Wednesday, February 5, 2014

February 4, 2014

The first month of 2014 has proven to be:

a) A normal pause in an ongoing bull market
b) The result of the Fed’s reduction in bond purchases (tapering)
c) All about the growing weakness in emerging markets
d) The beginning of the next great bear market
e) All of the above
f) None of the above

Before I try to answer this question, let’s quickly review what happened in January:

US Stocks were lower: The Dow Jones Industrial Average (DJIA) fell 5.3%, the S&P 500 lost 3.6%, The Russell 2000 fell 2.8%, and the Nasdaq Composite lost 1.7%. Real Estate, Utilities, and Health Care are the best performing sectors in 2014 while Energy, Consumer Discretionary, and Consumer Staples have been the weakest.

International stocks followed US stocks lower with the Emerging Market Region significantly underperforming: The Dow Jones Global Ex-US index fell 4.3%, the European-heavy STOXX 600 pulled back 1.7%, the Developed Market Region fell 3.6%, and the Emerging Market Region lost 6.9%. Looking at major international markets, the Japanese Nikkei is down 8.5% with only Russia (-9.2%) and Turkey (-8.8%) underperforming the Nikkei among the major international markets.

Bonds have rallied: as stock markets pulled back, investors once again turned to bonds. The Barclays Aggregate US Bond index is up 1.48% for 2014 erasing a sizable portion of the loss incurred by this key bond index in 2013. The US 10-year Treasury yield continued to fall closing Friday at 2.645% down from 3.03% at the end of last year. The most interest rate sensitive bond sectors like long government, long corporate, and preferred stock have been the best performing sectors in 2014.

Commodities continue to remain weak overall: The Dow Jones UBS Commodity index gained 0.3% in January primarily on the strength of Natural Gas (+17.9%) and Heating Oil (+6.6%). Gold added 3.5% to finish January at $1245.60 per ounce while WTI Oil fell 1.1%. I believe Natural Gas and Heating Oil have rallied as demand in January surged due to the bitter cold that has swept over much of the country. Gold rallied, in my view, on the general fear of some investors, and WTI Oil has lagged because of concerns about global growth.

Volatility has returned: As I noted in my first Update and Commentary of the year, volatility was subdued in 2013 and I suggested that it would be unlikely to see a similar calmness in 2014. If January is any indication, we will see greater volatility during the year. The CBOE VIX index, a measure of stock volatility, has increased from 13.38 at last year’s close to 18.41 at Friday’s close—a jump of 37.6%. To be fair, the VIX is a very volatile index and large swings are common. Even at 18.41 the VIX is not particularly high. Looking back to recent history, the VIX reached nearly 90 at the height of the Great Recession in 2008 and the upper-40’s in 2010 when the European crisis was at full boil. I expect to see continued volatility in 2014 as compared to 2013.


Given all that we know today, the answer in my opinion is: A—a normal pause in an ongoing bull market.

Let me provide you a list of some of the key data that I base my opinion on.

1) The first estimate of the real 4th Quarter Gross Domestic Product (GDP) came in at 3.2%. The number would have been higher except for a significant pullback in government spending (a good thing in my view). Additionally, the Price Index (my preferred measure of inflation) grew at a subdued 1.3%. While growth should be better, the economy is still moving forward despite government-induced structural headwinds.

2) Government spending as a percent of the economy has fallen significantly over that past three years. This is important because I firmly believe that the government does not utilize dollars as efficiently as the private sector, and when government spending grows, the output of the private sector falls.

3) The trouble with emerging markets has been underway for more than a year. This is not a new phenomenon; however, some countries like Argentina and Venezuela have reached tipping points where government policies require change or else hyperinflation will set in and severely hurt the middle class. My relative strength data has signaled that emerging markets were underperforming developed markets since September 2011.

4) The jobs picture remains ok. I did not say great because there remains a lot of trouble with the longer-term unemployed and the increasing numbers of workers who have given up looking. However, with the recent termination of permanent long-term unemployment benefits as part of the budget deal early this month, expect to see a number of people move back to the employment rolls. Additionally, with the economy continuing to grow at a steady basis, look for job growth to continue as well.

