Equity markets, both here and abroad, reversed their recent losing trends and posted solid gains for the first week of October.  The big economic headline last week was the official US unemployment rate falling to a four-year low of 7.8%.  Although markets rallied strongly on the news Friday morning, they did not hold much of the day’s gains and closed well below earlier session highs.

For the week, the Dow Jones Industrial Average (DJIA) added 173 points (1.3%).  The S&P 500 gained 1.4%, the mid- and small-capitalization dominated Russell 2000 and tech-heavy NASDAQ both increased by 0.6%.  For the week, at least, larger companies were favored over smaller ones.  As we kick off the 4^th quarter, the DJIA is now up 11.4% for the year.  The S&P 500 is up 16.2%, the Russell 2000 has risen 13.8%, and the NASDAQ is up a strong 20.4%.

Financials and Health Care were the best two performing major economic sectors gaining over 2.5% each.  They were followed by Consumer Discretionary, Consumer Staples, Industrials, and Telecom.  All of these top sectors out-performed the S&P 500 for the week.  Information Technology and Energy were both slightly negative on the week and the laggards among sectors.  For the year, Consumer Discretionary, Health Care, Telecom, and Financials are the leading sectors while Utilities, Energy and Real Estate are the bottom three.  All sectors, however, remain positive and only Energy and Utilities are underperforming the DJIA.

International stocks were up nicely this past week.  The MSCI (EAFE) index gained 1.2% for the week while the European-focused STOXX 600 added 2.1%.  The Asian/Pacific and Emerging Market regions lagged gaining 0.1% and 1.1% respectively.  European investors have continued to be buoyed by Mario Draghi’s (European Central Bank President) commitment to his own version of quantitative easing for European Union (EU) countries.  Most of the EU is in recession, unemployment is at record levels, and it appears that Greece is hopelessly addicted to continued bailouts.  Yet the stock market continues to go up.  I believe this reflects the power of monetary policy in today’s economic environment.  I remain uncomfortable making any significant investments in international securities, especially European securities, and have avoided this major asset category so far in 2012.  However, I do believe that European leaders will make every effort to keep Greece within the EU and to maintain the strength of the Euro.  Even if they are successful, I believe Europe will struggle to create any real economic growth and will have trouble outperforming the US and emerging markets going forward.

US Treasury yields reversed course and the 10-year gained 0.11% to close Friday at 1.737%.  The 30-year yield also added 0.14% to close the week at 2.965%.  Analysts suggested that the sell-off in US Treasuries was the result of the unexpected drop in the unemployment numbers thus increasing the chances that the Federal Reserve would delay or curtail its recently announced bond purchases (QEIII).  No one knows at this point how the Federal Reserve will act, but yields on Treasuries did jump on Thursday and Friday.  Spanish and Italian sovereign 10-year yields fell and closed Friday at 5.686% and 5.054% respectively.  I found it interesting that Bill Gross of PIMCO revealed that he purchased both Spanish and Italian debt on news that the ECB would begin buying EU sovereign debt.  Reintroducing the private sector into the mix has to be a good thing for European bond markets for now.  The question in Europe remains, however, when will the Spanish government officially request the ECB to step in and purchase Spanish debt?  Overall bonds were generally down last week with the Barclays US Aggregate bond index dropping 0.2%.  Extend duration government bonds was the worst performing sector while international sovereign debt and international inflation protected bonds were the best performing sectors..

The US Dollar index fell 0.8 % last week and the Euro gained 1.4% against the US Dollar to close Friday at $1.303.  The sell-off in the US Dollar is a result, I believe, of the Federal Reserve’s accommodative monetary policy that weakens the US Dollar, and because of the ECB’s own easy monetary policy that reduces the attractiveness of the US Dollar as a safe haven investment.  However, there remain many unknowns about Europe today.  How the EU handles Greece’s continued bailout needs, or Spain’s expected request for ECB intervention in its own bond purchases, and how effectively the EU moves in making meaningful structural changes to the way it governs financial affairs between member countries has to be resolved.  All of these, and more, are issues that will influence markets, including currency markets, over the coming months.    

