Tuesday, January 8, 2013

The conclusion of the first round of fiscal cliff talks resulted in a surge in equity markets both here and abroad. The Dow Jones Industrial Average (DJIA) gained 497 points (3.8%) last week while the S&P 500 also added an impressive 4.6%, the Russell 2000 gained 5.6%, and the NASDAQ jumped 4.8%.  The first week performance in 2013 of all the major US indexes beat any of the best one-week gains posted in 2012.  The broad international index, MSCI EAFE, and the European-centric index, the STOXX 600, added 1.7% and 3.3% respectively.  In the meantime, the sparse economic news recently published suggested that the US economy is growing at a steady, but very modest rate.

The books are closed on 2012 and given all the fears fostered by worries over debt and economic growth in Europe, the sluggish US economy, and a slowdown in China; market returns were very acceptable.  For the year, the DJIA was up 7.3%, the S&P 500 gained 13.4%, the Russell 2000 added 14.6%, and the NASDAQ led the major broad indexes with a 15.6% gain.  Bonds did well too.  The broad Barclays Aggregate Bond index posted a respectable 4.5% gain.  Commodities were mixed with the broad DJ UBS Commodity index down 1.1%, while gold gained 6.9%, and WTI Oil lost 7.2%. 

Every major economic sector posted a positive gain in 2012.  Financials led all sectors gaining 26.2% followed by Consumer Discretionary (24.6%), Health Care (19.0%), Materials (17.3%), Real Estate (17.6%), Industrials (17.1%), Telecom (16.6%), Information Technology (14.0%), Consumer Staples (11.0%), Energy (3.4%), and Utilities (1.8%).

International markets held their own with the US in 2012 despite the negative headlines and poor economic performance.  The MSCI EAFE index gained 13.6% and the STOXX 600 added 14.4%.  The emerging markets sector gained 14.0%, the Asia/Pacific region added 13.1%, and the Americas region posted a 12.8% gain.  Performance of some of the more important countries according to the Wall Street Journal: India ̶  +25.7%, China ̶  +10.9%, Germany ̶  +29.1%, France ̶  +15.2%, Spain ̶  -4.7%, United Kingdom – +5.8%, and Brazil ̶  +4.7%

While bonds in general underperformed stocks in 2012, there were several bond sectors which did very well.  The Preferreds and Emerging Market sectors were the best performing of the bond sectors gaining a little more than 18% each.  High Yield followed with a gain of just over 14%.  Short-term and Long-term US Treasuries were the weakest performing sectors for the year gaining just 0.4% and 3.36% respectively.
The US Dollar Index fell 0.5% in 2012.  The Euro gained 1.9% against the US Dollar while the Japanese Yen fell nearly 13%.  The US Dollar became one of the key “safe haven” investments in 2012 attracting buyers in times of difficulty while the Euro was attractive when traders were willing to take on more risk.
As noted, the UBS DJ Commodities index fell 1.1% and thus underperformed stocks and bonds.  Gold managed a gain while WTI Oil fell.  Brent Oil, which prices oil from Europe and the Middle East, gained 3.5% due to Geo-political and currency issues.  Oil consumption in general has been falling recently and has certainly been holding back oil prices.  Agricultural commodities saw the biggest gains in 2012 with Wheat and Soybeans gaining 19% and 18% respectively, while Coffee and Orange Juice were the biggest losers posting losses of 37% and 31% in 2012.  Commodities are volatile making investing in individual commodity sectors, especially in the agricultural sector, a very risky proposition.  Commodities are predominantly driven by global economic factors of supply and demand, coupled with the movement of the US Dollar, and with economic growth sluggish though most of 2012, commodity prices reflected that sluggishness.

The first round of the fiscal cliff negotiations are completed.  Taxes are going up across the board along with new spending in the form of extended jobless benefits.  The implementation of sequestration spending cuts has been pushed back two months and will join the debate over the debt ceiling as the first set of critical challenges facing the 113th Congress.  This will undoubtedly lead to more political brinkmanship and, I believe, the possibility for continued volatility in the markets.

