2016 MARKET OUTLOOK AND COMMENTARY

January 10, 2016

After an unsatisfying 2015, markets both here and abroad ushered in the New Year with a sharp sell-off.  You can see below that the key indexes fell between 6% and 8% in just 5 trading days.  For those who are historians, both the Dow Jones Industrial Average and S&P 500 had their worst first week performance of a year ever.  Ouch.

Time Period	Dow Jones Industrial Average (DJIA)	S&P 500	Russell 2000	NASDAQ
2015	-2.23%	-0.73%	-5.19%	5.73%
Week 1, 2016	-6.19%	-5.96%	-7.90%	-7.26%

Source:  The Wall Street Journal (Past performance is not indicative of future returns).  As of market close January 8, 2016.

International markets shared in the selloff as well with most global indexes down around 6%.  China suffered the most with the Shanghai Composite losing 10%.

Time Period	Global Dow xUS	STOXX 600	Dow Jones Devel Mkt Region Total Stock Market	Dow Jones Emerg Mkt Region Total Stock Market
2015	-6.63%	6.79%	-2.59%	-15.86%
Week 1, 2016	-6.10%	-6.69%	-6.06%	-6.24%

Source:  The Wall Street Journal (Past performance is not indicative of future returns).  As of market close January 8, 2016.

The 5-day decline of 6% in the S&P 500 this past week is eerily similar to the 11% 6-day decline in the S&P 500 from August 18^th to August 25^th last summer.  Now as then, most analysts and commentators place much of the responsibility squarely on the back of China and that country’s slowing economy and weakening currency.  Similarly, oil prices fell 10.5% last week compared to 9.6% over the six-day stretch last August.  What is new this time around is the Federal Reserve has raised interest rates a quarter of a percent, and I would argue the geopolitical threat from terror has increased.

A fair question to ask is whether US investors should be worried about a Chinese slowdown.  I will address this topic and my outlook for 2016 in the next section.

Before turning my attention to 2016, I would like to do a quick look back to some 2015 data. 

The best performing sector in 2015 was Health Care with a nearly 6% gain followed by Consumer Discretionary (+4.8%) and Information Technology (+3.6).  Energy (-25.5%) was the worst performing sector by far followed by Materials (-12.3%) and Utilities (-8.2%).  Avoiding or under-weighting these sectors was important for portfolio performance in such a lackluster year.

The Federal Reserve raised interest rates for the first time in seven years increasing the overnight lending rate by a quarter percent (25 basis points) the third week in December.  Speculation about the Fed’s move was one of the dominant topics in 2015, yet after the move, little changed.  Interest rates finished the year marginally higher in a year when rates meandered about.  The benchmark 10-year US Treasury closed up 0.1% to 2.27%.  The Bond asset category was a disappointment in 2015.  The Barclays US Aggregate Bond index was up just 0.6% and only five of the sixteen taxable bond sectors tracked by Morningstar^® were positive in 2015.  The best performing taxable bond sectors were Preferred Stocks (+3.2%), Intermediate Government (+0.4%), and Short-Term Bond (+0.2%).  The worst performing sectors were Emerging Markets Bond (-6.0%), World Bond (-4.1%), and High Yield (-4.0%).

Commodities continued their downward free-fall in 2015.  The Dow Jones UBS Commodity index, which captures a broad swath of key commodities, fell 25% last year after falling 17% in 2014.  WTI Oil, a key component of the commodity sector and US economy, fell 30.5% in 2015.  Since oil’s most recent peak in July 2014 ($93.85), the price has fallen over 60% closing last Friday at $37.04.  The impact on falling oil prices both here and abroad has been profound.  According to the research firm FactSet, earnings in the Energy sector are estimated to decline 59% in 2015.  FactSet is also estimating that earnings across the S&P 500 will fall 3.3% in 2015.  However, if the decline in Energy earnings were stripped out of the estimate, the other nine sectors are expected to post a net increase of 1.1%. 

The US Dollar continued to gain in strength in 2015.  The US Dollar index, a comparison of the US Dollar against a basket of the other major currencies, gained 9.3% in 2015.  The US Dollar was up 10.3% against the Euro and up nearly 1% to the Japanese Yen.  The impact of a stronger US Dollar helped contribute to lower US corporate earnings, poor international stock and bond performance at home, and a decrease in demand for oil overseas.  Currency fluctuations play an important role in global economics and I believe will continue to do so in 2016.

