Tuesday, May 20, 2014

MARKET UPDATE AND COMMENTARY
May 18, 2014


Financial markets continue to move without clear direction with the possible exception of small capitalization stocks.

Over the past two weeks, the Dow Jones Industrial Average (DJIA) fell 0.13%, the S&P 500 gave back 0.17%, the NASDAQ dropped 0.81%, and the Russell 2000 (small cap stocks) fell 2.29%. For the year, the DJIA is down 0.5%, the S&P 500 is up 1.6%, the Russell 2000 is down 5.2%, and the NASDAQ is down 2.1%.

Economic news, like the markets, was mixed. There were ten key economic reports over the past two weeks. The Wall Street Journal defines these key reports as “market moving” indicators. Six were better than consensus, three fell below, and one met consensus. I will have more to say about some of the most significant report in my next section.

International markets have shown some interesting short-term trends. Russia has rallied 9.8% over the past two weeks, as investors there feel more comfortable for now that Putin apparently is not going to invade Ukraine triggering more and substantial sanctions from the West. India just elected Narendra Modi as Prime Minister. Mr. Modi’s election signals a shift to a strong pro-growth, pro-business agenda and in the process, he has pushed out the more progressive Congress Party after 67 years of rule. India’s primary market is up 7.7% over the past two weeks. Russia and India are two key emerging market countries and helped push the Emerging Markets region up 2.6% last week. For the year, the Emerging Market region is also up 2.6%. The Developed Markets region is up 1.5% year-to-date, and the European focused STOXX 600 is up 3.3%.

Commodity markets have shown little change recently as I noted in my last Market Update and Commentary. The Dow Jones UBS Commodity Index (a broad indicator of commodity performance) is down each week so far in May (-1.9% for the month) leaving the index up 7.5% for the year. Gold is flat for May and up 7.5% for the year. WTI Oil has shown recent strength and is up 3.7% for the year. Agricultural commodities are generally up for the year primarily because of drought conditions in much of the growing regions in the US.

The Barclays US Aggregate Bond index is up 0.9% over the past three weeks and is now up 3.2% as bond yields continue to fall. The US 10-Year Treasury yield closed last Friday at 2.52%. This is the lowest Friday close for 2014. While bond investors have seen a nice bump in returns so far this year, I do not consider this a particularly positive development. Lower yields, in my opinion, signal a lower economic growth outlook—not the direction any of us want to see right now. Lower yields in turn foster a weaker US Dollar which, over the long-term, is not a positive.


IS INFLATION CREEPING INTO THE ECONOMY?

Of all the key economic reports released over the past couple of weeks, I want to focus on the Producer Price Index (PPI) report for April released last Wednesday. This report measures the average price changes in the final price of goods and services produced in the US. Consensus had expected a jump of 0.2% but the April number came in at 0.6%. This suggests that inflation is now running at a rate of about 2% over the past year when the same data six months ago showed inflation running at just 1%. Why is this significant?

One of the primary concerns of the Federal Reserve’s current and long-running accommodative monetary policy has been that by keeping interest rates so low for so long coupled with the unprecedented purchases of bonds (Quantitative Easing—QE) was that this would ultimately cause inflation to rise beyond the Fed’s ability to control it.

I am not of the opinion, as some commentators have suggested, that last year’s run up in equity markets was caused by a flood of money into the economy from the Federal Reserve’s QE program. Rather I believe that the rise in stock market prices resulted from strong corporate profits. I have also stated recently that I do not believe the markets are headed for some kind of severe correction because the Fed’s monetary policies are accommodative and we have not seen a Fed-induced rise in interest rates. However, I do feel that if the Fed does not get future monetary policy right (returning monetary policy to a more neutral position compared to the accommodative policies in place now), we could be in store for some inflation and higher interest rates. Inflation has been kept in check up to this point because banks have not made loans with their excess reserves. I also believe that this is also the reason why the stock market has not been stimulated artificially. Simply put, much of the money created by the Fed by QE is not in circulation in the day-to-day economy.

Bankers have understood all along that the Fed pumped up bank reserves in the hope that the banks would then lend the money to get the economy kick started. However, I believe that bankers have been fearful that the Fed could quickly pull back the excess reserves creating cash shortages at the banks because most loans are made over a multi-year period. No banker would make a multi-year loan if they were concerned that the Fed could pull money back next month. If you look at the graph above, you can see in the blue line (Monetary Base) how the Federal Reserve created a lot of money via bond purchases (QE), but there has been no discernible change in money (gold line) actually moving into the economy (Money Stock: M2). Money Stock (M2) is the source of inflation, not the Monetary Base. If banks sense that the Fed is not about to pull back the money that is currently in reserve, lending will increase, money stock will increase, and I believe inflation will follow. To counter the outflow of money from the Monetary Base, the Federal Reserve, in my opinion, will be forced to raise rates currently paid on reserves to entice banks not to lend out the money.

It is too early to determine if the rise in the PPI is a signal that money is moving out of reserves and into the economy, but it is certainly something to watch closely. If the Fed is forced to raise interest rates before the general economy is on solid footing, it could increase the likelihood of a contraction in economic growth.

I will conclude by saying that Fed monetary policy is not the most interesting of subjects to discuss, but hopefully you can get a sense of how influential the Fed can be on the markets.

LOOKING AHEAD

I believe the economy is stuck in a rut and we will be in this rut for the time being. This does not change my current belief that US stocks are the favored major asset category. There has been no changes in the overall relative strength relationships between the major asset classes for some time now.

Therefore, my broad guidance remains in place. 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 am very aware of the recent weakness in the small cap sector and am considering a change from small cap growth to small cap value. Looking at the major economic sectors, the Materials and Financials sectors are now favored. I should point out that from a pure performance perspective (as compared to relative strength which is slower to move) Real Estate, Utilities, and Energy have been the best performing sectors in 2014 while Consumer Discretionary the weakest. As of Friday, the Industrials sector, along with the Information Technology, Financials, and Consumer Discretionary have not exceeded the S&P 500 in performance. Only Consumer Discretionary is negative year-to-date.

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 and I am not selling current positions but not adding new money to this major asset class. While I continue to strongly advise against owning the Emerging Market region, I am aware of the recent positive performance of this region. I believe that the sudden improvement in Russia and India are behind the numbers. I do believe India is a country on the rise.

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.

Commodities appear to be stymied at this time. The Energy sector is my favored Commodity asset sector.

Home sales will be the most significant reports out next week with Existing Home Sales for April scheduled for release on Thursday followed by New Home Sales on Friday. The second revision of the 1st Quarter Gross Domestic Product (GDP) will be released the following Thursday, May 29th. Recall that the first estimate came in at 0.1% growth. It is too early for the consensus figures to be available, however, several economists whose opinions I value expect to see this number fall to the -0.3% range. I do not believe the markets will overreact to this negative number given the understanding of the winter’s negative impact on the economy.




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