I said two weeks ago that the Gross Domestic Product (GDP) is the report card on US economic policy.  Although the initial fourth quarter data for 2012 will not be released until January 30th, most economists believe that overall, 2012 will have mustered little more than 2% to 2.5% growth compared to the post World War II rate of 3.25%.  Several of the pundits I respect have suggested that 2013 will look much like 2012 from a GDP perspective.  Another year of 2% - 2.5% of growth more or less.  I believe they are probably on target.  The reason I say this is very simple:  there is going to be little different about economic policy in 2013 from what we experienced in 2012.

Think about it for a moment.  We have the same President, the same Congress, and the same Federal Reserve.  Mr. Obama is determined to raise taxes and increase spending, Congress, at least the House of Representatives, is fighting to get our national debt and spending under control with very limited success, and Mr. Bernanke at the Federal Reserve is committed to keeping monetary policy accommodative enough to keep the financial markets from reflecting the dysfunction in our fiscal policies.  While there may be some agreement here or there, if Congress and the President repeat history, their agreements will nibble around the edges but fail to take any meaningful action towards curbing spending.  So I believe we will just get more of the same.  The real issue for 2013 is whether or not economic policy will be capable of generating enough  growth to lower unemployment meaningfully, and help reduce Federal borrowing levels.

One of the really good economists that I follow, Scott Grannis of the Calafia Beach Pundit, wrote an interesting blog recently when he opined that the Republicans have got it wrong by focusing so much on the debt when they should be focusing on growth.  He says, “it is the spending that requires taking on the debt that crushes the economy.”  His point is this.  Debt is a good thing when used properly and dangerous when not.  Borrowing money provides capital to the borrower to invest in projects that are expected to earn a higher rate of return then the cost of borrowing the money.  This investment creates economic activity and growth.  Problems occur only when borrowed money fails to provide an adequate return and the borrower is unable to pay the lender back.  This is precisely where the US government finds itself today.  Money is borrowed and, for the most part, is spent on entitlements that fail generate adequate economic growth.  Without adequate economic growth, revenues are not available to pay all the bills, so the government must continue to borrow more and more to keep up with all the spending.  If the government did not have unlimited borrowing capacity or the ability to print money, it would have been declared bankrupt years ago.  So the important question at the end of the day is: will economic policy generate enough growth to stem the cycle of too much borrowing to pay for all of the spending in Washington and beyond?  As I have said, I do not believe economic growth will be adequate to make a meaningful difference; however, it will be enough to keep the status quo in place.  Do not expect much GDP growth in 2013 over 2012.

The coming year, however, does bring some interesting opportunities.  The first is energy.  Energy production in the US is growing rapidly thanks to new technology that allows access to oil reserves once considered impossible to harvest.  Natural gas production is also growing dramatically, and due to the cheap cost of gas, many industrial manufacturers are switching from oil to natural gas.  This low-cost source of energy is breathing new life into the US manufacturing base and, I expect, will for years to come.  The low cost of energy will also benefit the individual consumer by lowering energy costs thus helping to offset higher taxes and health care costs.

Other areas of the economy showing signs of growth include the home building industry and the automotive industry.  In both cases, demand has begun to overtake supply.  Since the Great Recession in 2008, consumers were losing more homes to foreclosure than they were buying.  Home prices fell dramatically as a result.  Those that could buy houses delayed their purchases (when possible) with the perception that by waiting another couple of months that house they wanted would be even thousands of dollars cheaper.  That became a self-filling prophecy.  The natural economic activity of most people has pushed many back into the market, and thanks to ultra-low borrowing costs courtesy of the Federal Reserve, housing starts and sales are up and this is encouraging.  The same can be said about automobile sales.  Cars can only survive so long on the road, and many consumers have delayed car purchases as long as possible, and so they are now returning to the market to replace cars that have reached the end of their useful lives.