Commodities pulled back last week with the UBS Dow Jones Commodity index falling 0.5%.  Oil captured most of the commodity headlines as oil prices swung widely during the trading sessions primarily on news of gasoline shortages and rationing in California.  For the week, WTI Oil closed at $89.92 per barrel (-2.4%) for the week and is now down 9% since the start of the year.  A slowing global economy and weakening US Dollar continue to weigh negatively on oil prices.  Gold added $6.30 (0.4%) per ounce to close Friday at $1780.80.  For the year, gold has 13.7% and, I believe, continues to reflect investor concerns over Federal Reserve monetary policy that weakens the US Dollar.

UNEMPLOYMENT REPORT AND OTHER THOUGHTS ABOUT THE ECONOMY

As I noted at the top of this week’s Update, the unemployment report made a splash when announced on Friday with the overall unemployment rate dropping from 8.1% to 7.8%.  This news, however, was accompanied with another weak monthly jobs gain of 114,000.  I am not going to spend time explaining the nuances between the household survey and the establishment survey, or to speculate whether there was political manipulation of the numbers, but I will say that the report was not nearly as robust as it appears on the surface.  I believe the markets agree with this observation because the DJIA only closed up a modest 35 points on Friday.

The household survey, which is the basis for the overall unemployment rate, indicated that 873,000 new jobs were created in September.  This is the largest monthly job gain in 30 years.  What the survey also showed was that two-thirds of every new job was a part-time job.  What prompted a jump of 582,000 part-time jobs?  I think you need to look no further than another statistic that shows 1.2 million long-term unemployed have lost their unemployment benefits so far in 2012.  So while the headline number looks like a strong move in the right direction, the surge in part-time jobs does not lead, I believe, to long-term economic growth necessary to move the Gross Domestic Product (GDP) above 2%.

Another discussion that has been part of the political dialogue this fall has been the effectiveness or lack of effectiveness of the stimulus bill passed at the beginning of President Obama’s term.  Scott Grannis who publishes the Calafia Beach Pundit blog, made an interesting observation this past week.  His breakdown of the $840 billion stimulus spending package showed that 75% of spending went in the form of transfer payments.  Some of the examples he used to illustrate the transfers included the “cash for clunker” program, the first time homebuyer tax credit, education spending, and tax subsidies.  Spending in these types of programs does not create wealth, it simply takes it from one private citizen and gives it to another.  Scott also said that spending for infrastructure and transportation, the “shovel-ready” projects, amounted to only $65.5 billion or just 8% of the overall spending plan.

I put these two observations together to emphasize that economic growth must come from a truly expanding economy where real wealth is being created which in turn supports a growing and robust private sector economy.  This has simply not occurred.  I believe our “plow horse” economy is growing because most Americans get up every day determined to be productive and work hard for themselves and their families.  This is why my faith remains firmly grounded in the American worker and economy.

LOOKING AHEAD

Banks and bond markets will be closed Monday in observance of Columbus Day.  Stock markets will be open.

Key US economic reports are limited this week.  The International Trade report for August will be released Thursday morning.  Consensus for this report is for the trade deficit to increase by $2 billion from July’s $42 billion to $44 billion.  The larger the trade deficit, the bigger the drag on the US GDP.  Energy imports are a big part of what drives the US trade deficit, and so energy prices do matter.  Additionally, exports can be hurt by weak European and other regional economies. So if we are exporting less due to a slowing global economy and energy imports rise, you get higher deficits.  The Initial Jobless report is also scheduled for release on Thursday morning as it is every week.  Consensus calls for first time claims to reach 370,000.  The Producer Price Index for September will be released on Friday.  This report tracks prices paid by domestic producers of goods and services and gives insight to future prices consumers may end up paying.  Experts are expecting the monthly change to drop from an increase of 1.7% in August to an increase of 0.8% for September.  The year-over-year core (less food and energy) increase is expected to remain unchanged at 0.2%.  As has been the case with most economic data for the past six months or so, the mediocre results are not contributing to a dynamic and robust economy.

