Market Analysis...Out Like A Lamb, In Like A Lion

After an explosive rally in December, the upward momentum faded in December. In fact, the Dow finished up the year in slightly negative territory at 10,717.50, down 0.6% for the year. The S&P 500 and NASDAQ, on the other hand, managed to eke out small gains. The interesting thing to note is that after many attempts in 2005, the Dow finally managed to close above 11,000 earlier this month. In fact, it traded over 11,000 for three days. The unsettling news is that the Dow failed to hold that level, and has fallen back to the mid-10,800s. At the same time, the Dow Jones Transportation index, which I haven't really talked about, has also shown some weakness, after a very strong year last year. In fact, this index has been moving steadily higher since hitting bottom in early 2003 (see the weekly chart below). The transports are a very good proxy for business in the country as much of what gets made here must be transported by planes, trucks and railroads. If the transportation index heads south, it would be a very bad harbinger of things to come. Ideally, the Transports and Industrials would move in lockstep, to clearly identify a direction for the overall market.

Flash: High Oil Prices Are Back!! But then again, they never really left. In reality, the ascent in oil prices just took a breather. As I've been saying for years, high oil prices are here to stay; get used to it. After bottoming out at about $56 in November, the price for West Texas Crude is again closing in on $70 per barrel. This time, people are talking about potential trouble in Nigeria. Mark my words, there will be more talk of disruptions from Venezuela, Iran, and other countries who realize that the best way to cause problems in the US is to disrupt delivery of our precious oil.

Treasury yields continue to fall, and are now around the midpoint of the high and low marks of 2005. The bond market is clearly telling us something. Bond investors do not fear inflation right now. The Bond King, Bill Gross of PIMCO, has said that the bear market in bonds is over. I don't want to argue with a guy who manages around $1 trillion. Concurrent with the strength of bonds is the weakness in the dollar (see the chart in the Trend section). Since September, these two items have moved in lockstep with each other. The spread between the 10-year Treasury and the TIPS remains around 2.40%.

After all the sturm and drang in 2005, the markets ended basically flat for the year. In fact, the 0.6% drop in the Dow Jones Industrial average was the smallest annual change in 79 years! When the Dow closed at 11,043 on January 11, it was the highest closing price since June 2001. Yet with everything that happened in the market and the world last year, as I sit here typing this morning, most investors have nothing to show for the last year, and little if anything to show for the past five years. And I don't like their chances in 2006; but more on that later.

Last Month's Results...Quiet End

As always, I provide the following chart to show the raw results for the month, the quarter-to-date and the year-to-date. December provided an anti-climactic ending after the huge rally in November. Most of the major indices finished flat or slightly down for the month, although they all managed to finish up for the year, except the Dow, which was down fractionally. For the year, large-cap stocks out-performed small-cap and value trumped growth by a little. In general, international stocks did much better than domestic ones. Not shown on the chart, but of great importance to WAM's clients, energy was the best performing sector in the market in 2005.

What I'm Doing Now...Continuing What Works

2005 was a tremendous year for WAM as it produced its third straight year of double digit returns and beat the S&P 500 by the widest margin in its 8 1/2 years in business. This was done by successfully implementing the sector investment strategy that I have been talking about for the past few years. Our core sectors of energy, natural resources, precious metals and defense all had banner years. Other sectors like large cap finance and specialty retail also did pretty well. A few of our special situations recovered a bit towards the end of the year, leaving us with strong gains in almost every position.

Of course there will always be losing investments, and we had a few of those this year. A couple of those stocks were sold for tax-loss purposes, and others were sold because the investment thesis was no longer in our favor. As we head into 2006, we hold only one or two key positions that are down, and I expect that to change this year.

Really the only thing that changed for WAM in 2005 was that we began to make greater use of Exchange Traded Funds (ETFs) to implement our sector investment strategy. I expect that as more targeted ETFs are created, we will continue to increase our exposure to this interesting product.

