Monday, June 24, 2013

                                                                  SPECIAL REPORT

Note: I have been working to publish my Market Update and Commentary on a bi-weekly schedule, and considering my travel schedule, I indicated last week that my next Update would not be published until July 7th. However, I am writing this Special Report to address last week’s market actions.

“Markets are always worth listening to, but sometimes they are also hard to figure. We’ll admit to putting Thursday’s global stock-market and commodities rout in that category.”

--Wall Street Journal Editorial, June 20, 2013

I could not think of a more appropriate commentary with which to begin my Special Report. The sell-off of 560 points (3.7%) in the Dow Jones Industrial Average (DJIA) in just over a day’s worth of trading from Wednesday afternoon through close of markets on Thursday has certainly raised the nervousness level in many investors. Markets sell off all the time, but why would the editorial board of the Wall Street Journal be left to publicly scratch their heads over last week’s action?

The answer requires a look at the Federal Reserve. If you read Federal Reserve Chairman Ben Bernanke’s official statement and listened to his press briefing Wednesday afternoon, his message was very clear. He is suggesting that the economy’s strength, not weakness, is the reason why he feels that the potential exists to consider reducing the level of bond purchases the Fed is making sometime late this year or early next. He also made the strong point that he has no intention to curtail bond purchases and raise short-term interest rates at the same time. He said that he would consider raising interest rates only if the unemployment rate fell to 6.5%. The message of an improving economy by the Fed is typically not the basis for a market sell-off and hence the statement by the Wall Street Journal.

I noted in my last Market Update and Commentary that there was nearly 100% consensus that the Fed would curtail its bond purchase program (also known as Qualitative Easing III) at some point, but there was little consensus of when it would begin. The Chairman clarified his position on Wednesday and the markets sold-off. I am struck by a couple of points of in-congruence between what the markets expected and received, followed by the market sell-off. First, economists and pundits had been criticizing Mr. Bernanke for his lack of clarity regarding QE III following the May Federal Open Market Committee (FOMC) meeting. Now he is being criticized in some circles (including St. Louis Fed Chairman James Bullard) for putting a timeframe and thus clarity around his future actions. Second, many critics of Mr. Bernanke have been saying for some time that the unending bond purchases by the Fed are hurting the future economy. So now when he says that an improving economy may be setting the conditions to allow for slowing and ultimately eliminating QE III, the markets sell off. Mr. Bernanke has been telegraphing his intentions for some time now that steady economic growth—precisely what Mr. Bernanke has be saying would be grounds for curtailment and ultimately termination of QE III, actually gave the markets what they expected. In my opinion, the outcome of last week’s FOMC meeting should be viewed as a net positive.


While I may believe that last week’s Fed action will ultimately be a good thing, the stock and bond markets are acting like a drug addict going cold turkey. I am using this rather unpleasant analogy because that is the most common analogy I saw used this past weekend in the financial press, and it is a powerful way to try to explain what is going on. The story goes something like this. The economy has become addicted to the easy money that has been provided by the Fed. The economy got a temporary rush of euphoria that has felt great, but the euphoria is false and cannot last. Cold sweats set in when the easy money drug is reduced and ultimately stopped. The addicted economy goes through a somewhat unpleasant withdrawal, but ultimately finds peace and balance without the need of the artificial stimulus. This is a rather simplistic way to look at the markets today, but so far it appears to be accurate.

The rapid rise in interest rates is, in my opinion, the most disruptive aspect of last week. The US 10-year
Treasury yield has now jumped nearly 1% (88 basis points) since the end of April when the 10-year yield closed at 1.666%. Friday it closed at 2.542%. The size and speed of this jump is something we have not
seen in years and is certainly putting pressure on bond prices everywhere (bond prices fall when interest rates go up). I have learned long ago that predicting interest rates is without a doubt the hardest and most inexact endeavor economists undertake, however, as you can see by the chart below, the recent move upwards is barely a blip. This does not diminish the loss of principal bond holders have felt, but it is important that many economists see the 10-year Treasury yield as barometer of future economic growth and inflation, and given the lackluster growth of the economy, interest rates are probably closer to the top than the bottom. That said, I still believe that investors must pay a great deal of attention to their bond portfolios today.

From an equity stand point, I believe that a pause or moderate correction has started. Stocks markets are now off about 5% from the peak towards the end of May. When I look at my key technical indicators, I see the pressure of equity prices easing, but I also see that the momentum has turned enough to suggest that there could be more weakness ahead for the near future. This market is potentially setting up a buying opportunity for investors.

Going into what may again prove to be a volatile week, the prudent investor should check their portfolios security by security. Consider trimming positions if you are surpassing your ability to sleep comfortably at night, or tighten up sell-stops and then let the market dictate which stocks will be eliminated from your portfolio for now. Finally, look at the bonds. For most investors, the goal should be to keep maturities short (less than 7 years), evaluate your bond sectors and think about reducing interest rate risk and focus more on credit risk. I suggest this because in today’s markets, the risk to your bond portfolios losing value due to interest rates rising, in my opinion, is greater than the risk of a company going bankrupt.

In summary, we are in a volatile period. Markets are reacting to the new realities that the Federal Reserve will not be buying bonds forever. However, I believe the message for the markets is a very positive one and I am glad to know that the end of QE III is a possibility. Don’t be complacent—I’m not. Review your portfolios and monitor your holdings, and call me if you have any questions.

Paul L. Merritt, MBA, AIF®, CRPC®
NTrust Wealth Management

P.S. If you think this type of analysis would be of benefit to anyone you know, please share this communication with them.

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.