I must also say that Europe and China seem to be pulling back from their own crisis and giving investors renewed confidence.  The Europeans, I believe, have discovered the power of the printing press and the European Central Bank stands ready to start spreading Euros like mad; while the new Chinese government appears to be encouraging more growth in order to ingratiate themselves with their population.  So these two important economic areas look less troublesome than they did at the start of 2012.

So here we are.  Our economic lives look good—for today.  All sarcasm aside, I do not believe the economy is on the brink of falling back into recession; neither is it, unfortunately, ready to suddenly sprout wings causing the GDP to grow at 4% or even 3.5%.  I think 2% - 2.5% will be the norm.  I also do not expect any major changes in the unemployment rate that closed out 2012 at 7.8%.  The overall economy is just not providing the growth to create new jobs fast enough to bring that number down sizably.  We must remain ever vigilant with the dysfunctional governance in Washington.  It would take little effort by our political leaders to muck things up and hurt our anemic GDP growth rate.  I fully expect that the concept of an “event driven” market to remain solidly in place making good economic decisions harder to come by.  Sector and stock selection will be critical, and many bond sectors are potentially at risk if interest rates begin to rise (I believe this is a big unknown for 2013).  Finally, be ever vigilant of what the Federal Reserve is doing.  Every experienced investor will tell you, “don’t fight the Fed,” and I believe this statement still rings true.  I have little doubt that asset prices have been boosted by the easy money floating through the economy, and should the Fed reverse course on monetary policy (highly unlikely), asset prices could suffer.

Let us go forward this year with cautious optimism but remaining ever vigilant that events or circumstances could cause a major turn of fortune. 


Markets remain buoyant from the initial fiscal cliff deal and the Federal Reserve’s adherence to quantitative easing policies.  The President and Congress must return to the bargaining table to resolve the debt ceiling issue and sequestration.  This will continue to occupy investors’ attention for the next several months.

I will be watching several economic reports over the next couple of weeks including the Initial Jobless Claims (every Thursday morning), International Trade (January 11th), Retail Sales and the Producer Price Index for December (January 15th), the December Consumer Price Index and Industrial Production (January 16th), and December Housing Starts (January 17th).  All of these reports are expected to deliver numbers consistent with an economy growing at a 2%+ growth rate.  I have also noticed recently that when a report deviates from the consensus either good or bad, there has not been much impact on the markets due to their obsession with fiscal policy debates in Washington.  I believe we will see more of the same.

My broad market indicator of trend and risk, the New York Stock Exchange Bullish Percent (NYSEBP) remains in a column of X’s meaning demand is back in control.  The NYSEBP closed last Friday at 65.72 compared to the previous week’s close of 60.54.  This is a bullish signal for the markets and I am encouraged by this recent strength.  As I have said before, I will be especially pleased if the NYSEBP moves above its previous high of 67.38 on September 14th because this will reverse a 2012 trend of lower highs. 

The CBOE Volatility index (VIX) decreased sharply last week falling to 13.83 at market close on Friday.  This is a very significant improvement from a high of 23.23 on December 28th.  The VIX is an indicator of investor nervousness of future market changes.  The lower the VIX the greater the probability that volatility will be subdued in the future.  While I like watching the VIX, it is also one of the most volatile indices in the markets.  Complacency is not a virtue in today’s markets.

The Dorsey Wright & Associates analysis of the markets remained unchanged last week.  Among the major asset categories, US Stocks are ranked first, followed by Bonds.  International Stocks has risen to the number three position and has significantly narrowed the gap with Bonds.  Currencies remains in fourth position while Commodities is in last.  When Cash is included, Commodities falls to sixth place and Cash is fifth.  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 remains in the fourth position while Industrials has displaced Consumer Staples in fifth position.  Information Technology has moved from fourth to sixth.  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.  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 Precious Metals are the favored sectors within the Commodity category.

My next Market Update and Commentary will be published in two weeks. 

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.