The New York Stock Exchange Bullish Percent (NYSEBP) rose 0.40 to close Friday at 66.36.  The recent weekly up and down movement of this critical broad market indicator reflects the uncertainty found in the markets.  However, the NYSEBP is in a column of X’s meaning that demand is in control, and with a reading of 66.36, two-thirds of US stocks on the New York Stock Exchange are in a buy signal.  These numbers favor US stock ownership at the current time.

The Dorsey Wright & Associates analysis of the markets have remained unchanged for most of the summer.  Data indicates that US stocks and Bonds are the two favored major asset categories followed by Foreign Currencies, International stocks, and Commodities.  Middle capitalization stocks are favored, as is growth over value, and equal-weighted indexes over capitalization weighted indexes.  Equal-weighted indexes are those where each stock in the index is weighted the same, while in capitalization-weighted indexes the larger stocks have the largest weighting consistent with their size relative to the other stocks.  The relative strength sector weightings favor Consumer Discretionary, Health Care, and Information Technology.  US Treasuries and International Bonds are favored in the Bond category, while US and Developed Markets are favored within the International stock category.

Paul L. Merritt, MBA, 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 3^rd quarter provided investors solid returns despite consecutive weekly losses to close out the quarter and growing concerns about a global economic slowdown.  The Dow Jones Industrial Average (DJIA) gained 4.3%, the S&P 500 was up 5.8%, the Russell 2000 added 4.9%, and the NASDAQ led all major US indexes with a 6.2% gain for the quarter.  The gains over the 3^rd quarter illustrated just how difficult it is for investors to place their faith in such maxims as, “sell in May and go away.”  The last two years following this maxim would have helped, but not this year, and over the longer-term, empirical evidence has not supported this somewhat popular view.  For the year, the DJIA is now up 10.0%, the S&P 500 is up 14.6%, the Russell 2000 has gained 13.1%, and the NASDAQ is up a solid 19.6%.

Telecom led all sectors in performance in the 3^rd quarter and is now the second best performing sector for the year.  The major phone companies (AT&T and Verizon) have benefited by our obsession with phones, and I believe we will continue to do so as phone technology continues to improve.  Telecom was followed by Energy, Consumer Discretionary, and Information Technology.  Real Estate, Utilities, Industrials, and Consumer Staples were the weakest sectors during the quarter and all underperformed the DJIA.  For the year, Consumer Discretionary, Telecom, Information Technology, Health Care, and Financials are the top performing sectors and all bested the S&P 500’s return.  Utilities, Energy, and Industrials are the bottom three performing sectors through the first three quarters of the year and only Utilities and Energy have not outperformed the DJIA.  All sectors are positive for the year. 

International stocks rallied last quarter with the MSCI (EAFE) index posting a strong 7.2% gain.  Looking at the various regions around the world, Europe (STOXX 600) led with a gain of 6.9% followed by Emerging Markets which added 6.5%.  The Asia/Pacific region lagged all others with a gain of 4.5%.  I believe Europe, which had been hard hit over the debt crisis, rallied off lows as the European Central Bank (ECB) stepped forward promising to provide support via a bond-buying program, while the Far East has been hurt by a slowdown in Chinese manufacturing. 