Statistics To Watch...Generally Bullish

• There was a disappointing increase of only 108,000 non-farm jobs in December after strong growth in November. Average hourly wages rose to $16.34 from $16.32. They started the year at $15.86, an increase of 3%, which is similar to the rate of inflation. The average workweek remained flat 33.7 hours.
• The number of unemployed workers in December fell to 7.38 million from 7.58 million in November. The greatest increase in employment were in leisure and hospitality, food services and drinking places. The number of seasonally adjusted people who for economic reasons could only find part-time work fell to 4.1 million. There were another 3.8 million people for whom business conditions or lack of opportunity forced them to take part-time work. The number of marginally attached workers (those individuals who had looked for work sometime in the past year, but not in the past four weeks, and are therefore not counted as unemployed) rose to 1.6 million. My adjusted Comprehensive Labor Index™ was flat at 9.2%, it's lowest rate of the year. The official unemployment rate reported by the government dropped slightly to 4.9%.
• The number of people holding more than one job in December rose to 7.83 million, it's highest level of the year.
• The most recent four-week average for initial jobless claims held steady at around 323,550 for the last month. The low for the year was 306,000 and the high was 394,000 (post-Katrina).
• The University of Michigan Consumer Confidence Index in December rose again (not surprisingly) to 91.5 from 81.6 in November. The highest mark of the year was 97.1 twelve months ago.
• According to CBO estimates, the government ran a surplus of about $12 billion in December, which was smaller than expected, but reduced the deficit for the first three months of the fiscal year to $113 billion.
• According to the Census Bureau, the U.S. trade deficit fell slightly to $64.2 billion in November from an adjusted high of $68.1 billion in October. Trade with China was $18.5 billion of that deficit.
• The Labor Department reported that on a seasonally adjusted basis, the CPI for all urban consumers fell 0.1% in December, after falling 0.6% in November. The drop in oil prices accounted for the most of the downward move both months. The "core" CPI, which excludes food and energy, remained steady at 0.2%.
• The Federal Reserve reported that total outstanding consumer credit was unchanged in November, at $2.15 billion. Consumer indebtedness remains at record levels.
• The American Association of Individual Investors' (AAII) bullish sentiment was surprisingly weak recently, falling to 41% for the week ended December 26. This mild pessimism doesn't match up with the consumer confidence numbers. Recent numbers will likely be higher thanks to a strong stock market.
• According to the Census Bureau, retail trade and food service sales edged up 0.7% in December and were up 6.4% from the same period last year.
• The Census Bureau reported that privately owned housing starts in November rose 5.3% from October to a seasonally adjusted annual rate of 2.123 million. This was 17.5% above the same period last year.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in November fell 11.3% to a projected 1.245 million units (after rising 11.4% in October). The estimate of 503,000 new homes for sale, representing about 4.9 months of supply at the current rate of sales, is the largest supply of the year.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes were were down 1.7% in November to a projected 6.97 million units. The estimate of 2.903 million existing homes for sale, representing about 5.0 months of supply at the current rate of sales, is the largest available supply in years. Average sale prices remain high.
• The Institute for Supply Management (ISM) index of manufacturing activity measured 54.2 in December, down from 58.1 in November. This marks the 31st month in which economic activity in the manufacturing sector is reported to have grown. Anything above 50.0 is considered to be an indication of growth.
• According to the Bureau of Economic Analysis, the "final" estimate of real gross domestic product, the output of goods and services produced by labor and property located in the United States, increased at an annual rate of 4.1% in the third quarter of 2005. This is down from the "preliminary" estimate of 4.3% but up from the "advance" estimate of 3.8%. It shows how imprecise the measurement of GDP really is.
• The Fed ramped up its policy of flooding the market with dollars. The Fed increased M-3 by $92 trillion in December. The Fed has increased the supply of M-3 by 7.8% this year and by 8.6% in the last three months alone. This injection of money is very inflationary and continues to erode the value of the dollar. This is one of the scariest numbers that I report on.
• Foreigners now hold over $1.5 trillion in US debt. Have you written your thank you notes yet to the Chinese and Japanese governments for financing our country?
• The NYSE reported that in late December, the final price for a seat on the Exchange sold for $3.55 million. As the NYSE is now a public company, "seats" will no longer be sold.

Trends To Watch

The broad, year-long range of 11,000 to 10,000 for the Dow managed to hold all of last year, only to be broken to the upside after some strong early-year trading in 2006. The Dow managed to remain above 11,000 for a few days, but has retreated a bit to back below 11,000. It's hard to say which direction it is headed. For all intents and purposes, the trading range holds.

The price of gold exploded in November and early December to a peak price of $541 per ounce, its highest price in 18 years. In mid-December prices dropped considerably, to a low of $490. Since then, prices have spiked up and the February futures contract is currently trading for almost $555 per ounce, which is roughly equal to the high price of $554 per ounce last reached in March 1981. The trend continues to be onward and upward.

As I mentioned earlier, the value of the dollar seems to have topped out in November, along with the yield on the 10-year Treasury, and has been falling ever since. The index is now hovering just above its 200-day moving average and appears to be very oversold, so it wouldn't surprise me to see a little rally.

The price of oil broke out of its consolidation pattern and is in a strong uptrend. Obviously, the next key price level is $70.

The real estate market continues to show signs of weakness. It will be interesting to see if rates continue to fall, and if that sparks a new surge in home sales.

Finally, let's look at interest rates and the yield curve. Right now, the Fed Funds lending rate is 4.25%. 2-year Treasuries yield 4.36%, as do the 10-year Treasuries. The 30-year Treasury yields 4.53%. This is a very flat yield curve, and is one that was nominally inverted (where short-term yields are higher than long-term yields) a few weeks ago. If the Fed increases the lending rate at their next meeting on the 30th, that will very likely create an inversion. If that happens a recession is very likely to follow within the next 9- to 12-months.

Forecasts...Looking Back and Looking Ahead

In my January 2005 newsletter, I made 7 forecasts for the market and the domestic economy. Let's see how I did: