy, and Materials are the bottom three performers for the year, with Utilities posting a slightly negative return (excluding dividends).  With dividends included, every economic sector is positive for the year.

International markets continue to perform well in spite of troubles around the world.  The broad MSCI (EAFE) index was up 0.8% last week and is now up 11.0% for the year.  The European STOXX 600 index was up 1.2% and is now up 14.2% for the year.  With all of the turmoil within the EU, the most common explanation I have read about the strength of the European equity markets has more to do with recovery from very oversold levels rather than a vote of confidence for future economic growth.  For the year, growth is consistent across all the major regions around the world with very little advantage between them.

The bond market was unchanged last week with the Barclays Aggregate Bond index losing just -0.01% for the week.  The yields on US Treasuries rose slightly on the November jobs data, but the 10-year (1.623%) and the 30-year (2.813%) yields continue to reflect significant pessimism about the future growth of the US economy.  As I have reported previously, buying a US Treasury bond at nearly any maturity today could mathematically lead to a loss when inflation is factored in.  There are several widely accepted ways to measure inflation.  First, is the Consumer Price Index (CPI) prepared by the Bureau of Labor Statistics (an agency within the Department of Labor).  The latest CPI data shows the current rate of inflation at 2.2%.  The Bureau of Economic Analysis, found within the Department of Commerce, calculates the Gross Domestic Product (GDP).  As part of their calculation, they strip out the effects of inflation to determine “real” GDP.  Known as the GDP deflator, this measure of inflation was just reported at 2.8%.  Some economists see this number as a better indicator of true inflation because it is calculated across the entire economy, not just a specific basket of goods.  Whether you choose to use the CPI as a measure of inflation, or the GDP inflator, what is clear is that to own a US Treasury bond today could provide a negative real return on your investment. 

The US Dollar index gained 0.3% last week marking the first positive week in the past three.  The Euro fell just one-half of one cent to close the week at $1.293.  For the year, the Euro/US Dollar value is now essentially unchanged.  A report in the Wall Street Journal suggests that the US Dollar index has become a barometer on the direction of equity markets (WSJ Dollar Index Shows the Way for the Stock Market, December 7, 2012, by Stephen L. Bernard and Vincent Cignarella).  According to Bernard and Cignarella, “the current 60-day correlation between the WSJ Dollar index and the Dow stock index is currently negative -0.91 where 0 means there’s no correlation at all and negative -1 means a perfect negative correlation where one rises while the other falls.”  So recently when the US Dollar has strengthened (risk off), the stock market has subsequently fallen.  While there is no likelihood this relationship will last or is one which I would develop a trading strategy upon, I do believe that it shows how the “risk on” and “risk off” mind-set has become a major feature in today’s markets.

The Dow Jones UBS Commodity index fell 0.9% last week for the second week in a row.  Gold has fallen $46.30 (-2.6%) over the past two weeks to close Friday at $1705.50 per ounce, while WTI Oil has also fallen -2.6% over the past two weeks to close at $88.26 per barrel.  Analysts report that oil prices have fallen due to increasing inventories and lower demand, and that gold prices have fallen because investors are concluding that the Federal Reserve’s policy of continued bond purchases has not weakened the US Dollar as anticipated.  While I believe that oil prices move more on fundamental supply and demand issues, I believe that gold prices are much more subjective and dependent on investors’ perceptions about overall global monetary policy and the threat of imminent currency weakness—especially the US Dollar.  A strengthening US Dollar has reduced the price of gold recently.


The US economy has found and maintained a steady, albeit weak heartbeat in 2012.  The November employment report confirmed that the growth of new jobs has been just enough to avoid slipping back into a recession.  Scott Grannis, one of my favorite economic analysts (Calafia Beach Pundit), believes that the US economy requires a monthly growth rate of 130,000 jobs to meet population growth, and the average monthly growth rate of 151,000 in 2012 has provided that and a bit more.  However, Scott also believes that this anemic growth rate will not be adequate to raise tax revenues sufficiently to pay for the current and projected levels of government spending.  I share his beliefs on these subjects.  The consequence of the employment situation and economic growth in the US leaves further gains vulnerable to the political games currently being played in Washington—especially if the outcome in Washington is higher taxes for the majority of taxpayers.

There are just 21 days left in 2012.  The President and the Republicans in Congress do not appear to be making any progress regarding the looming tax hikes and spending cuts known as the fiscal cliff.  I said two weeks ago that I doubted a grand bargain would be reached, and the more likely scenario would be a small agreement that would postpone the full consequences of the fiscal cliff into early 2013.  I hedged my comments by reminding everyone that to expect any meaningful compromise was questionable because all of the same players are in place today as was two years ago, as will be in January.  Watching the past two weeks of “negotiations” has left me more pessimistic than before.  I believe today that there is almost zero chance that a grand bargain will be achieved, and I am growing more doubtful that any meaningful compromise will be realized anytime soon.  So the key question now is how will the markets react to this new reality?