5) Housing is in a long-term positive trend. Shaking off the housing bubble in 2008 has taken years to accomplish, but that is what has happened. Like other markets, this recovery will not be in a straight line upward, but a positive trend is in place.

6) The energy revolution has taken hold. This is and will remain one of the most important factors of long-term growth in the US economy. Energy creates jobs both in the oil sector but also in manufacturing sector where low energy prices can make a huge difference in manufacturing costs. Lower energy prices mean more money in the pockets of consumers and that helps everyone. Energy has the potential to be a positive force force in long-term economic growth over the next twenty or thirty years.

With the positives comes the negatives, and how these negatives work out can help determine how quickly markets get back in a winning direction.

At the top of my list of concerns is a dysfunctional Washington. I just have not seen enough out of our political leaders to give me confidence that they will tear down some of the barriers to strong economic growth. My concerns deal with the impact of rising premiums and deductibles resulting from Obamacare on the average American family’s budget, no Keystone Pipeline, the never-ending stream of regulations foisted on the private sector, and the potential battle of the debt ceiling later this month. Much of this has been underway for several years and the private sector has withstood the challenge, so I anticipate 2014 will be the same.

Another concern will be the growth in corporate profits. Through Friday about 250 of the 500 companies that comprise the S&P 500 index have reported 4th quarter earnings. The vast majority of those companies beat growth expectations by an average of 8%, however, there have been some very visible misses including Amazon and MasterCard. Keep in mind that a miss can include not projecting acceptable earnings figures to investors for the remainder of 2014. This week there are another 150 or so companies reporting. We should have a good feel for how corporate profits are looking by Friday.

International markets may continue to hold the possibility for negative surprises especially in growth rates in Europe, banking concerns in Europe, and the strains in emerging markets. The political turmoil in the Middle East has subsided for now, but this dangerous part of the world can heat up at any time.


I have delayed publishing my Market Update and Commentary by about a day due to the market turmoil yesterday (Monday). The DJIA was off 326 points and registered a 2.1% drop. The S&P 500 fell 2.3%, the Nasdaq fell 2.6% and the Russell 2000 dropped 3.2%. That is volatility! It has pushed most indexes down more than 5% for the year. Most of the reporting is suggesting that the drawdown continues to focus on fears of a global growth slowdown. Emerging markets are contributing, but even here in the US, a key manufacturing indicator showed an unexpected reduction in the rate of growth for January. The Employment Situation report coming out this Friday will again take on extra significance due to this perceived contraction of growth expectations.

What I have been looking for is to see if there is any notable structural changes to my indicators. What I have observed is clearly a weakening of some key indicators but not a breakdown. For example, the New York Stock Exchange Bullish Percent (NYSEBP) fell to 57.5--a level not seen since late September of last year. Remember that the NYSEBP tells me about the general direction and riskiness of the market. A reading of 57.5 following recent highs of around the mid-70’s is showing some weakness, but it is also signalling a reduction of risk. The S&P 500 index is about 89% oversold meaning that in general the market has gotten much cheaper in the last few weeks and selective buying opportunities may present themselves.

The longer-term structural strength of the data I follow remains in place so the overall guidance has not changed. I favor US stocks overall of the six major asset classes I follow. Within US stocks I prefer small and middle capitalization companies over large cap. I also continue to favor the Consumer Discretionary, Health Care, Industrials, and Financials sectors. Consumer Discretionary has been weak so far in 2014 so I am watching this very closely.

International stocks currently rank number two of the six asset classes. However, I strongly advise against owning the Emerging Market region and suggest continued focus on the Developed Market region—especially Europe.

Bonds have shown some life with the pullback in interest rates. A defensive move for sure. However, I continue to like the High Yield and Floating Rate sectors.

I am avoiding Commodities completely at this time.

Finally, after the big sell-off to start out the week, there have been some pundits suggesting that the Fed should either suspend the purchase of bonds (suspend tapering) or even go back and buy bonds outright and reverse the past two policy moves by the Fed. In my opinion this would be a terrible mistake because the Fed would be signaling investors that they believe our economy is too weak for more normalized monetary policy. Therefore, I do not believe the Fed will change its current course and continue reducing bond purchases.

My next Market Update and Commentary will be published around February 17th.

Paul L. Merritt, MBA, C(k)P®, 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. 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.