Current Market Analysis

Before I begin this month's newsletter, a bit of housekeeping. Obviously, I'm a bit late getting the newsletter out this month. Going forward, it will be my intention to publish earlier in the month. Therefore, I will not write one in February, allowing me to send the next newsletter out in early March. Now, let's begin.

The promise of a new year and a new administration has already begun to tarnish in the face of increasingly dour economic news and a stock market that is struggling to remain above the lows established last November. That being said, it is very constructive that the market, as represented by the Dow Jones Industrial Average, has indeed remained above the closing low of 7,552.29 set on November 20. Every day that the market remains above that level increases the possibility that the worse may be behind us. That doesn't mean that the worst is over, but that the possibility exists that it may be. I am amazed at how well the market is actually holding up as the economy worsens. We know all the bad news; we read it every day in the papers and watch is every day on CNBC. Yet the market is hanging in there. That suggests some optimism.

Notwithstanding that optimism I referred to, the current market picture is still a bit bleak. The Dow Jones Industrial Average is down about 4.5% since I wrote to you last month. Importantly, it has stubbornly remained above the November low, the 50% mark of 7,470 and the October 2002 low of 7,286. These are all important technical levels. As long as the market can rise, or even just remain steady, in the face of the deteriorating economy, that is very positive. In addition, new lows on the NYSE have fallen dramatically since hitting 92% of all stocks traded on October 10. That also is positive as we look forward. So now let's look and and see what the charts tell us.

The daily chart of the Industrials shows the recovery from the November 20 low and the creation of a trading range between 8,000 and 9,500, or even 9,000 if you shorten the time frame. I don't mind staying within this trading range for a few months while the worst economic news is reported. If we don't violate that bottom, it increases the likelihood of a solid rally down the road.

The weekly chart again shows a base being formed above that important support level. Let's hope I don't have to show where the next support level would form.

On January 20, the Transports closed at 2,959.40, which was below the November 20 closing price of 2,988.99. That's not good news. But since the Industrials did not also break to a new low, this is actually bullish for the market, according to Dow Theory. As long as the Industrials don't confirm this low with it's own new low, it sets the stage for a upward move. We'll keep a close watch on this non-confirmation.

The "bond bubble" that I talked about last month may have already been pricked. As you can see, the yield on the 10-year Treasury has surged from 2% to above 2.7% in just a month. If yields simply rise back to the "normal" levels pre-Lehman levels of between 3.25% - 4.25% then bond holders will have suffered significant losses. That being said, it wouldn't surprise me to see yields fall one more time before ultimately rising much higher over the next few years.

One bit of good news is that the panicked "flight to safety" of t-bills is starting to abate. A yield of 0.125% is still absurdly low, but it's better than 0.0%. As investors demonstrate more willingness to buy risky assets, t-bills yields will continue to rise back above 1%.

