January 18, 2008

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

Last month I asked "Is the market getting better or worse? Is the economy getting better or worse? Are things going to get better or will they get worse?" Well, at least in the short-term, the market has clearly gotten worse, the economy has clearly gotten worse and in general, things over-all have gotten worse. The action on January 2 represented the worst point loss ever for the first day of a new year, and was the worst percentage loss since 1983. We also managed to record the worst three-day start to a year since 1932. We're likely to have the dubious distinction of suffering through the worst three weeks to start a new year in quite some time when this week mercifully ends tomorrow.

At best, the market is in the midst of a powerful correction. At worst, we are in the early- to mid-stages of a serious bear market. I do believe, as I've been writing for months, that we are already in a recession that began in the 4th quarter of 2007. I don't think it will be horribly deep or terribly prolonged. My guess is that it'll be over by the end of the first half of this year. If that's the case, the market will likely begin to recover in a few months. What we do as investors depends on our age, our investment time horizon and our objectives. But as I've said repeatedly, the worst thing you can do it panic. Make sure you have an intelligent plan, then follow that plan until you have to come up with a new plan.

As I write this mid-day on the 17th, the Dow Jones Industrial Average is trading at 12,350, down about 13% from the peak last October, and down about 6.5% since I wrote last month. Even the prospects of a large rate cut by the Federal Reserve by month-end is doing nothing to salve this market. As more and more experts get on the "recession bandwagon", and the financial institutions continue to suffer from the mortgage/credit crisis, the outlook for the market justs gets gloomier.

Before we go to the charts, let me say something about my own feelings about the markets right now. There is a growing fear that is almost palpable right now. Jim Cramer is screaming on CNBC almost daily. Large financial institutions like Merrill Lynch, Citigroup and MBIA are writing off billions in assets and desperately trying to raise capital to shore up their balance sheets. I guarantee you the ambulance chasing lawyers are salivating right now over the multi-billion dollar lawsuits which will be filed shortly. I'm also sure that our esteemed government will quickly join the fray with multiple high-profile and conveniently televised investigations to get to the bottom of why the evil corporations have fleeced the poor, unsuspecting investing public. (Please notice my sarcasm here.) The circus is coming to town my friends. The only thing missing are the magazine headlines claiming "The Death of Capitalism" or "The Coming Economic Apocalypse". That, dear reader, will mark the bottom. When the general media and the public at large finally throw up their hands and proclaim that the end is upon us, then we'll know that the good times are about to return. My own feeling is that things will improve in the second half of the year and that 2009 will be even better. But I'm getting ahead of myself. Let's take a look at some charts and see what the market says.

There is no way to sugarcoat the message of these charts; things are bad and getting worse. The daily chart of the Dow Jones Industrial Average shown below is very busy, but I wanted to show a few things. First, you can see the second violation of the August low of 12,500. You can also see the clear breakdown of the "head and shoulders" pattern taking the Dow down towards the low of 11,939 set last March. I've also highlighted the volume spikes attending each of the last three drops in the Dow. Lastly, and somewhat ominously, you'll notice that the 200-day moving average has crossed above the 50-day moving average. That's very bearish and suggests that things could head lower before the move higher. The only possible good news in this chart is the RSI and MACD are oversold, and could be headed for a short-term bounce.

The next chart is a weekly picture of the Dow since the beginning of the bull run in 2003. What you'll notice here is that again, RSI and MACD are very oversold, but the correction in the Dow hasn't yet violated the trendline drawn in blue and the moving averages haven't yet crossed. Now this could simply be a factor of time and the continued poor action could be an inevitability. Or it could show some support when you take a longer view of the market, which tends to drown out some of the daily noise. The price action in the next month or two will tell the story here.

The picture for the daily chart of the Transportation average is even worse than the Industrials, which isn't surprising given the more economically sensitive nature of the companies that make up this average. Not only have the Transports twice fallen below the August 2007 low, but it is also now flirting with the August 2006 low. The moving averages crossed last September, presaging this action, and the divergence between them is widening. That suggests further negative action.