US Treasury yields pulled back sharply the last two weeks of September after rising on news that the ECB and US Federal Reserve pledged to make sizeable bond purchases.  The 10-year yield closed Friday at 1.628% compared to a yield of 1.863% two weeks earlier.  The 30-year has traded similarly and closed Friday at 2.823%.  I believe that Treasury yields at this level reflect significant pessimism among bond investors who do not see robust growth for years to come.  European investors have renewed bond purchases of European Union (EU) sovereign debt now that the ECB has said they would also purchase bonds.  Spain, the most significant risk in the EU, has seen its 10-year yield fall from 6.857% on August 31^st to 5.938% at last Friday’s close anticipating ECB purchases.  However, in order for the ECB to begin purchasing Spanish debt, Spain must make a formal request to the ECB.  To date, this has not happened and there is great internal political pressure to avoid such a request.  Spain’s debt problems are growing and I would expect bond investors to start getting nervous waiting on the Spanish government to make a formal request.  I believe it is just a matter of when, not if, a formal request will be made.  As I have said before, watch the sovereign yields, the yields reveal how markets are thinking about the economic future of countries.  The Barclays US Aggregate bond index gained 1.7% in the 3^rd quarter and is now up 4.2% for the year.  Emerging Market debt led all bond sectors in performance over the past quarter with gains matching the major US stock indexes.  International treasuries and quality corporate bonds also did well.  Extended duration US Treasuries and corporate bonds were the weakest bond sectors.  For the year, Emerging Market bonds, Preferreds, and High Income are the best performing bond sectors while short duration bonds of all types are the weakest.

The US Dollar index fell 2.0% in the 3^rd quarter and is now down 0.3% for the year.  The US Dollar’s weakness, I believe, is due to the Federal Reserve’s commitment to easy monetary policies expressed in terms of ultra-low interest rates and indefinite bond purchases.  Pumping dollars into the economy increases the supply of US Dollars and the more of anything you have, the cheaper it becomes--Economics 101.  However, as doubts are increasing over the effectiveness of the latest round of stimulus, the US Dollar gained strength and the US Dollar index was positive the last two weeks in September.  I believe currency traders are very unsure about how the next few months are going to play out.  The Euro gained 2 cents (1.5%) against the US Dollar in the third quarter and closed Friday at $1.285.  For the year, the Euro is down about one cent (-0.7%) to the US Dollar.   

Commodities were among the best performers last quarter.  The Dow Jones UBS Commodity index posted a 9.7% gain on the strength of precious metals, natural gas, and oil.  Gold gained $170.30 (10.6%) per ounce for the quarter and is now up 13.3% for the year.  Gold is a hedge against weak currencies and I believe these gains reflect investor worries about easy global central bank monetary policies.  WTI Oil also did well this past quarter gaining 8.4% to close Friday at $92.10 per barrel but is down 6.8% for the year.  Brent Oil gained 14.7% last quarter reflecting more concerns about the Iranian problems than WTI, I believe.  Brent is up 4.5% for the year.

UNCERTAINTIES ABOUND HEADING INTO THE 4^th QUARTER

As we start the last quarter of 2012, I sense a great deal of unease.  One does not need to look far to see what investors are worried about.  The upcoming US elections, the looming fiscal cliff, a European debt crisis that is hitting its third anniversary, and slowing manufacturing in China are among the biggest concerns.  US economic data has not provided any inspiration either.  Last week the final revision of the 2^nd quarter Gross Domestic Product (GDP) was revised downwards from 1.7% to 1.25%.  Most talking heads on TV pushed that report aside insisting that number was “old news.”  Durable goods orders plummeted in August, and unemployment is holding steady at just over 8%.  More worrisome is that job creation is barely keeping up with demographic increases in the work force (100,000 new workers every month).  Housing appears to be bottoming and that is a positive signal, however, unless the economy grows at something more than 2% GDP, I do not see the prospect of more robust housing growth.  In short, economic signals are weak.

Yet the S&P 500 is up nearly 15% so far in 2012.  How can that be you might ask?  The answer is simply that the stock market is a forward-looking economic indicator.  If investors believe that the current price of stocks relative to future growth and value is cheap, then they will buy stocks and the market will go up.  This has been the message the markets have been signaling all year—stocks are cheap relative to future growth. 

