Tuesday, May 19, 2015

May 17, 2015

US markets continue to struggle to find their footing in 2015 as continued sluggish economic data for April casts doubt on the strength of current economic growth. Some of the recent data cited as worrisome include Industrial Production (-0.3%), the Producer Price Index (-0.4%), and Retail Sales (0.0%). Offsetting some of the negative effects of weaker economic data was the April Employment Situation report that showed job growth rebounding in April to 223,000 new, non-farm payroll jobs created and the unemployment rate dropping 0.1% to 5.4%. The Federal Reserve generally considers an unemployment rate around 5% to be full employment.

Source: The Wall Street Journal (Past performance is not indicative of future returns). As of market close May 15, 2015.

The first quarter earnings season is wrapping up. As of May 8th, FactSet reported that with 89% of S&P 500 companies reporting earnings, 71% have exceeded the median estimated growth rate. This is better than many analysts projected; however, FactSet also suggested that part of this success was attributable to massive downward revisions early in the quarter that substantially lowered the bar for most companies. Energy companies in particular have suffered earnings declines more than any other sector. To get a perspective on what has happened in the energy sector, I examined the first quarter 2014 and 2015 revenue and net income data of the five largest energy companies (based on market capitalization) which are ExxonMobil (XOM), PetroChina (PTR), Chevron (CVX), Petrobras (PBR), and British Petroleum (BP). The combined quarterly revenues of these big five fell from $374 billion in Q1 2014 to $249 billion in Q1 2015, a drop of $125 billion (-33.4%). Net income fell from $22.6 billion in 2014 to $11.2 billion a drop of $11.4 billion (-50.5%). Numbers this large will have an impact throughout the economy, especially on Gross Domestic Product (GDP). The money not flowing to the energy companies is more money in the pockets of consumers, however, an improvement in consumer spending has yet to materialize.

Looking at sector performance, the Health Care sector continues to lead among the ten major economic sectors with a gain of 8.3% so far in 2015. Following the Health Care sector is Consumer Discretionary (+6.0%), and Materials (+5.6%). The Utility sector is lagging all others having lost 6.7% year-to-date. The Financial sector is down -0.3% making it the only other negative sector tracked by Standard and Poors. The third worst performing sector is Energy that has thus far eked out a 0.2% gain.

International markets continue to perform well. The European-heavy STOXX 600 index leads the major indexes I track with a year-to-date gain of nearly 16%. Since the start of the 2nd quarter on April 1st, the STOXX 600 is down -0.2%, however. This drop in the STOXX corresponds with a 6.7% increase in the Euro. This rise in the Euro makes European exports more expensive and is considered a potential drag on earnings by some investors.

Source: The Wall Street Journal (Past performance is not indicative of future returns). As of market close May 15, 2015.

The Emerging Market region has also performed well in 2015 primarily on the strength of China’s market performance (+33.2%). China has the largest single country exposure in the Dow Jones Emerging Market region index with a weighting of 16.5%. South Korea (14%) and Brazil (12%) are the second and third largest holdings and these countries are up 10.0% and 14.5% respectively year-to-date helping propel this index forward. China’s market in particular has struggled recently (-3.0% since the start of May) and this is reflected in the Emerging Region index’s flat month-to-date performance.

Oil continues to perform well in 2015. WTI Oil closed Friday at $59.69 and is now up 12% for the year and a whopping 26% since April 1st. The number of oil rigs operating in the US continues to fall with just 660 active rigs last week compared to 1069 in October 2014. This sharp reduction in rigs gives some insight on why investors have bid the price of oil back up from its low of $47.06 on March 17th. Another factor influencing the price of oil is the strength of the US Dollar. A stronger US Dollar tends to help push the price oil and other commodities down because nearly all global commodity transactions are priced in US Dollars. As the US Dollar rises compared to other currencies, it raises the price to all international buyers. Anytime the price of a good goes up, the demand for that good falls all other things being equal. This appears to be the case with oil. The US Dollar reached its recent peak to all other currencies on March 13th and oil the price of oil bottomed on March 17th. As the US Dollar has weakened since March, the price of oil has risen sharply.

Interest rates play a major role in the value of the US Dollar. A major component for the demand of US Dollars by international investors comes from their desire to own higher-paying US Treasury bonds. If the spread (the difference between two similar bonds issued by two different countries) widens, investors will typically sell the lower-yielding bonds and purchase the higher-yielding bonds. A common trade recently has been owners of German 10-year Bunds (German treasuries) selling those bonds which have yielded as little as 0.08% on April 17th and purchasing US 10-year Treasury bonds which were yielding 1.85% on that day. It takes US Dollars to buy US Treasuries, so the demand for US Dollars increases. Today, the US 10-year bond is yielding 2.15% and the German 10-year Bund is yielding 0.62%. Spreads have narrowed and the demand for US Dollars has fallen.


