January 25, 2006

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Current Market Analysis
Last Month's Results
What I'm Doing Now
Statistics to Watch
Trends To Watch
Monthly Tip
Personal News and Notes

As I write this, after much sturm and drang, the market is basically flat so far this year. By now, most of the "experts", and many other market watchers (including yours truly - see below), have made their forecasts for the economy and the stock market for this year. The bottom line is that there is really only one opinion that matters, and that's the market itself. The best thing that we can do is watch, listen and try to intuit what the market tells us. Everything else is just noise that distracts us from what's really going on.

Over the last few months I have written that as long as the Dow Industrials remained above 12,000, the bullish trend would likely continue. And with nary a backwards look, the bull has continued to run. As I write this, the Dow has advanced about 150 points since I wrote to you about a month ago. Indeed, with the Dow at about 12,560, it is trading within a whisper of its all-time high. What concerns me is not so much that the Dow is trading near its high, but that it has risen to such heights, almost 2,000 points in about seven months, without any real corrections. And unless the laws of gravity have been repealed, sooner or later that correction will occur, and it is likely to be a whopper.

Since neither I, nor anyone else, knows exactly when this correction will happen, let's look at some charts to see if they offer any clues. The daily chart of the Dow Industrials clearly depicts the nearly vertical ascent since last July. It also suggests that the rally may be losing steam a bit as it hugs the bottom of the channel. The relative strength and MACD also seems to be weakening a bit. I just have a feeling that we're due for a breather sometime soon.

The following weekly chart shows the magnitude of the 5,500 point rise over the past four years. Only the first bull move in 2003 after the three year bear lasted longer than our current rally. Every other rally was followed by a correction before the ascent continued. I guarantee that a correction will happen. Unfortunately, I cannot tell you when it will happen or how severe it will be.

On a more positive note is the recent rally in the Dow Transports. After falling about 470 points below the May high, the Transports are now less than 190 points off the high. Should the Transports confirm the high in the Industrials, that would be a very bullish signal.

And what is the bond market telling us? Most obviously, rates are rising as bond prices continue to sell off. My guess is that the biggest reasons are investors demanding higher rates to offset a weakening dollar and foreign buyers slowing their purchases in the face of lower oil revenues. It could also be money rotating out of bonds into equities. There is no one answer anyway. What matters is that for now, rates are trending higher, which could worry interest rate sensitive homeowners. If rates surge over 5%, I think that would be a cause for concern.

So for now, and until the trend is broken, it appears the market will continue to move higher as the market is flooded with liquidity. That being said, I don't think it will take much to knock the bull off course. So I'll continue to enjoy the gains while being wary of signs of the inevitable slowdown.

Last Month's Results

As always, I provide the following chart to show the raw results for the month, the quarter-to-date and the year-to-date. The results for December were a mixed bag, with large-cap value and international leading the way, while technology and growth stocks lagged again. For the year, value soundly trounced growth by more than a 2:1 margin. All in all, it was for me a surprisingly good year in 2006. I had expected the broad averages to be down for the year (more on that later in this letter). As I write this, the broad market is already up a bit this year, so maybe we'll have five consecutive up years, although I won't be betting my client's money on that.

Name of Index	Dec	QTD	YTD	Description
S&P 500	2.93	7.92	13.62	Large-cap stocks
Dow Jones Industrial Average	1.97	6.71	16.29	Large-cap stocks
NASDAQ Composite	-0.68	6.94	9.52	Large-cap tech stocks
Russell 1000 Growth	0.34	5.93	9.07	Large-cap growth stocks
Russell 1000 Value	2.24	7.99	22.25	Large-cap value stocks
Russell 2000 Growth	-0.24	8.76	13.35	Small-cap growth stocks
Russell 2000 Value	0.87	9.03	23.48	Small-cap value stocks
MSCI EAFE	3.15	10.41	26.86	Europe, Australia, Far East
Lehman Aggregate	-0.58	1.24	4.33	US government bonds
Lehman High Yield	1.10	4.19	11.85	High-yield corporate bonds

What I'm Doing Now

I began the year much like I ended last year; by selling off underperforming holdings in order to raise some cash. In this market, it doesn't hurt to have to capital available for when the inevitable correction hits. And while cash doesn't earn a big return, it doesn't lose money either.