I am not suggesting that all is well and we can push blindly forward.  Quite the contrary.  I am saying that investors must be aware of what is going on around them and invest smartly.  The Motley Fool website recently published a story (Dangerous Denial—September 20, 2012) citing a study released by Franklin Templeton Investments that found 56% of investors thought the US stock market had fallen each of the past three years.  In fact, the S&P 500 is up nearly 60% since the start of 2009 without a single down year.  I was shocked when I saw this, but then again not surprised when I stopped and thought how negative financial media coverage is of current events.  The media cannot help themselves.  It sells papers and gets people to tune in.

So we head into the last quarter of 2012 with a lot of worry.  Legitimate worries.  Situations that must be monitored.  October is a month that carries with it the memories of crashes in 1929, 1987, and 2008.  What October also has delivered are 51 monthly gains in the DJIA out of the past 84 Octobers (going back to 1929).  In other words, October has been up 60% of the time.  Going back just 10 years, October has been positive 70% of the time.  Will this October be positive?  I have no idea.  What I do know is that diligence and the tools to monitor markets are important to investment decision making.  It is also necessary not to let maxims or adages or even headlines throw us off sound investing practices.  Pick strong technical investments, watch the general trend of the markets, and be prepared to adjust as necessary.

LOOKING AHEAD

There are some key reports this week that might influence the markets.  The September ISM Manufacturing Index will be out at 10 AM Monday morning.  It is expected that this timely report will show that manufacturing has contracted for the third consecutive month.  The September Employment Situation report will be released on Friday morning.  Consensus expects 17,000 more jobs created in September than were created in August for a total of 113,000 new jobs.  The unemployment rate is expected to hold steady at 8.1%.  These two reports will provide a relatively current look at the state of the economy and may have even more importance given their proximity to the presidential election.  

The New York Stock Exchange Bullish Percent (NYSEBP) ended the 3^rd quarter at 65.96 down 2.3% from the previous week’s close.  This drop is the worst weekly performance for this critical technical indicator since the first week in June.  However, one week does not make a trend, and with a reading of nearly 66, it means that two-thirds of stocks are still on a point and figure buy signal—demand for stocks remains firmly in control.  It will take a drop to 61.37 to reverse this reading.   After the pullback in US markets over the past two weeks, the overbought reading of the S&P 500 has dropped to 33% indicating that markets are not significantly overbought at this time.  Should the markets begin to correct, the key support level for the S&P 500 is 1350.  This would reflect a drop of 6.3% from current levels.

The Dorsey Wright & Associates analysis of the markets indicate that US stocks and Bonds are the two favored major asset categories followed by Foreign Currencies, International stocks, and Commodities.  Middle capitalization stocks are favored, as is growth over value, and equal-weighted indexes over capitalization weighted indexes.  Equal-weighted indexes are those where each stock in the index is weighted the same, while in capitalization-weighted indexes the larger stocks have the largest weighting consistent with their size relative to the other stocks.  The relative strength sector weightings favor Consumer Discretionary, Real Estate, Information Technology, and Health Care.  US Treasuries and International Bonds are favored in the Bond category, while US and Developed Markets are favored within the International stock category.

I would like to finish up this weekend by telling everyone that my daughter’s wedding in Richmond on the 22^nd was a huge success.  Thank you all for your warm wishes and thoughts.

RIP Taylor.  You were a great companion on Saturday and Sunday mornings as I worked at my desk.

Paul L. Merritt, MBA, 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

Quantitative easing is once again part of US monetary policy following Thursday’s announcement by Ben Bernanke that the US Federal Reserve would begin another program to buy mortgage-backed securities.  Some form of easing was anticipated following recent statements by Mr. Bernanke indicating he was in favor of intervention; however, many economists did not expect the unlimited duration of this new policy.  This third round of easing (referred to as QE3) had an immediate and positive impact on stock markets and “Risk On” assets, and rippled through the remainder of other markets both here and abroad.  The net effect of the Federal Reserve’s action will be to pump more and more money into the economy, which, I believe, will push prices for nearly everything higher, and exert influence over the markets near term.  As I review the past week, you will see this QE3 theme affecting every major market and asset category.