As the equity markets have cratered, the bond market has boomed, reducing yields on the 10-year Treasury to historic lows. I wrote last month that "I think yields have further to fall over the next few months." That has certainly proven to be the case. You can see from the chart below that in only six months, yields have fallen from about 5.3% to 3.6%. I wouldn't be surprised to see this yield fall to 3.0% before the year is over before moving back up again.

Last Month's Results

As always, I provide the following chart to show the raw results for the preceding month, the quarter-to-date and the year-to-date. After a horrible November, the market leveled off a bit in December, although there was no "Santa Claus Rally". For the first time in a few years, growth trumped value and bonds beat both the S&P 500 and the Dow Industrials. Small-cap value had a particularly bad year. I would expect value stocks to significantly outperform growth in 2008, especially in the first half of the year.

Name of Index	Dec	QTD	YTD	Description
S&P 500	-0.86	-3.82	3.53	Large-cap stocks
Dow Jones Industrial Average	-0.80	-4.54	6.43	Large-cap stocks
NASDAQ Composite	-0.33	-1.83	9.81	Large-cap tech stocks
Russell 1000 Growth	-0.36	-0.77	11.81	Large-cap growth stocks
Russell 1000 Value	-0.97	-5.80	-0.17	Large-cap value stocks
Russell 2000 Growth	0.63	-2.11	7.05	Small-cap growth stocks
Russell 2000 Value	-0.85	-7.27	-9.78	Small-cap value stocks
MSCI EAFE	-2.25	-1.71	11.63	Europe, Australia, Far East
Lehman Aggregate	0.28	3.01	6.97	US government bonds
Lehman High Yield	0.29	-1.29	1.87	High-yield corporate bonds

Statistics To Watch

According to the Department of Labor, the most recent four-week average for seasonally-adjusted initial jobless claims, for the week ended January 17, was 328,500, a decrease of 14,500 from a month ago.
Non-farm payroll employment rose by meager 18,000 in December, following a revised higher gain of only 115,000 in November. Goods production, manufacturing and production continues to lose jobs with lower paying retail and service jobs, plus government, showing the majority of the growth. Average hourly wages grew a bit to $17.71. The average workweek remained steady at 33.8 hours.
The number of unemployed workers grew 7.7 million. The seasonally adjusted number of people who could only find part-time work rose to 4.7 million and the number of marginally attached workers inched down to 1.3 million. The number of people holding multiple jobs fell to 7.58 million. My Comprehensive Labor Index™ rose to 9.37%, while the unemployment rate reported by the government rose to 5.0%.
According to Alan Abelson of Barron's, 89% of all payroll additions in 2007 were do to an adjustment to the figures called the Birth/Death ratio, which is another phantom calculation used by the government to create their inflated employment estimates. This ratio is a backward-looking estimate of new jobs created by new businesses. For a more detailed explanation of this arcane calculation, please read John Mauldin's July 13, 2007 newsletter by clicking here.
According to the CBO, the government posted a budget surplus of $47 billion in December, which was $5 billion more than a year ago. The deficit for the first three months of the fiscal year is running about $27 billion more than the prior year.
According to the Census Bureau, the U.S. trade deficit in November was $63.1 billion, much higher than the revised $57.8 billion in October. This was also the highest monthly deficit since September 2006. Our trade deficit with China fell slightly to $24.0 billion, but increased with almost everyone else in the world.
The Census Bureau reported that privately owned housing starts fell 14.2% in December, after falling a revised 7.9% in November, and was down 38.2% from a year ago, to a seasonally adjusted annual rate of 1.00 million units. New building permits were down 8.1% from last month and down 34.4% from last year, which suggests that the outlook for future housing starts remains bleak and continues to worsen.
The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in November fell 9.0% from the prior month and 34.4% from the same period last year, to a projected 647 million units. That is the lowest figure in the four years I've been tracking new home sales. The estimate of homes for sale is now 505,000, which represents 9.3 months of supply at the current rate of sales. The median sales price rose to $239,100, which is below the ever-shrinking 12-month average of $243,708. And these prices to not include the "incentives", like cash rebates, used by builders to entice people to buy their properties.
The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in November actually rose 0.4% from the prior month, but were still 20.% lower than the same period last year, to a projected 5.00 million units. The estimate of homes for sale, at 4.27 million, represents a staggering 10.3 months of supply at the current rate of sales. The median sales price rose slightly to $210,200, which remains below the 12-month average of $217,923. I don't believe we've seen the end of the housing mess quite yet.
According to RealtyTrac, foreclosures fell 10% in November to 201,950, after a small rise in October. Foreclosure filings were still up 68% from a year ago. The number of foreclosure filings dropped over the last three months, potentially signaling better times ahead.
The Institute for Supply Management (ISM) index of manufacturing activity was 47.7 in December, marking the sixth straight month in which the index has decreased. It was also the first time in over six years that the index has fallen below 50.0 which is the level above which economic growth is believed to exist. This again points to the lack of growth in our economy.
The Conference Board reported in November that it's index of Leading Economic Indicators "decreased sharply for the second consecutive month", and had been down four of the last six months. The leading index fell 1.2 percent (a decline of 2.3 percent annualized) from May to November, the largest six-month decrease in the index in six years.
The Bureau of Economic Analysis announced that the "final estimate" of GDP growth for the third quarter of 2007 was 4.9%, consistent with the "preliminary estimate" of 4.9% and up considerably from the "advance estimate" 3.9%. The increase in real GDP in the third quarter is misleading. There was a huge increase in exports thanks to a weak dollar and a large increase in government spending, especially on defense. Bet on GDP falling in the fourth quarter.
The Federal Reserve reported that the amount of outstanding consumer credit increased by 0.6% from the prior month in November, to $2,505 billion. The consumer is the last line of support for the sagging economy.
According to the Census Bureau, retail trade and food service sales fell 0.4% in December from the prior month but was still up 4.1% from a year ago. Those results were far worse than the analysts had expected and is very ominous.
The Fed increased M-2 by 0.5% in November. The supply of M-2 has increased by 5.7% in the last three months and 6.1% in the last twelve months. According to John Williams on his website "Shadow Government Statistics" (www.shadowstats.com), the increase in M-3, which is no longer reported by the government, likely exceeds 16% as the Fed tries to inflate us out of this recession.