OUTLOOK FOR 2016

Early last year (January 25, 2015) I talked about four big themes to watch in 2015:  Greece, the US Federal Reserve raising interest rates, geopolitical risks abroad, and the uncertainty surrounding US domestic politics.  While Greece created all sorts of trouble for the markets early in the year, the Europeans managed to stabilize the European Union.  The Fed did raise rates a quarter percent at their last meeting in 2015 and the sun still came up the next day.  Geopolitical challenges came and went.  Terror attacks continued and stability in the Middle East deteriorated without significant impact on markets.  However, oil prices fell during the political turmoil in the Middle East and that is a new twist on global economics.  Finally, my prediction that growth-oriented policies coming from Congress would be minimal has unfortunately turned out to be true.

While I did not feel like the economy was likely to grow at a rate greater than 2.5% in 2015, I thought equity returns would be better than they were.  I believe that the energy sector was responsible for much of what has challenged markets.  However, I also believe that the anti-growth fiscal policies via law and rulemaking, has much responsibility for lackluster growth as well.  Finally, a stronger US Dollar has diminished earnings of US companies that have large overseas earnings.

My outlook for 2016 is MORE OF THE SAME resulting in lackluster economic growth (less than 2.5% real gross domestic product (GDP), more volatility in the markets, and equity returns that fail to exceed the 8.5% average annual return of the S&P 500 since 1980.  I believe it would be a great year if we did meet that 36-year average, but I am not optimistic thinking we will fall somewhat short—something that has happened about four times every ten years since 1980.

Let me say upfront that I do not have a crystal ball or some magical powers to predict the future.  In fact, I have felt for years making predictions was a fool’s errand.  However, I do believe that it is very necessary to have some expectation about the near future to properly position portfolios.  Let me offer my rationale for why I think next year will look much like this year.

1)      All the actors on the global stage are the same.  The political and economic leaders are unchanged and are not expected to change in 2016 (clearly 2017 may be a different story).  We know what President Obama thinks about US economic policy, what Ms. Yellen thinks about monetary policy, what Ms. Merkel thinks about the European Union (EU), and so on.

2)      Going into the November presidential elections there will be no improvement in fiscal policies coming from Congress.  I do believe there remains more downside risk in Washington as President Obama tries to maximize the regulatory legacy of his administration in his last year.

3)      Corporate earnings and revenue growth have been slowing.  Corporate earnings is the food that feeds the market and without earnings growth, markets will struggle, in my view.

4)      Oil prices will continue to struggle to find equilibrium.  Even if oil prices do stabilize, I believe they will be lower than they have been over the past decade for the near future.

Here are some of the key themes and issues I anticipate will be important in 2016:

China remains a problem for the world.  The Chinese have a big challenge on their hands.  They are trying to turn a manufacturing economy into a more consumer-oriented economy.  Additionally, the communist lords who rule China have tried to have a capitalistic economy under their authoritarian rule.  By controlling the media, communications, corporations, and markets, they have managed to succeed as long as China remained at the center of the manufacturing universe.  Today, however, other countries like Vietnam, Malaysia, and Indonesia are all competing for low-cost manufacturing jobs.  This has placed growing pressure on Chinese manufacturers who are paying more for labor and struggle to get the financing necessary to upgrade their manufacturing capabilities.  Furthermore, the Chinese government’s push to have the Yuan as part of the International Monetary Fund’s basket of reserve currencies which till now has included the US Dollar, British Pound, the Euro, and the Japanese Yen; places pressure on the Yuan to be more freely traded and has led to a sharp devaluation in the past six months or so.  Until China proves that it can be a trusted and transparent member of the economic community, I believe there will be continued uncertainty in the global markets, but do not look for the global economy to collapse over this single issue.

I believe that oil prices will stabilize.  I do not know where that point of stabilization will occur, but I do believe it will.  This is how commodity markets have always worked.   I do believe the price will stabilize closer to $32/barrel than $95/barrel of our recent past.  I continue to believe that low oil prices are a great benefit for most of the economy, but clearly, the energy sector is under a great deal of stress.  The United States has the potential to become the world’s greatest oil producer but has a long way to go even as oil exports have been permitted for the first time in over 40 years.  Energy prices will continue to be a key issue in 2016.

The Federal Reserve will remain in the forefront of investors’ minds.  After getting the first rate hike accomplished last year, the discussion will now turn to the frequency and magnitude of future rate hikes. The Fed must walk a very tight balance between normalizing rates while not harming a sputtering economy or reacting too late to prevent an inflation surge.  Markets are currently predicting two additional 0.25% rate hikes this year and next.  Where would the financial media be these days if they did not have the Federal Reserve to worry about?

Interest rates should continue their upward trajectory; however, there are many factors that influence interest rates including the Fed, inflation, and economic growth.  Interest rates have historically been the most difficult to predict and the past few years have been no different.  Rising interest rates need economic growth and some degree of inflation to move upwards.  I believe real economic growth will continue to run below 2.5%, so for rates to rise considerably higher than where they are today, I think inflation will need to tick up.  Inflation, in my view, will remain subdued; however, if oil prices stabilize, there may be an uptick in inflationary pressure. I discussed this issue in some detail in my December 20, 2015 Update.  If inflation speeds up, the Fed may have to pick up the frequency and possibly the magnitude of their rate increases which may in turn put additional pressure on bonds.

The Bond asset category will continue to struggle in my view.  Rising interest rates, uncertainty in the lower quality bond sectors, and the Fed’s monetary policy all point to a similar weak performance like we saw in 2015.  Higher yields will continue to come from higher-risk assets that may be prone to periodic selloffs. 

The US Dollar will continue to strengthen in 2016—just not as fast.  The currency market is the largest capital market in the world with average trading volume in excess of $5 trillion each and every day.  The free flow of cash around the world is instrumental in orderly global trade, but it is also an indicator of the strength or weakness of a country or region.  Currencies trade like commodities and are subject to the same supply/demand issues that affect the price.  The US Dollar has been in demand because traders have believed interest rates on US Treasuries will continue to increase compared to other nation’s bonds, and because the security of US Treasuries is second to none.  Traders who fear the geopolitical turbulence frequently turn to US Treasuries thus increasing demand for the US Dollar.

European growth will continue to lag the US.  I have little confidence that developed European countries will be able to grow at levels close to or better than the US.  Europe is the US on steroids in terms of over-taxation, government regulation, and wealth transfer payments.  All of this gives me little reason to be optimistic about growth in developed Europe even as the European Central Bank (ECB) continues with its quantitative easing program.  Eastern Europe, if allowed to act independently of either the European Union or Russia could offer excellent investment opportunities.  However, this is a big if.  I believe Emerging markets will continue to struggle under the challenges of a stronger US Dollar and weakening demand from China.  As I have said recently, I am not ignoring international investing; I am just suggesting there are some serious headwinds to investment there now.

I believe volatility will increase due to the Fed’s desire to return to more normal monetary policies.  We have benefited since the 2008 recession by Fed policies that indirectly helped dampen volatility, and that has been a great thing for investors.  I do not know a single investor that enjoys volatility, but most accept this as the price to be paid to be a long-term investor.

Finally, I fear that acts of terror will continue in 2016.  As the world adapts to this new reality, I do not believe markets will over-react to such events provided they are isolated and have minimal impact on economic activity. 

LOOKING AHEAD

Although I do not believe 2016 will be a great year, I do believe the US economy is not going to fall off a cliff.  We appear to be in a transitional year.  After years of near zero interest rates from the Fed, we may well be for a period of rate increases, albiet small ones.  Leadership in the White House will certainly change in early 2017, but to who we have no idea.  From an investment perspective, I hope that the next President and Congress can do more to help growth than has been the case for so many years.

The S&P 500 is currently 71% oversold.  Traditionally, when markets become more than 100% oversold it becomes an attractive point of entry.  Another important signal I watch, the New York Stock Exchange Bullish Percent (NYSEBP) is an indicator of what I consider the overall riskiness in the market.  The current reading is 28 and I consider anything below 30 to be generally less risky going forward.  For perspective, the NYSEBP reached down to 26 last August during the first China related selloff, and to 18 during the last major correction in the fall of 2011.

Most of you are now familiar with the Dorsey Wright & Associates Daily Asset Level Indicator (DALI) chart below.

 

As of January 11, 2016.  Source: DorseyWright & Associates.

This chart outlines the most basic relative strength relationship between the six major asset categories.  Since my last Update, there has been no change in the order of the six major asset categories, but there has been some changes to the underlying tally scores of each.  Domestic Equities has shown some weakness falling from 341 to 323 since my December 20^th Update.  The numbers indicate that weakness in the small capitalization sectors is responsible for much of the decline.  Fixed Income (bonds) remains number two and has improved as has Cash (Money Market sector).  Currencies and Commodities have also improved although the Commodity asset category remains firmly in last place.  International Equities weakened by the continuing struggles of the emerging market sectors.

