Tuesday, April 22, 2014

MARKET UPDATE AND COMMENTARY
April 20, 2014


Let me begin by saying that I realize I am a week behind in publishing my Market Update and Commentary, but I have been suffering from a terrible case of the flu. It is the first time I have had the flu in years, and I am reminded that being sick is always a terrible alternative to everything else!

At times I have felt that my recent physical health has been mirroring the general health of the markets. However, upon closer examination, the markets feel worse than they really are. For the year, the Dow Jones Industrial Average is off 1% while the S&P 500 is up 0.9%. The worst performers of the major indexes I track are the tech-heavy NASDAQ (-1.9%) and the small/mid stock-heavy Russell 2000 (-2.2%). Within the broader context of the indexes there has been even greater turbulence within some of the best performing sectors in 2013. The Biotech sector is off 3.8% year-to-date (YTD) and down 12.6% over the past month, and the Internet sector is down 2.0% YTD and is down 11.5% over the past month. Quietly, the Utilities (+10.6%), Real Estate sector (+9.1%), and Energy (+4.8%) lead among the major sectors so far in 2014.

International markets have continued to keep up with US markets. The European-heavy STOXX 600 is up 1.3% in 2014. The Asia/Pacific region is the weakest performer (-1.3%) followed by the Emerging Market region (+0.3%). Japan has seriously underperformed most countries so far this year losing 10.9%. The big question hanging over most international markets is what impact will the daily escalation of tensions within Ukraine have on European and other international markets going forward. Russia appears to be the economic loser in 2014 with that country’s major exchange down 16.7%.

Commodities continue to perform relatively well in 2014. The UBS Dow Jones Commodity Index, a broad basket of commodities, is up 9.5% led by strong gains in the agricultural commodities such as coffee (+82%), pork (+45%), and orange juice (+21%). Rises in many of the agricultural commodities appears to be the result of weather-related supply/demand problems due primarily to drought troubles in many agricultural-producing areas in the US. Pork is suffering from an unprecedented loss of piglets to a virus causing prices to spike upwards. Energy prices have also been on the rise in 2014 with WTI Oil gaining 5.8% while the price of natural gas has jumped 14.0%. Gold is up 7.6% helping to bring this metal off multi-year lows. All of this is causing energy and food prices to push up at a higher rate than core inflation.

Bond traders, in my opinion, are very undecided about the future direction of interest rates. One day traders believe Fed Chairman Yellen is ready to raise interest rates earlier causing rates to jump upwards, the next they are convinced that the economy will remain sluggish and interest rates fall. The net effect has been for bonds to post modest gains in 2014 as interest rates remain range-bound and below where they finished 2013. The Barclays Aggregate US Bond index is up 2.3%. The US 10-year Treasury yield is currently 2.72% and well below 2013’s close of 3.03%. The Long Government, Preferred, and High Yield sectors are leading among bond sectors, however, almost all bond sectors are slightly positive so far in 2014.


COPING WITH VOLATILITY

Market volatility has returned in 2014 after a relatively benign 2013. As I pointed out in early Updates, the strongest performing sectors of 2014 (biotech and internet) are the biggest losers so far in 2014. This is not unusual as investors take profits in these sectors after strong runs. The lower-volatility sectors like Real Estate, Utilities, and Energy have outperformed as investors appear to be seeking relief from the wide swings found in the more volatile sectors like small capitalization stocks and the other sectors already mentioned. I have trimmed some of my positions in biotech and internet stocks, however, I still maintain that these sectors have the potential to provide strong returns in the future. I will return to these investments when they are no longer providing sell signals.

My pullback from the biotech and internet sectors does not reflect a retreat from stocks in general. US stocks still remain as the strongest major asset class according to DorseyWright & Associates (DWA). Let me repeat myself: US stocks remain the strongest major asset class and I am not abandoning stocks. I am moving stocks away from some of the higher volatility securities into core holdings and even a few value securities. I am maintaining my allocation to stocks, just trimming the higher volatility positions.

Another reason that I have not trimmed my allocation to stocks in general is that the Money Market fund category has actually fallen during this period of increased volatility. At the start of the year, the Money Market Fund category ranked 110th out of 129 category sectors tracked by DWA. Today, the Money Market Fund is ranked 130th out of 133. If the Money Market Fund category starts rising substantially, I believe it is a key warning sign that the underlying fundamentals of the market may be deteriorating, and this just has not happened. Nor has general strength of the US stock major asset class weakened. In fact, it has not relinquished a single tally to the other major asset categories since October 2011—an impressive show of relative strength.

Sixteen weeks (31%) of the year have now passed and there is little to excite most investors, however, as I have said before, a pause is not necessarily a bad thing at this time.

LOOKING AHEAD

Earnings season is in full swing. Publicly traded corporations are now reporting earnings for the first quarter of this year. Many analysts and investors are expecting a subdued quarter due to the terrible weather experienced by some of the most populated portions of the US. I share that view, however, it will be important to listen to what CEOs and CFOs say about earnings expectations for the remainder of the year. Profits drive the stock market, so earnings are critical.

There remains no shortage of doom and gloom in the media regarding a pending correction. One of the most common arguments for a large decline (>10%) comes from the simple fact that the US markets have not suffered a 10% correction since September 2011. I have written previously that this market has been less volatile than historical norms, however, saying we are due for a correction simply because we have not had a correction is a dubious claim in my view. My guidance is to stay focused on the data, and the data does not currently suggest that the markets are extremely overbought or expensive. They are not cheap, but they are not terribly extended either.

My broad guidance remains in place. I favor US stocks over all 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 Materials, Industrials, and Financials sectors. My sector recommendation has dropped Health Care and Consumer Discretionary for now, and Materials is a new addition. Finally I prefer equal-weighted indexes over capitalization-weighted indexes.

The International stock asset class still ranks number two of the six major asset classes. The weakness in International markets in relative strength terms continues. I am not selling current positions but not adding new money to this major asset class. I continue to strongly advise against owning the Emerging Market region. I include China in 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. The Energy sector is my favored Commodity asset class investment area.

While economic data released over the past week or two has been somewhat favorable, most investors seem to focus on the next set of data. Highlighting this week’s releases are the Existing and New Home Sales reports for March (Tuesday and Wednesday morning respectively), and Durable Goods Orders and Jobless Claims on Thursday. Existing home sales are expected to drop slightly while new home sales are expected to increase slightly. Jobless Claims are expected to increase by 9000 claims to 313,000 from the previous week’s tally of 304,000 while Durable Goods Orders for March are expected to drop marginally. The “plow horse” economy continues to plow along!

I will close my Update and Commentary by providing this year’s bracket analysis for the Men’s NCAA Basketball Championship (please go back and read my bracket analysis in the March 16th Market Update and Commentary if you missed it). As we all know by now, Connecticut won the championship as a #7 seed, the second lowest seed to win since 1985. The chart on the next page compares the overall record by seed for 2014 against the average record by seed from 1985 until 2013:



A couple of things jump out. First, the #16 seed failed to win over a #1 seed in the opening round keeping this record intact for now. Second, even though a #1 seed failed to reach the Championship game, they still posted the best overall record of all seeds. Finally, #7 Connecticut raised this year’s winning percentage for all #7 seeds. This is a fun example of the merits of relative strength and how it might be applied to investment decision making.




Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
Principal
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.