How you answer that question depends on whether you believe the markets have discounted, or baked in the bad news, into current market valuations. 

Bond yields are sitting near historic lows signaling a pessimistic view of long-term economic growth.  As I discussed earlier, US Treasury yields are so low that investors today are potentially locking in losses in real terms out to almost thirty years.  Can rates go lower, absolutely, but how much lower?  I believe they could fall further but not significantly lower.  Bill Gross of PIMCO recently opined that the growing debt level in the US would contribute to annualized bond returns in the 3% to 4% range over the next few years, not the 6% average annual return of the Barclays Aggregate Bond index over the past 15 years.  For bond investors accustomed to these near equity-like returns, it may leave an empty feeling.  Additionally, bond investors must be sensitive to interest rates especially of longer duration US Treasuries and corporate bonds.  In my view, any sharp increase in interest rates will hurt these sectors the greatest.

Depending on which pundit you listen to, stocks, particularly US stocks, are either very overvalued or a great bargain.  Not the kind of clear guidance anyone likes to hear.  Each side has empirical evidence to support their views, however, the immediate question is are stocks overpriced or cheap today?  Using the Dorsey Wright & Associates ten-week trading band (ten-week price history) as an indicator, most US stocks are just slightly overvalued.  The lack of any recent price movement tells me that investors are more or less holding tight waiting for the circus in Washington to sort itself out.  If you are nervous or have a very low risk tolerance, than I believe you should be underweight stocks in your portfolio, and if I were forced to make a call on stocks, I would say that failure in Washington would hurt stocks in the short term.  The severity of any selloff would depend on investor belief that a reasonable compromise could emerge from our political leaders in a reasonable timeframe.

The rest of 2012 and early 2013 will remain a challenging time for investors.  I hope that our leaders will put the best interest of the American people ahead of their political aspirations or parties.  I cannot think of a time in recent history where we need grownups in Washington more than we do today!


My broad market indicator of trend and risk, the New York Stock Exchange Bullish Percent (NYSEBP) continues to see supply (selling) in control, but the percentage of stocks in a buy signal has improved somewhat following three consecutive weekly gains.  The NYSEBP closed Friday at 56.40 up from a low of 53.59 on November 16th.  The percentage of stocks in a buy signal must improve to 59.70 before buying momentum will have sufficiently returned to put the NYSEBP into column of X’s (demand/buying in control).  Another consideration is the NYSEBP is around its mid-point of 50 suggesting that risk is not especially high or low at this time. 

The CBOE Volatility index (VIX) remains at a subdued level closing Friday at 15.87.  Since the start of the year, the VIX has ranged from a high of 27.73 on June 4th to a low of 13.45 on August 17th.  The VIX is an important indicator of investor nervousness and fear of increased negative volatility.  To help put the VIX in perspective, the VIX reached 89.53 at the height of the 2008 market on October 24, 2008.  The VIX can move sharply, however, for now it is not flashing major fear signals.

The coming week has several important economic events.  First, the Federal Reserve Open Market Committee (FOMC) will be meeting and Chairman Bernanke will address the press on Wednesday afternoon.  The Fed is expected to leave its target for short-term interest rates between 0% and 0.25%, with the only unknown being the language about the anticipated duration of this policy.  For now, the Fed has committed to this low interest rate policy until mid-2015.  There is also some expectation that Chairman Bernanke may address additional bond purchases geared to stimulate the economy and lowering unemployment by keeping mortgage rates low.  International Trade will be released on Tuesday.  Investors will be watching exports very closely to try and gauge the health of the global economy—increasing exports will be seen as a positive signal.   Weekly Jobless Claims will be reported on Thursday morning as usual and consensus is calling for 370,000 new claims with no change from the previous week.  Finally, Retail Sales for November will be released on Thursday morning.  Sales are expected to jump 0.6% following a Hurricane Sandy-reduced -0.3% change in October.

The Dorsey Wright & Associates analysis of the markets remains unchanged as it has for most of the year at this point.  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 are unchanged: Consumer Discretionary, Health Care, and Financials.  Consumer Staples, Real Estate, and Information Technology are in positions four through six.  Energy and Utilities are in 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.  Energy and Agriculture are the favored sectors within the Commodity category.

As a reminder about how event driven the markets have become.  Overnight Sunday (December 9th), the Italian Prime Minister, Mario Monti, announced he would step down as soon as the 2013 budget was approved.  The Italian stock market has fallen more than 3% on the news as of this writing.  Event driven markets make investing challenging because traditional economic factors can take a back seat to headlines.

My next Market Update and Commentary will be published in two weeks.  I hope everyone is wrapping up their holiday shopping and plans are in place for your family’s celebrations.

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 European region.