The high yield bond sector’s struggles will conintue in 2016 primarily because of the energy sector, and the year will yet another mediocre year for bonds in general.  The best bond sectors at the start of the year are high credit quality and municipals.  I think the floating-rate (bank loan) sector is oversold enough to find the values compelling along with their good yields. 

I believe commercial real estate could provide positive returns as supply continues to lag demand and is a sector I am evaluating.

I cannot stress enough that the weak start in 2016 is just that, a weak start.  Volatility is the price you pay to be an investor.  There are 51 more trading weeks remaining in the year and while I believe this will be a below trend year for equity returns, I do think markets will be positive for 2016.

I hope all of you had a very Happy New Year and cheers to your happiness, health, and prosperity!

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.

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 sub indices, measuring both sectors and stock-size segments, are calculated for each country and region.

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.

MARKET UPDATE AND COMMENTARY

December 20, 2015

After seven years, the Federal Reserve finally raised their overnight lending rate a quarter of one percent Wednesday afternoon (December 11^th) and markets initially cheered the move with US stock markets posting a three-day winning streak culminating Wednesday with gains of about 1.5% in the major indexes.  Unfortunately, investor enthusiasm vanished on Thursday and Friday as the major indexes gave back all of the gains early in the week to close the week with very modest losses.

Time Period	Dow Jones Industrial Average (DJIA)	S&P 500	Russell 2000	NASDAQ
1st Half 2015	-1.14%	+0.20%	+4.09%	+5.30%
Q3 2015	-7.58%	-6.94%	-12.22%	-7.35%
Q4 to Date	+5.18%	+4.45%	+1.85%	+6.56%
Week of Dec 14- Dec 18	-0.79%	-0.34%	-0.23%	-0.21%
Year-to-Date	-3.90%	-2.59%	-6.95%	+3.95%

Source:  The Wall Street Journal (Past performance is not indicative of future returns).  As of market close December 18, 2015.

As the year draws to a close, I suspect that most investors feel like 2015 has been a real let down after a couple of good years of gains without much volatility.  My broad explanation of what has happened would necessarily begin with a discussion about declining oil prices and the devastation of energy-related corporate earnings.  The necessary contraction by energy companies in response to lost earnings has in turn spread over to other sectors most notably the Materials and Industrials sector.  As of December 18^th, the analytical company, FactSet, estimates that Energy sector earnings will decline 59% in 2015, followed by the Materials  (-8%), and the Industrials (-1%) sectors.  The losses from these three sectors will overwhelm those sectors that have posted gains to result in an estimated combined decline in profits of -0.5% for companies within the S&P 500 this year.

While International markets did just a bit better last week, there has not been much to cheer about abroad in 2015 either.

Time Period	Global Dow xUS	STOXX 600	Dow Jones Devel Mkt Region Total Stock Market	Dow Jones Emerg Mkt Region Total Stock Market
1st Half 2015	+3.22%	+11.32%	+2.13%	+2.09%
Q3 2015	-12.60%	-8.80%	-9.09%	-19.33%
Q4 to Date	+2.05%	+3.87%	+3.11%	+1.34%
Week of Dec 14- Dec 18	+0.37%	+1.53%	-0.23%	+2.42%
Year-to-Date	-7.94%	+5.46%	-4.26%	-16.54%

Source:  The Wall Street Journal (Past performance is not indicative of future returns).  As of market close December 18, 2015.

I continue to remain less than enthusiastic about international markets primarily because Europe has shown no ability to deal with the expansive government domination of most economies (high taxes, low growth), the influx of refugees, and negative demographic trend (European families are not reproducing enough children to replace the existing population).  Emerging markets are suffering from bad governance, the collapse of the commodities markets, and a strong US Dollar.  China brings its own set of issues as the leadership there continues to devalue the Yuan, provide unreliable economic data to international investors, and I cannot shake the feeling that they are building cities in which no one lives.  Furthermore, I believe the Chinese economy is extremely immature in that the government still has too much control over data reported and tosses money managers it dislikes into jail to highlight just a couple of problems.  However, I believe facts can change and lead to good investing opportunities.  I will never exclude a market in the face of building momentum, and I have only modestly cut my allocations to developed markets abroad, but I have not made any new investments there either in the past couple of months.