At the start of the year, I said there were four issues overhanging the markets and would likely affect markets both good and bad, and that markets would remain volatile and fail to get traction until some of these issues were resolved. I will review the status of each as I see them today.

1) When and by how much the Federal Reserve raises interest rates? This has been the number one focus of investors so far in 2015 and remains an unanswered question. Consensus built earlier in the spring for a June rate increase of 0.25%. Falling interest rates in Europe as the European Central Bank started its version of quantitative easing coupled with uncomfortably weak economic data at home has more and more investors believing any interest rate increase will not come before September or even early 2016. While I personally believe it is time to start raising rates and get ahead of inflation, I believe rates will more likely increase in September than June. I also believe that raising rates 0.25% should not have a negative long-term impact on stock valuations; I am not prepared to suggest that there will not be a short-term negative impact to markets.

2) Will Greece stay in the European Union (EU)? Greece managed to pay for its most recent bond obligation to the International Monetary Fund (IMF) last week by borrowing from the IMF. You read that correctly, Greece borrowed money from the IMF just to give it right back. The account Greece borrowed came from funds previously reserved for Greece so the IMF agreed to allow this transaction. Unfortunately, that account is nearly empty and Greece faces three separate repayments in June including €1.6 billion ($1.8 billion) to bond holders on June 12th. It will be hard to see how the Greeks can work around these payments because I have read they do not have the funds to meet their obligations. As negotiations between the Greeks and European officials have progressed this year, I believe the Europeans are not going to accommodate the Greeks. This raises the likelihood of Greece leaving the EU and returning to the Drachma, but many believe this will not be a crisis for the markets as was feared several years ago. So while this remains an important issue, it may be less of a problem than previously perceived.

3) Will geopolitical problems affect markets? At the start of the year the global situation looked grave, particularly in the Middle East with the spread of ISIS. Since then there has been little improvement, but impacts on financial markets has been negligible. I believe this status quo will remain in place for now and not have a major impact on markets.

4) Will the newly elected Congress achieve progress towards passing pro-growth fiscal policies or will Washington continue partisan fighting? I said back in January that I was not optimistic about any improvement in the domestic political situation, and unfortunately, this view has proven to be true. I continue to believe that Washington will not make any move towards implementing pro-growth fiscal policies unless there is a change in the White House in 2016. I do not expect any market improvements attributable to improving fiscal policies.


There has been a lot of discussion in the financial media regarding the current valuation of US markets. Some analysts are suggesting that we are in a Fed-induced bubble and that asset prices are wildly overvalued. Part of their reasoning is that the lack of a major correction since that Great Recession (we have had several 10% corrections since 2011) means we are due for a big one at some point. While I do not believe we are free of periodic corrections, I also do not believe we are due for another major correction. The numbers simply do not justify that conclusion.

The May 8th FactSet discussion of corporate earnings puts the 12-month forward price/earnings ratio (a widely used measure of value in stocks) of the S&P 500 at 16.8. The five-year average has been 13.8 and the ten-year average is 14.1. Clearly stocks are more highly valued, but not to the extreme. Additionally, the DorseyWright & Associates Overbought/Oversold status reading of the S&P 500 is +29% (>+100% indicates significant overvalue) meaning stocks are fairly valued base on the most recent ten-weeks of trading activity. What these numbers mean is that buying into this market is still okay, but outsized returns like we had in 2013 are most likely behind us. Markets can still grow from here, however, it is going to be harder to make money than it was in the early stages of this current bull market.

US stocks and International stocks are still ranked one and two of the six major asset categories I track. Equal weight indexes are favored over capitalization-weighted indexes. Small and Mid Capitalization stocks are favored as is Growth over Value. Within sectors, Health Care, Industrials, and Consumer Discretionary are favored.

Over the next several weeks some of the key economic reports due out will be the release of the Federal Reserve’s Open Market Committee minutes (May 20th) from their last meeting on April 29th. The second revision of first quarter’s GDP report will be issued on May 29th (some are expecting the revision to be downward to a negative growth number), and Jobless Claims released every Thursday morning continue to excite investors.

As I have said before, whenI look out onto the horizon, I continue to see more of the same. Some growth, a lot of headwinds due to poor fiscal policies, and a belief that Americans always adapt and overcome. The markets have not made much in the way of gains this year, but sometimes a pause is not a bad thing. I will continue to monitor events and markets and will keep you appraised of my observations.

If you have any questions or comments, please do not hesitate to reach out to me.

Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
NTrust Wealth Management

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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict.

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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.