I tend to err on the conservative side for my clients. I'd rather do nothing and hold onto cash, rather than impulsively chase a quick trend or a trade. I am an investor, not a trader. My long-term view and general patience, in addition to my occasional good ideas, are why my clients pay me to manage their money. My natural conservatism and patient stewardship allows them to sleep at night knowing that their money is in good hands. I'm not looking to make a quick buck; I want to build wealth for my clients that endures for generations.

Statistics To Watch

The most recent four-week average for initial jobless claims, for the week ended January 22, fell to 308,250 from 325,000 a month ago.

According to the Department of Labor, non-farm payroll employment rose 167,000 in December, up from a revised upward 154,000 in November. I don't mind the December increase that meaningful because all the increase came from the service industries, and most of that came from retail as store staffed up for the holidays. Average hourly wages rose to $17.04 from $16.94. The average workweek remained flat at 33.9 hours. The number of people holding multiple jobs rose slightly to 7.95 million.

The number of unemployed workers remained 6.8 million in December. The seasonally adjusted number of people, who for economic or business reasons, could only find part-time work, inched up to 4.3 million and the number of marginally attached workers fell to 1.3 million. My Comprehensive Labor Index™ was flat at 8.49% while the unemployment rate reported by the government held at 4.5%.

The Conference Board reported that it's index of Leading Economic Indicators increased 0.3% in December after November and October were both revised downward. The December increase notwithstanding, the Leading indicator continues to point towards a slowing economy.

The University of Michigan Consumer Confidence Index dipped slightly to 91.7 after falling to 92.1 in November.

According to the CBO, the government posted a budget surplus of $40 billion in December, following a revised deficit of $76 billion in November. That resulted in a deficit of $85 billion for the first quarter of the fiscal year, which was about $35 billion better than a year ago. Receipts in December are generally higher than those in many other months because of quarterly payments of corporate income taxes and greater withholding for individual income taxes as a result of year-end bonuses and additional seasonal employment.

According to the Census Bureau, the U.S. trade deficit in November fell for the third straight month to $58.2 billion from $58.8 billion in October as exports rose faster than imports, likely due to the cheaper dollar.

The Labor Department reported that on a seasonally adjusted basis, the CPI for urban consumers rose 0.5% in December, marking the first increase since August, while the "core" CPI, which excludes food and energy, rose 0.2%. Rising energy costs fueled most of the gain in CPI.

The Federal Reserve reported that the amount of outstanding consumer credit rose 0.5% in November to a new high of $2.39 billion from a revised $2.377 billion in October. I suggested last month that this number would rise in November and December. I'm confident that December will follow suit.

According to the Census Bureau, retail trade and food service sales rose 0.9% in December, and were up 5.4% from a year ago. These numbers are very consistent with the November results.

The Census Bureau reported that privately owned housing starts continued their modest rebound in December, rising 4.5% from November, but were still down 18% from the same period last year, to a seasonally adjusted annual rate of 1.64 million units. Similarly, building permits were down 24% from last year. I think the increase in starts can be largely attributed to the unseasonably warm weather across the country, but especially in the Northeast, which showed a 25% increase in starts from November.

The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in November rose 3.4% from revised October levels, but was down 15.3% from the same period last year, to a projected 1.047 million units. The estimate of new homes for sale, at 545,000, represents 6.3 months of supply at the current rate of sales. The median sale price rose to $251,700, the highest number since April.

The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in November rose 0.6%, but was 10.7% lower than the same period last year, to a projected 6.28 million units. The estimate of homes for sale, at 3.82 million, represents a 7.3 months of supply at the current rate of sales. The median price of homes sold dipped slightly to $218,000.

In their latest US Foreclosure Market Report, RealtyTrac reported that 109,652 properties nationwide entered some stage of foreclosure during December, a 9.0% decrease from November but a 35% increase from a year ago. This was the fifth straight month that foreclosures exceeded 100,000, the first time this has happened since they started reporting in January 2005.

According to the Mortgage Bankers Association, the most recent four-week average for mortgage loan application volume is up 0.8% while the refinance index is up 1.1%. Clearly, lower interest rates is once again stimulating mortgage interest, which is also helping the housing market.

The Institute for Supply Management (ISM) index of manufacturing activity was 51.4 in December, up from 49.5 in November. Anything above 50.0 is considered to be an indication of growth. We'll see if this is the beginning of a new growth trend for manufacturing.

The Fed increased M-2 by 0.6% in December, or a 7.2% annualized rate. The supply of M-2 has increased by 7.8% in the last three months and 5.3% in the last twelve months as the Fed is just flooding the market with money. Their stated concerns about inflation are laughable as they are inflating the money supply at a staggering rate. I'm certain this increase in the money supply is one of the key reasons for the rise in the stock market.

Overall, things in the economy appear pretty good. Manufacturing has recovered a bit. The employment picture has improved. Inflation, at least in the way the government deems to report it, is tame. The housing sector has brightened and interest rates are reasonably low but rising. This "Goldilocks economy", supplemented by a powerful fiscal stimulus and lower oil prices, is helping to power the stock market to new highs. But beware; the market is priced for perfection right now, and it wouldn't take much to knock it off its lofty perch.

Trends To Watch

The "Big Picture" of the market, represented by the Wilshire 5000, continues to look bullish. The trading range looks strong, the index is trading above it's moving averages and it has almost returned to its all time high of 14,991, set in early 2000.

The decline in the price of West Texas crude is one of the more important trends in the market and our economy right now as price reductions in gasoline and home heating oil acts like a tax break, putting money right in the wallets of consumers. As I've said many times, I believe oil prices are headed higher over time. In the short-term however, the trend has been substantially lower as the price has plunged about 37% since July. There are many reasons for the drop, but that's all past history now. The question before us is what happens next. I think the $50 per barrel price is an important support level. As it dipped towards that level, the price appeared very oversold. It is clearly too soon to call a trend right now, so I'm just going to sit tight and watch.

The price of gold has formed an interesting declining triangle pattern. As the Fed continues to destroy the value of the dollar, and as interest rates rise, gold is looking better and better. As I write almost every month, regardless of the short-term moves, I believe the long-term action is going higher and as I consider my investments in gold to be partially "portfolio insurance" or hedges against "what if?", I'm perfectly happy to sit with my positions for the foreseeable future, regardless of the short- or medium-term moves.

I want to quickly revisit the Dow Jones Commodity Index (which represents 19 physical commodities). You will notice that each time a bottom was made after a major oversold position a strong rally followed. I think we can be looking at the beginnings of such a rally right now. For full disclosure, please keep in mind that I'm very bullish on commodities as a long-term investment theme.

Even though the dollar has rallied recently, I think this is not a pretty chart, and doesn't bode well for the trend of the dollar. You can clearly see that the dollar is making lower highs on each rally and lower lows on each drop. Each rally started with RSI around 30 or lower, and each downward move began after a rally to RSI about 70. I'd say the dollar index is due for another drop and could fall below 82.

Given the improved status of the housing market, it should be no surprise the the sector continues to rally. So clearly, I was wrong about this one, at least in the short run. My instincts tell me that there will be a reversal before this year is over.

Finally, let's look at the inverted yield curve below. The Fed Funds lending rate is still 5.25%. 6-month t-bills now yield 5.16% (up from 5.07% last month), 2-year Treasury yields have moved up to 4.93%, 10-year Treasury yields are up to 4.81% and 30-year Treasury yields are up to 4.91%. So while the inversion remains, it continues to tighten a bit as the longer end moves up to meet the short end. The spread between 10-year treasuries and TIPS are holding between 2.2% and 2.3%, suggestion very little fear of inflation in the bond market.

Forecasts...Looking Back and Looking Ahead

In my January 2006 newsletter, I made 8 forecasts for the market and the domestic economy. Let's see how I did:

I said that the Dow would go no higher than 11,500 during the first half of the year before falling to between 10,000 and 10,500 by the end of the year. Well, the Dow hit a peak of 11,640 on May 9 before falling to a low of 10,706 on June 13, then 10,739 on July 14. After that, the Dow was a moonshot, rising to 12,463 by the end of the year. So I started well but was remarkably wrong by the end of the year.
I said that "At the risk of again underestimating the Fed, and their new incoming Chairman, I think that the Fed will stop tightening at 4.50%. Not only that, but I think before the year is over, we will be talking about lowering rates again." For two straight years I underestimated the Fed, which raised rates to 5.25%. And while there was some talk about lowering rates, it hasn't happened yet.
Regarding 10-year Treasury rates, I thought that the yield would hold between 3.75% and 4.50% for most of the year and that we would have a clearly inverted yield curve sometime in the first half of the year. I was a little conservative here. Rates moved from a low of about 4.40% when the year began to a high of about 5.25% in June, then back to about 4.60% by December. The average rate for the year was 4.77%.
I thought that the dollar would fall to about 1.50 to the Euro. I was right about the trend, but wrong about its severity. The dollar fell from about 1.22 to 1.33 right before the end of the year.
Last year I said that "the price of oil will not only remain above $50 per barrel, but that it will likely exceed $60 per barrel for a most of the year, and that it will move above $70 sometime this year." Hmmmm. The price of West Texas Crude did in fact stay above $60 for most of the year, and did move above $70 when it peaked at $79 in July. From that peak, it plunged as low as $57 before settling right at $60 by the end of the year.
Last year I wrote that "I expect gold prices to remain north of $500 per ounce and crest $600 before the year is over." Similar to the action on oil, gold moved from about $520 per ounce to about $730 in May, after which it plunged to $540 in June, before recovering to end the year at about $640.
On the political front, I speculated that "I expect the US troops to remain in Iraq and Afghanistan, and for the cost of these war efforts to come in much higher than the current government estimates. I think we'll see more Latin American countries, like Venezuela, moving further to the Left. Look for more announcements from Argentina. Unrest will likely increase in some of the African countries. Political and economic unrest around the world will continue to roil the world stock markets." On balance, most of that came to pass.
Finally, GDP growth for the year will come in around 3%, the trade gap will grow, the federal deficit will remain steady or grow slightly, my Comprehensive Labor Index™ will average around 9.5% (adjusted) while the government's unemployment index will stay between 4.8%-5.0%. A mixed bag here. The average of the most recent four quarters of reported GDP was exactly 3.0%, but fluctuated wildly from a low of 1.8% to a high of 5.6%. The trade gap did grow for the first two-thirds of the year before falling in the last few months. The deficit was lower than expected. Unemployment fell to 4.5% while my adjusted CLI dropped to 8.5%.

Overall, my predictions were not nearly as accurate in 2006 as they were in 2005. Not surprisingly, this made for a more difficult investment environment. So what does my crystal ball reveal for 2007? I'm glad you asked.

I expect the Dow Jones Industrial Average to fall this year. It is too much to expect gains in five consecutive years for an index, and a market, already priced to perfection. A 10% drop to about 11,250 wouldn't surprise me, although it may not be that severe.
I expect the Fed Funds rate to remain unchanged for the first half of the year, then drop between 0.25% to 0.50% the second half of the year as the economy continues to slow and possibly sinks into a mild recession.
I think the range on the 10-year Treasury will be between 4.25% and 5.00% with an average of about 4.50%. I also think the yield curve will remain inverted until the Fed reduces short rates.
I think that the dollar will continue to decline against the Euro, although not in a straight line. Ultimately, I expect it to get as low as about 1.40.
I expect the price of oil, which is now hovering just above $50, to trade in a tight range around $50 or $55 early in the year before rallying back above $60 later in the year.
I expect gold prices to remain north of $550 per ounce while averaging more than $600 for the full year. If the dollar weakens too much, or if conditions in the Middle East deteriorate, gold could again surge over $700.
I don't think we have yet seen the bottom in the housing market, and that defaults will rise and homebuilders will swoon again.
Finally, GDP growth for the next four quarters will average around 2.5%, the trade gap will shrink as the dollar falls, the federal deficit will grow again thanks to spending on the war and the lack of any new economic stimulus, my Comprehensive Labor Index™ will rise back above 9.0% as the economy weakens while the government's unemployment index will rise to around 5.0%.

So there you have it. My Fearless Forecasts for 2007. Like you, I'll be watching closely to see how these forecasts pan out, and to see what happens in the market this year.

Personal News and Notes

In March I will celebrate the 10th Anniversary of WAM. We've come a long way in 10 years and have provided a great service to a lot of investors. I invite you to contact me to see how I may be able to help you and your family develop, implement and monitor an investment plan that will help you achieve your financial goals.

By the time my next newsletter graces your inbox, a new Super Bowl champion will have been crowned (I'm picking the Colts) and pitchers and catchers will have reported to Spring Training, marking the beginning of a new baseball season. Let's Go Mets!

I hope all of you had a great holiday season and have returned invigorated for your best year yet. As always, I thank you for your interest and consideration.

Best regards,

Greg Werlinich
President