Oil is the most significant story in commodities for the second year in a row.  After the price of a barrel of WTI Oil lost 46% in 2014, it is currently down another 24% in 2015.  I have already discussed the impact this has had on earnings, but I also believe this condition will not last indefinitely.  As oil prices have declined, US consumption has increased for the first time in a number of years.  Higher demand is a natural product of cheaper prices.  Energy production will balance with demand and I believe oil prices will stabilize.  When energy prices stabilize, the threat of inflation will return because the decline in energy prices has masked broader inflation in the economy.  Scott Grannis who writes the Calafia Beach Pundit created the chart below to illustrate this point.

 

The blue line is reported inflation and the red line shows what inflation is when the effects of energy prices are stripped out of the calculation.  When oil prices collapsed back in 1986, you can see how inflation excluding energy maintained its levels as it is doing today.  Assuming oil prices will find an equilibrium (which I believe they will), the mitigating impact of falling oil prices will no longer be present and I would expect Total Inflation (blue line) to return to about 2%.  More on this in the next section.

Before I discuss interest rates and the bond asset category, I want to remind you that the Federal Reserve controls the overnight lending rate between banks and the Federal Reserve.  It does not control any other rates including interest rates paid by the US Treasury on its bonds.  Traders in the private sector determine all other rates.

Interest rates in general increased slightly last week.  There has been much financial media attention to the decline in interest rates Thursday and Friday, however, I think it is impossible to determine the impact of the Federal Reserve’s decision to raise the overnight lending rate simply on rates of Treasuries in the days immediately following the Fed announcement.  Until we see more inflation building into the economy and improving economic growth statistics, I do not believe there will be much change in rates for the short-term.

The real news in the bond world has focused on the high-yield bond sector.  High-yield bonds have seen some negative volatility in the past couple of weeks due to concerns of diminished liquidity (not enough buyers as sellers enter into the market).  Again, much of the story centers on the energy sector because low oil prices have hurt cash flows of many smaller companies and fears are increasing that default rates will increase in the coming months.  One high yield fund manager, Third Avenue Management LLC, suspended redemptions because they could not sell their positions fast enough to meet cash requests.  This announcement sent nervous investors across the entire sector to the exits hurting many different high-yield managers.  Morningstar^® reports that the high-yield sector has declined 3.5% over the past month and is now down 4.8% for the year ranking the sector 15^th out of the 16 taxable bond sectors Morningstar^® ranks.  Nine other taxable bond sectors are negative as well leaving bond investors in the same circumstance as stock investors for 2015 facing negative returns for the first time in a number of years.  If you believe that 2016 will be a better year than 2015, and that energy prices will stabilize as I do, then I believe the recent sell-off in the high yield bond sector is oversold.  However, I will continue to watch this bond sector very closely going forward.

MORE ON ENERGY, THE ECONOMY, AND THE FED

Investors cannot look at events in isolation; the world just doesn’t work that way.  The old kids song, “Dem Bones” that teaches children “the foot bone is connected to the ankle bone, and the ankle bone is connected to the leg bone,” and so on is what comes to my mind when I think about how nearly everything is interconnected in the 21^st century and how 2015 evolved. 

Oil is a commodity and as such the value of a barrel of oil is very dependent on supply and demand—economics 101.  The more supply you have of something compared to demand the price will fall.  The opposite is true as well.  For years, the Organization of Petroleum Producing States (OPEC) set the price of oil by colluding to set production levels to maintain acceptable (to OPEC) oil prices.  As US production of oil decreased, the US became the world’s largest importer of oil and was thus vulnerable to OPEC.  As a response to the Arab-Israeli War in 1973, OPEC stopped exporting oil to the United States.  This quadrupled the price oil in just a matter of months.  By 1974, gas lines were common throughout the United States, and OPEC’s power helped push the United States and Israel to negotiate a settlement with the Arabs that was much more favorable to the Arabs then would have otherwise happened.  In the years following, Saudi Arabia willed OPEC to maintain oil prices at levels they determined.  The cartel worked well until 1986 when Saudi Arabia decided to punish non-complying OPEC members who ignored quotas by pumping as much oil as possible, the price of oil plummeted, and the Saudi’s made their point. 

As it has turned out, the 1986 period was just a precursor of things to come.  Since the mid-1970’s the rest of the world made efforts to break OPEC’s stranglehold on oil production and prices.  Oil production began or was expanded in countries like Mexico and Brazil, and exploration began in inhospitable areas like the North Sea and Alaska.  The US passed fuel mileage legislation and over time, we have become a significantly more fuel-efficient country.  The domination of OPEC on the world has been broken.  However, the Saudi’s ability to pump large amounts of oil and push the price of oil down has contributed to the 65% decline in WTI Oil since the end of 2013.  The motivation of Saudi Arabia today is much the same as it was in 1986 and that is to maintain its market share.