For the week the Dow Jones Industrial Average (DJIA) added 287 points (2.2%), the S&P 500 gained 1.9%, the NASDAQ increased 1.5%, and the small and mid-capitalization dominated Russell 2000 led US indexes for the second week in a row adding 2.7%.  Historically September is the weakest month for stocks, but that has been anything but the case so far.  For the month, all of the major stock indexes are up led by the Russell 2000 that has posted a 6.5% gain in just two weeks.  The S&P 500 is up 4.2% followed by the DJIA and NASDAQ which are each up by 3.8%.  For the year the DJIA is now up 11.3%, the S&P 500 is up 16.6%, the Russell 2000 is up 16.7%, and the NASDAQ continues to lead with a 22.2% gain.

Utilities was the only major economic sector negative this past week as the “Risk On” theme hurt the more defensive sectors.  The other weak sectors last week were Consumer Staples and Health Care.  Energy, Materials, Financials, and Industrials were the best performing sectors and exceeded the DJIA for the week.  For the year, Financials is now the best performing sector followed by Consumer Discretionary, Information Technology, and Real Estate.  Utilities, Energy, and Consumer Staples are the weakest.  The Utilities sector, although positive for the year, has significantly underperformed the other sectors so far.

International stocks continued to rally this past week led by the Emerging Markets region that posted a gain of 4.3% for the week.  The “Risk On” theme sponsored by the Federal Reserve’s and European Central Bank’s (ECB) monetary policies has given a strong boost to international stocks both in terms of overall risk tolerance by investors, but also by weakening the US Dollar which helps international investment valuations here in the US.  The MSCI (EAFE) gained 3.7% and the European STOXX 600 index gained 1.3%.  In addition to the Emerging Markets region, the Asia/Pacific region also did well gaining 3.6%. 

The Barclays US Aggregate Bond index posted its second consecutive loss last week losing 0.43% as “safe haven” bonds were sold in favor of riskier assets.  The 10-year and 30-year US Treasuries were especially hard hit with yields jumping dramatically for both bonds.  The 10-year yield increased from 1.668% to 1.863% and the 30-year yield moved north of 3% to close last week at 3.089%.  This is the first time since May 4^th that the 30-year US Treasury yield closed above 3%.  As with stocks, the key theme in the bond markets was “Risk On.”  For those who may not be aware of the diversity of the bond market, it is important to realize that the bond market is anything but a homogenous pool of like-style investments.  I track over 13 different bond sectors on a weekly basis from the ultra-conservative US Treasuries to riskier high yield bonds and preferreds.  Some bonds are sensitive to credit risk (the ability of companies to pay back their bonds) while others are sensitive to interest rates (the upward or downward movement of interest rates).  Still others are not even bonds.  The floating rate sector is not comprised of bonds at all, but rather bank loans that are made by banks to companies.  This past week the “Risk On” theme affected bond markets as safe-haven bonds like US Treasuries significantly underperformed for the week while corporate high-yield and preferreds did very well.  Bond sectors that provide investors some protection against rising rates like Treasury Inflation Protection Notes (TIPs) and floating rates also did well.  International bonds did well with the weakness in the US Dollar.

The US Dollar came under considerable pressure after the Fed announced the terms of QE3.  As I have said, the net result of QE3 will be an increase in the supply of cash, and the more cash you have in the economy, the less valuable it becomes.  The US Dollar Index fell 1.8% this past week and was the worst weekly performance by the index in 2012.  The Euro gained 2.5% against the US Dollar to close last Friday at $1.313.  This was the largest weekly percent gain in 2012 and marks the highest Friday close for the Euro since late April.