Trends To Watch

Below is the graph of the Financial Spyders Index. For the past two months I warned that I thought the financial sector has farther to fall, and indeed it has. And the news continues to get worse - see the recent headlines from Citigroup and Merrill Lynch, whose combined write downs exceed $30 billion. While I don't think this crisis is over yet, I get the feeling that we may be getting close as the pessimism in this industry is starting to reach the hysterical stage. One more big blow-off and the stage could be set for a big rally.

While the price of West Texas Crude has corrected strongly since breaking the magic $100 per barrel barrier at the end of 2007, it still remains within the trading range, albeit on the low end of the range. Last month I said that "it is just a matter of time before that level ($100 per barrel) is breached, and there is nothing the pundits and talking heads who give all the reasons why it shouldn't be this high can do about it. That being said, there is no reason why we couldn't have a bit of a retracement or consolidation before the next move higher begins." Well, as you can see below, we broke $100 then started the consolidation. I believe that the current recession could drive oil prices even lower, although I don't believe it'll go much lower than $80. Then as the economy recovers, demand will again drive the price of oil above $100.

You are now looking at one of the only bullish sectors in the domestic stock market right now. The price of gold has soared about 50% over the past year. Two months ago I said that "when the Fed cuts the rate again . . . the price of gold will likely be closer to $900 than $800." It just took a little extra time for this to happen. I think the price is a bit overbought right now. I think gold will consolidate a bit, maybe to as low as $850 before beginning the next phase of this bull run. Given the expectation of further rate cuts ahead, I expect the price of gold to break $1,000 before the year is over, and possibly before this quarter is over. Use any period of consolidation as a buying opportunity.

I find the chart of the price of copper very interesting. One would think copper prices would be in the tank given all the doom and gloom in the market these days. Yet, while it has weakened a bit, the price of copper is holding above the support level of $3.00 per pound. And it is still very high when viewed against its historical price. I believe that copper prices will resume their upward path by the second half of the year and due to continued demand from China and the rest of the developing world.