The United States has experienced a revolutionary growth in oil production primarily due to giant technological advances.  Proven oil reserves (reachable with current technology) make the US the largest potential oil producer in the world dwarfing Saudi Arabia.  In terms of natural gas, the US has proven reserves that can last for 700 years.  These facts, I believe, should have a significant positive impact on life in the US economically and geopolitically.  However, the rapid decline in oil prices has caused short-term disruptions and I believe we are witnessing the impact of these disruptions including shutting down rigs, loss of jobs, diminished economic growth in supporting industries, and the possible bankruptcy of fringe producers.  As a practical matter, high-yield bond investments in this sector and related sectors may suffer a spike in defaults as the weaker players exit.  I believe these issues are behind much of the recent turbulence in the stock market and the chart below shows the loose correlation between percentage changes in the AMEX Oil Index (blue line) and the S&P 500 Index (orange line).

Longer-term, however, I believe the energy sector will adapt, adjust, and profit.  I cannot stress enough the importance new technology has had in driving down production costs.  I have read that the newest rigs are producing oil for as low as $29 per barrel.  This allows oil companies to be profitable at far lower prices than previously thought.  With the United States resuming its place as the largest producer of oil in the world (and if oil exports are once again permitted), the power of OPEC will continue to diminish and I believe oil prices will stabilize. 

What happens when energy prices stabilize?  Scott Grannis estimates that the bond market is pricing in an inflation rate of just 1.25% over the next five years, considerably below the approximately 2% ex-energy inflation rate currently estimated to be in the economy today.  The connection between stable oil prices and an increase in inflation could force the bond market to re-price bonds down to account for higher inflation should it materialize.  Higher inflation could also lead the Federal Reserve to reevaluate the pace at which it raises interest rates.  Right now markets are generally expecting the Fed to move in a very deliberate (slow) pace in an effort to avoid the kind of shocks on the economy that investors dislike.  However, if inflation gets going, the Fed may have to move faster than what investors are thinking and I believe that may be problematic much as the unexpected size of price declines disrupted the energy sector.  Oil was an important story in 2015 and I believe it will be again in 2016.

LOOKING AHEAD

The year is limping to an unimpressive end.  Many will soon be turning their attention to 2016 and what prospects the new year will bring.  I will address 2016 in an upcoming Update, but for now let’s focus on the near-term.

Most of you are now familiar with the Dorsey Wright & Associates Daily Asset Level Indicator (DALI) chart below.

As of December 20, 2015.  Source: DorseyWright & Associates.

This chart outlines the most basic relative strength relationship between the six major asset categories.  Since my last Update, there has been no change in the order of the six major asset categories, but there has been some changes to the underlying tally scores of each.  Domestic Equities is unchanged both in terms of being the strongest category and with a tally rank of 341.  Fixed Income (bonds) remains number two, but its tally score fell from 238 to 232 meaning other major asset categories have strengthened slightly at the expense of Fixed Income.  Cash, the money market sector, tally increased from 205 to 211.  International Equities added 3, Currency fell by 1, and Commodities added 4.  These small changes are notable only for looking at the subtle changes underway in the markets, however, there is nothing to suggest the need to make any major adjustments to your portfolios.

As I discussed earlier, the drop in the High-yield bond sector is notable.  If you have a short time horizon the weakness is important and may justify some changes, however, if you are a long-term investor, I do not believe wholesale changes in your fixed income allocations are necessary at this time.  However, further weakness may cause me to change this view.  The High-yield sector must be watched closely.  The Fed’s raising interest rates a quarter percent will not, in my view, ease the challenge for investors who require income beyond the meager interest earned on CDs or money market funds.

One additional comment on the fixed income sector.  I mentioned earlier that the fixed income asset category in general has been a disapointment in 2015 with negligible returns at best and a couple of percentage point drop at worst.  As we enter 2016 I am searching for signs to see if 2016 will be any better.  So far I have not found that evidence.  More on this in future Updates as well.

This will be my last Update for 2015.  I hope you and your family have a warm, loving, and happy holiday season. 

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.

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 sub indices, measuring both sectors and stock-size segments, are calculated for each country and region.

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.