A weak US Dollar drives commodity prices higher and this was certainly the case last week.  The Dow Jones UBS Commodity index gained 3.2% and is now up 4.1% in September.  Gold added another $29.50 (1.7%) per ounce to close Friday at $1770.00.  Gold is up $82.40 (4.9%) this month as central bankers around the world have announced they will print more money.  Oil also increased $2.66 (2.7%) to close Friday at $99.03.  Worries over escalating tensions in the Middle East are partially responsible for the increase in oil; however, the weakening US Dollar is also a major factor in rising oil and commodity prices.  For the year, the Dow Jones UBS Commodity index is up 8.1%.

QE3 AND ITS IMPLICATIONS FOR INVESTORS

I will attempt in a limited space to explain QE3 and the ramifications it may have on investors.  I have already spent time recently discussing central banks and their role in setting monetary policy and thus influencing economic policy both here and abroad.  If you did not read the past three or four Weekly Updates, I would encourage you to go back and review the middle sections.

So what exactly did the Federal Reserve do with QE3?  Three things actually.  First, Chairman Bernanke said that the Fed would keep the Federal funds rate low (0.0% to 0.25%) until mid-2015 (an extension of another year); second, the Fed is continuing Operation Twist (buying longer-duration Treasuries as short-term Treasuries mature) until the end of 2012; and third, the Fed is going to begin purchasing $40 billion of mortgage-backed securities per month indefinitely until the job market improves.  The Federal Reserve’s statement on Thursday said this move “should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.” The net result of this extremely accommodative monetary policy is to push cash into the economy with the expectation that all of this money will help stimulate economic activity and ultimately drive down unemployment.

For investors, I believe, this means that the “Risk On” trade is back and the risk of future inflation has been increased.

The concept of “Risk On” and “Risk Off” scenarios emerged as a dominant theme in the post-Lehman Brothers bankruptcy era and ensuing financial crisis.  This past April, HSBC published a paper authored by Stacy Williams, Daniel Fenn, and Mark McDonald titled, “Risk On – Risk Off, Fixing a Broken Investment Process.”  In their outstanding report, the authors conclude that long-standing investment principals used by most asset managers have been challenged by the extremely high correlation of asset classes in the past three years.  In the past, it was assumed that different asset classes had different correlations and therefore provided investors benefits through diversification.  Since the start of the financial crisis, the degree with which asset classes move together (correlation) has increased dramatically and securities trade, not on their own fundamentals, but on the market’s perceived levels of current risk.  According to the paper’s authors, the cause of this new phenomenon is primarily attributable to “a new systemic risk factor.”  They see this new systemic risk factor coming directly from “global intervention, QE and policy response of an unprecedented scale across many countries—and markets are pricing in the bimodal nature of consequences.”  In other words, massive intervention by central banks and governments in the global economy has distorted traditional economic relationships and there is great uncertainty about whether these interventions will achieve the desired outcomes.  When investors feel like policy actions are positive (at least in the short term), we see the “Risk On” trade emerge, while pessimism leads to “Risk Off” trades.

It is also important to note that another factor associated with the “Risk On – Risk Off” theme is that movements tend to be event driven.  The announcement of quantitative easing or the Greek financial crisis are just two examples of this and in each case, investors are making judgments about the levels of systematic risk in markets.  With the “Risk On” trade comes strength in riskier assets: stocks, commodities, and some bonds.  Not all stocks or all commodities or some bonds will benefit by the “Risk On” trade but most do.  Defensive sectors, higher yielding stocks (which are seen as more conservative) may lag, for example.  However, the general trend is up, up, and away with prices.  Safe haven assets such as US Treasuries and the US Dollar will pull back.  This is what we saw happen this past week.

If traditional investment principals no longer work as effectively in the current “Risk On – Risk Off” environment, then what are investors to do?  The authors of the HSBC article describe four approaches to investing in today’s world.  I want to highlight one of the approaches they refer to as “Seek unaffected active strategies.”  They go on to say, “some active strategies, such as momentum, have remained largely impervious to Risk On – Risk Off.”  I fully support this conclusion and have for some time.  This is why I use the relative strength (RS) research provided by Dorsey Wright & Associates.  RS is a form of trend following and trend following is tied to momentum.  I believe RS is a sound tool upon which to make investment decisions.  When old school concepts no longer work or are no longer as effective, then it is time to adapt and move forward and that is what RS analysis does.