So how is the dollar? After strengthening a bit in November and December, it appears to have resumed its downward path. At least in the short run, I don't see a catalyst for being bullish. The impending Fed rate cuts are likely to weaken the greenback even further. The widening spread between the 50-day and 200-day moving averages would seem to confirm the negative outlook.

The housing sector rallied a bit in December, leading some experts to claim that the bottom was made. Last month I said "I don't believe it. I think we're still a long way from the bottom. Don't try to catch a falling knife." As you can see, things quickly got worse. I don't think we've seen the bottom yet.

What about China? The Shanghai Index, which I use as a proxy for China, has had some interesting activity. After a stunning multi-year rise, it corrected heavily early in the fourth quarter before heading back up in December. You'll notice that the moving averages are beginning to converge, which suggest a possible weakness. It wouldn't surprise me to see the price fall to test the 200-day average. When the US sneezes, the rest of the world often catches cold.

The yield curve has continued to steepen and drop. What must happen next is for the short end of the curve to drop further. Last month I said that "I think that before 2008 is over, the Fed Funds rate will be no higher than 3.5%, as opposed to its current 4.5% level. It might even be as low as 3%." The current Fed Funds rate is now 4.25% and will likely be 3.75% after the next meeting in January as the Fed will fight the recession tooth and nail, inflation and the dollar be damned.

Forecasts- Looking Back and Looking Ahead

In my January 2007 newsletter, I made 8 forecasts for the market and the domestic economy. Let's see how I did:

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. This was my worst prediction from last year as the Dow finished the year at 13,264, up 6.4%. I may have just been wrong in my timing as we're now in the midst of 13% correction. I hope we don't find our way to 11,250.
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 was pretty accurate here. The Fed started to cut in August as the economy began to slow and slip into recession. They cut a total of 1.50% over the five months.
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. This turned out to be mostly right too, as rates hovered between 4.60% and 5.00% for most of the year before tumbling to 3.6% in the fourth quarter. And the inversion has gone away.
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 was pretty accurate on this one. It fell almost to 1.49 before finishing the year around 1.475.
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. Well, I was right on the trend, but completely wrong about the strength of the rally, as oil pushed almost to $100 per barrel. The good news is that I captured that rally with my investments.
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. The price of gold never fell below $600 as it traded between $630 and $700 for the first eight months before surging to $850 over the final four month of the year.
I don't think we have yet seen the bottom in the housing market, and that defaults will rise and homebuilders will swoon again. This was an easy one. Home sales have plummeted and delinquencies and foreclosures have soared.
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%. GDP over the last four quarters averaged about 2.85%. The trade gap did fall until November, when it rose strongly. The federal budget deficit fell $87 billion in the fiscal year. Unemployment hit 5% in December and my Comprehensive Labor Index™ finished the year at 9.37%

Overall, my predictions were mostly on target in 2007. Call me if you'd like to know how that impacted my investment performance for the year. So what does my crystal ball reveal for 2008? I admit this is a very difficult environment in which to try to make predictions. That being said, here they are:

Like last year I expect the Dow Jones Industrial Average to be down for the year. It is already off 9% in only twelve days of trading and will likely fall further, although probably not in a straight line. I believe the worst of it will be done in the first half of the year before a rally ensues in the second half. Let's put the year-end price around 12,500.
The Federal Reserve target rate will likely drop 1.00% in the first quarter, and possibly another 0.25% to 0.50% to a low of between 2.75% and 3.00% before the Fed finishes cutting rates. The recession will last two to three quarters and be done by the end of the first half of the year.
I think 10-year treasuries will fall to as low as 3.25% before rallying back up to between 4% and 4.25% by the end of the year.
I think that the dollar will continue to fall as the Fed cuts rates. It could get to 1.60 vs. the Euro. Then I expect the dollar also to rally in the second half of the year as the economy strengthens.
The price of oil could sink as low as $80 per barrel early this year during the worst of the economic news. Then I expect it to strengthen and again trade over $100 per barrel, possibly getting as high as $110 as demand soars and supplies remain tight.
The price of gold will be the biggest story of 2008 as prices will surge above $1,000 per ounce. Prices will average better than $900 per ounce for the year. There will be the inevitable profit-taking and consolidations, but the general trend will remain upward.
I still don't think we've reached the bottom of the housing mess, but we're likely getting closer. I believe the worst of it will be over in the first half of the year. Then defaults will start to fall, sales will improve and the inventory of homes for sale will decrease.
The two biggest investment stories of 2008 will the the declaration of the recession and the subsequent recovery from it and the financial and political impact of the Sovereign Wealth Funds.
Finally, GDP growth for Q4 2007 through Q3 2008 will likely average no better than 2.0%, with the last half being better than the first half. The trade gap, on balance, should improve over the course of the year thanks to a weaker dollar helping exports and a sick economy hurting imports. The federal deficit will likely grow again as tax revenues shrink. The unemployment rate will likely rise to 5.5% and the democrats will take the White House with the economy being the most important issue.

