Tuesday, January 7, 2014

January 2, 2014


I am not going to spend a lot of time recapping the big stories in 2013 or talking about their impact on the markets. I believe I address these topics during each of my regular Market Updates over the course of the year, so I intend to focus on lessons learned and what, if anything, we should take away from 2013 as we look ahead to 2014.

By all measures, 2013 was a terrific year for stocks and a lame year for bonds. The Dow Jones Industrial Average gained 26.5%, the S&P 500 added 29.6%, the Russell 2000 rose 37.0%, and the NASDAQ led all major indexes with a gain of 38.3%. When dividends are added back into the S&P 500, the total return for 2013 was 31.9%. This ranks 2013 as the 13th best year since the S&P 500’s creation in 1926 and the best year since 1997.

International stocks also did well. The Dow Jones Global Dow Index gained 20.8%, however, the emerging markets region failed to join in the gains with the Dow Jones Emerging Market TSM index down 6.0%.

Bonds widely underperformed stocks in 2013 as interest rates climbed dramatically during the second half of the year. The Barclays US Aggregate Bond index fell 2.2% while the yield on the 10-year US Treasury bond increased from a low of 1.623% to close the year at 3.030%. Not every bond sector underperformed. The High Yield and Bank Loan sectors provided total returns of about 6.9% and 5.6% respectively.

Commodities in general was the worst performing of the six major asset classes I follow. The Dow Jones UBS Commodity index fell 9.6% in 2013 led by a 28.2% drop in gold prices. Silver, corn, coffee, and wheat also fell more than 20%. Natural gas ended the year 24.6% higher and WTI Oil gained 7.3%.


When it comes to addressing the lessons to take away from 2013, I am reminded that we are talking about just a single year out of the history of the markets. I prefer to think about lessons learned as more like a refresher course on investing fundamentals. So here are my takeaways:

#1. Dismiss the noise surrounding the markets and focus on the data. Going into 2013 it was clear that the political dysfunction in Washington would be the dominant story and it was. The media told everyone who would listen that the turmoil surrounding the budget deficits, sequestration/spending, Obamacare, the government shutdown, and the Federal Reserve’s curtailment of Quantitative Easing (tapering) would wreak havoc on the stock market and that a market meltdown was just around the next political curve. Both political parties fed into this narrative because each side blamed the other’s policies for causing the expected pain in the market. During all of 2013, the data I follow and provided to me by DorseyWright & Associates was saying that US stocks was the favored asset class, and performance ultimately supported this observation. International stocks pushed Bonds out of the second spot on January 25, 2013 and remained a solid number two the rest of the year. No asset class (International stocks, Bonds, Currencies, Commodities, and Money Market) ever came close to challenging the dominance of US stocks during the course of the year, and this is how we are going into 2014. Keep your emotions out of your investment decision making process.

#2. Allegiance to simple asset allocation for allocation’s sake can be costly—also known as doing nothing. The bond market, as measured by the Barclays US Aggregate Bond index, was down 2.2% and significantly underperformed stocks. Many financial experts suggest that it is appropriate to adhere to a sizeable bond portfolio simply because that is what has become the norm. I share the belief that owning bonds is appropriate when an investor’s cash needs warrant a steady stream of interest payments, or their risk tolerance is such that they simply cannot stomach the typical volatility in the stock market. However, in years like 2013, owning bonds just because it has become an industry standard, cost investors dearly. If you look at the total return of a typical 60/40 portfolio of stocks and bonds, the return for 2013 comes in around 18.6%. A good return, but well below the potential returns offered by a more stock-heavy portfolio.

#3. It is important to pay attention to sector investments. Being able to identify and rotate in and out of the major economic sectors is important not only in stock portfolios but bond portfolios as well. The difference between being invested in the best performing stock sector (Consumer Discretionary) and the worse (Real Estate) was over 41% this past year. Focusing on the strongest sectors and avoiding the weakest proved a profitable strategy in 2013. Bonds are really no different. Morningstar® has 15 different bond sectors it follows. The best performing sector (High Yield) outperformed the weakest (Long Government) by 20.2%.