LOOKING AHEAD

Markets will continue to absorb the implications of QE3 and activities in Europe and elsewhere.  I agree with one of my favorite market observers, Scott Grannis (Calafia Beach Pundit), that the one thing for certain the Federal Reserve did last week was raise the probability of future inflation and make it more difficult for the Fed to step away from QE.  When inflation becomes a problem (and I believe it will some day), the Fed will have to pull money out of the markets and that traditionally requires unpleasant actions.  The more money into the market today the more that will be required to be removed and the more painful future moves will be. Offering a possible preview, Egan-Jones, one of nine nationally recognized statistical rating agencies announced last week that they were cutting the US’s credit rating for the third time from AA to AA- (the lowest rating among “high grade”bonds) citing the Federal Reserve’s continued monetary easing and debt purchases.  Eagan-Jones was the first ratings agency to cut the US credit rating back in July 2011.  It is too early to tell if any of the other rating agencies will follow, but it does provide some indication of how bond markets may eventually look upon the Fed’s latest actions.

After the busy week last week, this coming week has just a few economic reports due out.  Housing will be the focus on Wednesday as August Housing Starts and Existing Home Sales will be released.  Both reports are expected to show some modest increases from July’s data.  Initial Jobless Claims will be out Thursday morning.  Consensus is for 373,000 new claims, down from last week’s 382,000 increase.  The number remains too high and was likely one of the reasons that the Fed pushed for QE3.  The employment situation remains a real concern.

The New York Stock Exchange Bullish Percent (NYSEBP) closed Friday at 67.58 up from 62.56 up from 60.03 the previous week.  This important indicator about the general trend in US stocks has remained positive now for 14 weeks.  When the NYSEBP reaches 70, risk levels are becoming elevated.  It does not mean that a pullback is eminent, it is just that the risks of such an event are increasing.  Likewise, the S&P 500 is now overbought by 83% compared to last week’s 65% and the previous weeks level of 35%.  Corporate high yield, emerging market income, and US small cap stocks are the most overbought at this time exceeding 125%.  I believe that prices for these specific categories are high enough to hold off putting new money to work there.  After the past two weeks of gains, most categories (except bonds) are now overbought by 100% or more indicating caution.  Again, risk levels are elevated for now.

The Dorsey Wright & Associates analysis of the markets indicate that US stocks and Bonds are the two favored major asset categories followed by Foreign Currencies, International stocks, and Commodities.  Middle capitalization stocks are favored, as is growth over value, and equal-weighted indexes over capitalization weighted indexes.  Equal-weighted indexes are those where each stock in the index is weighted the same, while in capitalization-weighted indexes the larger stocks have the largest weighting consistent with their size relative to the other stocks.  The relative strength sector weightings favor Consumer Discretionary, Real Estate, Information Technology, and Health Care.  US Treasuries and International Bonds are favored in the Bond category, while US and Developed Markets are favored within the International stock category.

Understanding how this market has become event driven and the potential for events to move markets, the next foreseeable “event” is the fiscal cliff.  Congress has just a week to do something before they go on recess prior to the November elections.  Much to do in so little time.  My guess is that we will just have to hope that a lame duck Congress can do something before we get into another fiscal crisis.  I do not think the Federal Reserve can do much more on the monetary side of the economic equation to save the politicians from themselves.

On a personal note, I will be taking next week off and not writing an update.  My daughter, LeeAnn, is getting married in Richmond on September 22^nd and I will have the honor of walking her down the aisle.  I want to wish LeeAnn and her future husband, John Martin, great happiness and success.

Paul L. Merritt, MBA, 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.