So there you have it. My Fearless Forecasts for 2008. Like you, I'll be watching closely to see how these forecasts pan out, and to see what happens in the market this year.

What I'm Thinking and Doing

This is a very difficult time to be an investor, and an equally difficult time to be an investment advisor. But it is at times like these that people like me earn our money. I do believe that we are in a recession. I think it will extend through this quarter into the next. I don't think it will be a very deep or protracted recession. In fact, I expect the second half of the year to be better than the first. The wild card for me is the election. I don't yet have a good feel for how that may impact the market. What I am clear about is that the winning candidate better not allow the Bush tax cuts to expire in 2010 or the economy, and the stock market, will surely head lower.

I want to repeat something that I wrote last month. I believe one of the biggest investment themes of 2008 will be the impact, economically and politically, of the Sovereign Wealth Funds. Very simply, a SWF is an investment fund owned by a state or government. These funds can be thought of as private equity investment funds run by a country rather than companies like Morgan Stanley or Goldman Sachs. What makes this such a compelling story is that these funds are accumulating massive amounts of capital. Indeed, some of these funds already have tens or hundreds of billions in them. Taken together, we'll be talking about trillions of dollars. These funds have already begun to make their mark with investments in Blackstone, Citigroup, Merrill Lynch and Morgan Stanley, to name a few of the high profile investments made recently. As countries like China and the oil producing nations continue to generate staggering reserves of dollars they will continue to look to put that money to work buying assets in this country. Some would argue, and I tend to agree, that while the initial reaction to these investments may be a protectionist whine that "foreigners are buying up America", the reality is that these investment flows back into our markets are helping to support a stock market that might otherwise have dropped a lot farther. I'll be talking much more about this theme as the year progresses.

Over the past month or so I have continued to sell non-core, underperforming assets while adding to core positions. I have added to my energy, commodity, defense and precious metal positions. I am very confident that, current conditions notwithstanding, each of these sectors remains in a long-term bull market. As an investor, not a trader, you have to look past the noise of the current period and look ahead to the future. I realize that it can be very difficult when the market seems to be crumbling around you. Nobody said this would be easy. But if you can buy when everyone else is selling, then sit tight and allow your investment thesis to play out, you can make a lot of money in the stock market. You just have to have the courage of your convictions, some capital, time and patience.

If you would like a second opinion regarding your investment strategy, or are thinking about making a change, now is a great time to speak with me. Why not give me a call and ask how I might be able to help you and your family secure your financial future.

Personal News and Notes

In three weeks Lily will turn 10, leaving me with only one child in the single digits. Lily also got her braces this week, joining Nola as a brace-face. The colorful braces of today are a far cry from the miles of metal that I wore when I was their age. They have no idea how lucky they are. Remember the humiliation of head and neck braces? Today's braces are almost a fashion statement by comparison.

I'll be watching the Giants this weekend, rooting for another upset, as they play the Packers in the NFC Championship Game. Go Big Blue! And just think, it's only a month until pitchers and catchers report to Spring Training.

That's it for this month. Remember, this newsletter is for you, my readers. If you have any thoughts or suggestions on how to make it even better, please let me know. If you have some ideas for future "Monthly Tips", or even better, if you'd like to be write a Tip, let me know that too. As always, I thank you very much for your continued interest and support and I look forward to writing to you again next month.

Best regards,

Greg Werlinich
President