#4. Don’t lose focus on the future by using the past to make investment decisions. Every performance report is required to have the disclaimer, “Past performance is not indicative of future returns.” I know you have seen it and I am required by my compliance department to include this disclaimer whenever I talk about performance. Past performance is what many investors I come into contact with use to make their investment decisions. Just think about how Morningstar® ranks the various managed investments they track. Their five star system is officially known as the Morningstar RatingTM and is based entirely on past performance. The problem is the past is the past and just as the disclaimer says—it is not indicative of future performance. I believe “trend following” offers investors a more robust way to make investment decisions. “Trend following” is neither predicting, nor ignoring (blind adherence to an allocation strategy—see #3), but rather taking enough information from the market to reasonably identify what the prevailing trends are today and making investment decisions on what is happening not what has happened.


I avoid the act of making predictions because I believe that being consistently correct is a near impossibility. I will leave the long range predictions to the economic and investment pundits. However, I am not afraid to make near-term observations based upon the data I see in the market or pointing out some historical trends that have occurred simply to provide perspective to the discussion.

#5. US stocks remain favored. Current conditions favor US stocks over all of the other major asset classes I follow. I am overweighting my stock allocation to US stocks going into 2014. Small capitalization stocks are currently favored, however, large cap stocks continue their recent outperformance and this is a trend I have been watching closely for the last month or so.

#6. International stocks remain in the favored #2 status among the six major asset classes. I believe there is more uncertainty surrounding international markets than there is the US at this time, but this asset class has shown strength. Developed markets are clearly favored over Emerging markets. I have heard the repeated mantra in the financial media that Emerging markets is the place to be, and that may eventually prove to be true; however, now is not that time. Stay focused on the strongest developed countries.

#7. Volatility remains subdued, but that can change quickly. This observation is based upon historical data. 2013 will go down as one of the least volatile markets in recent memory. During the course of 2013 there were no 10% or greater corrections and only one correction greater than 5% (7.5% between May 22nd and June 24th). Since this bull market began in March 2009 until the end of 2012, there have been an average of one 5% or greater correction every 4.6 months (3.8 times per year) and a 10% or greater correction once every two years. The last large correction ended September 3, 2011 marking a two-year four-month time span since the last major correction. Statistically, we are certainly due for a large correction and we should expect smaller corrections along the way. Markets never travel upward in a straight line.

#8. Interest rates will continue to rise. The benchmark US Treasury 10-year yield has moved considerably higher since May 2012 closing above the important psychological level of 3% at the end of the year. This move pushed “real” yield into positive territory. “Real” yield is after inflation yield and is determined by subtracting the rate of inflation from the current yield. While there are many ways to calculate inflation, I prefer to use the Gross Domestic Product (GDP) deflator which is also known as the GDP price index. This is the factor that determines “real” GDP growth. Third quarter 2013 is the most recent data available and the GDP deflator was 1.9%. This means that the “real” yield on the US Treasury 10-year yield is about 1.1%. At the beginning of May 2013 and using the same GDP deflator of 1.9%, the “real” yield on the 10-year US Treasury was a negative 0.3%. In other words, investors were literally paying the Federal Reserve to hold their money in the form of 10-year Treasury bonds. The impact of rising rates on bond investors in 2014 will be similar to what happened in 2013. I believe that the loss of price value will offset some of the gains from interest payments leaving investors with another so-so year. For now I continue to favor the High Yield and Bank Loan bond sectors.

#9. Expect political rhetoric to be even more shrill than 2013. I happen to believe this observation is a total no-brainer. Mid-term elections for Congress will occur in November. There is a lot at stake for both parties so I expect the media noise will be deafening and it may be easy for sound decision making to get lost in this media onslaught (refer back to #1). Stay focused on what the market data is saying.

Investing is not easy and it really never has been. Hindsight can remove many of the memories about the uncertainty surrounding past decision making and can mask the stress investors might have felt at the time, but for investors this remains a tough business. I believe this is why so many people will not open statements or why they rarely make changes in their 401(k) plans. They simply don’t know what to do. The good news is that there are more tools available today to help investors than ever before, and if you know how to use them in a systematic way, you will improve your chances of meeting your goals. Helping you navigate the chaos and uncertainty of today’s markets is what I do.

I want to say thank you to my clients who have given me the privilege of helping them meet their financial goals and guiding them through these turbulent and challenging times. I trust all of you have found my Market Update and Commentaries informative and useful. For those who are interested in learning more about how I manage investments and long-term planning, I welcome the opportunity to share with you more of my knowledge and expertise.

I wish each of you a very Happy New Year and a Prosperous 2014.

Paul L. Merritt, MBA, C(k)P®, 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. The Dow Jones Global ex-US index represents 77 countries and covers more than 98% of the world's market capitalization. A full complement of subindices, measuring both sectors and stock-size segments, are calculated for each country and region.