Monday, March 17, 2014

March 16, 2014

I spent some time this morning trying to come up with just the right adjective to describe how stock markets have acted so far this year. Some of the words that came to mind were “squishy,” “unsettled,” “rudderless,” “aimless,” and “lackluster.” I think I will go with lackluster. So far this year nothing stands out to me that would allow me to identify a theme for the markets, but we are just eleven weeks into 2014 so there is still time. For the year, the Dow Jones Industrial Average is down 3.1% hurt primarily by the year-to-date stock price performance of General Electric (-10.4%), Boeing (-9.8%) and Travelers (-8.7%). The S&P 500 has held up a little better having lost only 0.4% so far in 2014. The Russell 2000 (a broader index that has smaller companies in its database) is up 1.5% and the technology-heavy NASDAQ is also up 1.6%.

As this market struggles to find an identity, I believe that a number of stories are contributing to the indifferent market performance both here and abroad. The two biggest being the Russian incursion into the Ukraine coupled with the geopolitical implications of a resurgent Russia (and possibly a declining USA), and the growing unease about economic growth in China. The Russia story is sad but straightforward—tyranny over freedom. The world has seen this type of thuggish behavior many times before and I suspect, will for many generations to come. The China story is a new one—ongoing conversion to free markets in a totalitarian state in order to stimulate domestic growth. The China story is also more complex which I will address in greater detail in the coming weeks, but for now let me summarize by saying that the Chinese government has decided to let its currency float a little and is trying to clean up a “shadow” banking system that is enormous and unregulated. Think of the shadow banks as a black market collection of lenders. How the Chinese government navigates this transition has global implications. Also keep an eye on Israel and the unrest there as militants from the Gaza area have renewed their rocket attacks on the Jewish state.

With the geopolitical concerns escalating, investors have been moving some of their assets into more defensive positions notably bonds and gold. The yield on the US 10-year Treasury has fallen 0.38% or 38 basis points (bps) since the start of the year (as yields fall, prices of bonds rise). The Barclays US Aggregate bond index has improved 2.1% year-to-date eliminating most of the losses from 2013. Gold prices have surged in the face of the geopolitical uncertainty gaining $176.00 an ounce (14.6%) this year helping push the DJ UBS Commodity index up 7.3%. Oil prices have been relatively stable in the face of rising demand as the US, Iraq, and even Iran have stepped up production.


For those of you who have worked with me or have been reading my Updates on a regular basis know that I talk about Relative Strength (RS) as one of the key analytical tools I use to study the markets and make investment decisions. You also know that I like to use sports analogies to help explain how RS works in context of investments. There is no better time of the year than March Madness to learn about or refresh your understanding of how RS works.

The NCAA men’s basketball tournament is known as March Madness. It is a head-to-head single game elimination tournament to determine who is the best college basketball team in the land, and some would argue the most exciting couple of weeks in sports each year.

Sixty-four teams earn spots or are selected to compete in the tournament. The teams are divided into four regions of 16 teams. Since 1979, the NCAA has seeded the teams in each region based upon their perceived strength in an effort to prevent two outstanding teams from meeting early in the tournament and sending one of the better teams home prematurely. The NCAA’s selection committee is tasked to pick those teams that do not earn an automatic bid along with ranking every team and seeding them into the regions. They use a variety of quantitative and qualitative measures such as quality of schedule, number of victories, and recent performance to make their seeding decisions. Once the tournament starts, all the #1 seeds plays the #16, the #2 seeds play the #15, and so on. My friends at DorseyWright & Associates using information from CBS Sports have created the chart below to show you just how each seed has performed over the past 29 years.

Here are a couple of key takeaways:

1) No #16 seed has defeated a #1.
2) The #1 seeds have the highest win percentage at 80%.
3) The top three seeds have won 73% of all games played, while
4) The bottom three seeds have won only 7% (27 games) of games played.
5) The top five seeds have won 68% of all games played while the bottom 5 seeds have won only 17% of their games.

You may ask, so what. Why does this matter? Well for many fans both serious and casual, when it comes time to participate in the office pool and bragging rights are at stake, success may be no further away than simply picking by seed. Does this mean you will win? Probably not. In fact it is so hard to predict every game correctly that Warren Buffett and Quicken Loans have offered $1 billion to anyone who can do just that for this year’s tournament. What are the odds? The game rules estimate the chances are one in 9 quintillion! How much is a quintillion—let me just say it is so small that Warren Buffett is willing to wager $1 billion in an advertising campaign on those odds.

The good news is that as investors we do not have to pick each and every game correctly to succeed. We need to be generally right. There is always going to be a Cinderella team that disrupts the brackets or strong RS stock that disappoints, but that is simply the way it is. There is nothing we can do about that. But when confronted with uncertainty, thousands of choices, and countless opinions, I want to be able to focus my decision making on the “top seeds” and avoid the bottom ones.

Using a relative strength matrix like the example on the left (Dow Jones Industrials 30 components) allows me to identify the “top seeds” currently found in the DJIA and use this information as a guide to my investment decision making.

Let me interject an important reminder: past performance is not a guarantee of future returns and all investing involves risk. There is no full proof methodology that can guarantee success.

Matrices like the one on the left can be created for virtually any index or investment that trades on a daily basis. I use data derived from a similar group of matrices each week when I comment in the LOOKING AHEAD section about which asset classes, size and styles of stocks, and sectors I prefer. These matrices are dynamic and reflect the current strength of the evaluated investments or indexes at any given moment.

These tools are invaluable to help me focus my attention and analysis to those investments that I believe have a higher probability for success as compared to the entire universe, and while the concept is not new, technology has allowed the matrices to become more robust and responsive in just the past few years. As an Army brigade commander told me years ago when I was a young lieutenant, “work smarter, not harder!” This is a lesson I continue to live by today and certainly applies to relative strength analysis.


I know that I sound like a broken record because the overall relationships in the markets have not changed in many, many months. 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.

The International stock asset class still ranks number two of the six major asset classes. However, the International stock asset class has shown some weakness lately which has made it less attractive for now and I would avoid adding new money at this time. I continue to strongly advise against owning the Emerging Market region.

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.

The overall rally in the Commodity asset class continues and is looking slightly more attractive in the short term. While it may be too early fundamentally to add commodities to an allocation, the numbers are improving and are worth watching.

Last week’s 2% pullback in the markets marks the second largest weekly drop in 2014 and the S&P 500 has now pulled back 2.25% from its all-time high of 1878.04 on March 7th. As this market drifts for a while I believe you can continue to anticipate greater volatility, but as I have said before, the underlying fundamentals of this market have not changed.

My next Market Update and Commentary will be published around April 1st. I plan on spending a few minutes to analyze how this year’s seeds do compared to the historical averages and see if there are any lessons we can take away from this great example of relative strength.

Happy St. Patrick’s Day!

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.