Last Month's Results

• According to the Department of Labor, the most recent figure for seasonally-adjusted initial jobless claims for the week ended January 24 was 588,000. The four-week average is now 542,500. A year ago that figure was about 325,000. The unadjusted figure is a much higher 617,289.
• Non-farm payroll employment fell by a whopping 524,000 in December. The November job losses were revised from 533,000 to 584,000. This brings the number of jobs lost in the year, as reported, to a stunning 2.33 million. Average hourly wages grew a bit to $18.35, but the average workweek dropped to 33.3 hours, so real wages are actually falling.
• The number of workers reported in December as unemployed rose to 11.1 million, bringing the unemployment rate to 7.2%. We started the year with 7.7 million people out of work and an unemployment rate of 5.0%. The seasonally adjusted number of people who could only find part-time work jumped to 8.0 million and the number of marginally attached workers held at 1.9 million. The number of people holding multiple jobs fell to 7.43 million. My Comprehensive Labor Index™ rose to 15.54%, the highest level since the end of 2005. My CLI™ is much closer to the true unemployment number. I wouldn't be surprised to see the CLI™ at around 20% later this year.
• Calculating the federal deficit, already a quagmire, has gotten worse due to the Troubled Assets Relief Program (TARP). Now the CBO is reporting the deficit on a cash and adjusted basis. The CBO estimates that the Treasury will report a federal budget deficit of $491 billion for the first three months of fiscal year 2009. That's higher than the entire fiscal 2008 deficit. The CBO believes that the equity investments for that program should be recorded on a net present value basis adjusted for market risk, as specified in the Emergency Economic Stabilization Act of 2008, rather than on a cash basis as recorded by the Treasury. Evaluating TARP on a net present value basis, CBO estimates the federal deficit totaled $303 billion through December. If you understand that, please let me know and explain it to me. And now, get ready for TARP 2.
• According to the Census Bureau, the U.S. trade deficit in November was $40.4 billion, down significantly from $56.7 billion in October as imports plunged.
• The Census Bureau reported that privately owned housing starts dropped 15.5% in December, following a 15.1% decline in November, and was down 45.0% from a year ago, to a seasonally adjusted annual rate of 550,000 units. New building permits were also down 10.7% from last month and 50.6% from last year. The market must continue to clear out excess inventory.
• In January, the National Association of Homebuilders/Wells Fargo Confidence Index, which was created in 1985, fell to a new all-time low of 8, down from 9 the prior few months.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in December fell 14.7% from the prior month and 44.8% from the same period last year, to a meager 331,000 units. That is by far the lowest figure in the five years I've been tracking new home sales and follows downward revisions of the prior three months. The estimate of homes for sale is now only 357,000, which represents a staggering 12.9 months, or more than a year of supply at the current rate of sales. The median sales price fell to $206,500 and remained below the steadily falling 12-month moving average price of $228,350.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in December actually increased 6.5% from the prior month, but were down 3.5% from the same period last year, to a projected 4.74 million units. The estimate of homes for sale, at a much reduced 3.68 million, represents 9.3 months of supply at the current rate of sales. The median sales price fell further to $175,400, which remains below the steadily falling 12-month average of $197,275. As prices continue to fall, inventory is beginning to clear out.
• The S&P/Case-Shiller Home Price Index, which uses a three-month moving average to track the value of home prices across the US, fell to 166.05 in November, the lowest level since March 2004.
• According to RealtyTrac, foreclosures increased by 17% in December to 303,410, and remained 41% higher than a year ago. Foreclosures were up 81% in 2008. Nevada, Florida and Arizona, respectively, reported the highest foreclosure rates in the country while California had the highest actual number of foreclosures.
• The Institute for Supply Management (ISM) index of manufacturing activity fell to 32.4 in December. This is the worst level since 1982. Any number below 40 suggests a serious recession. The ISM index of non-manufacturing activity was a slightly better 40.6.
• The Conference Board reported that in December it's index of Leading Economic Indicators rose 0.3%, thanks in large part to the massive monetary stimulus. The six-month rate of decline is now -2.5% as the economy continues to weaken, and the outlook is no better.
• According to the Bureau of Economic Analysis, the "preliminary" estimate of GDP growth in the fourth quarter of 2007 was -3.8%, which while pretty bad, was actually better than the estimates of between -5% and -7%. GDP growth in the third quarter was -0.5%, down from 2.8% in the second quarter and 0.9% in the first quarter. The second quarter "growth" was an illusion thanks to a federal stimulus program.
• The Federal Reserve reported that in November the amount of outstanding consumer credit fell 0.3% from the prior month, to $2,571 billion. That means that consumer credit has declined in three of the last four months. That's good for consumers, bad for the economy.
• According to the Census Bureau, retail trade and food service sales fell 2.7% in December, and was 9.8% worse than a year ago. This marks the sixth consecutive month in which retail trade and food service sales fell on a month-over-month basis.
• The Fed increased the supply of M-2 by an astonishing 18.4% in the last three months. But the headline here is that they've increased the supply of M-1 (the narrowest definition of money) by a staggering 39.6%. The Fed is desperately trying to resuscitate this economy and avoid the horrors of deflation. So far, it isn't working as that money is not being put to work.
• The Conference Board Consumer Confidence Index fell in December to 37.7, which marks a new all-time low. This should come as no surprise.

The downward trend in the financial sector remains in force as no amount of federal assistance seems to help the bank stocks. The index continues to fall to increasingly lower lows while rallying to increasingly lower highs. This is very bad action. I would avoid this sector like the plague until the trend is broken.

At least temporarily, the housing sector is performing a bit better than the financials. That being said, I believe it's another premature rally and I expect this sector to test the November lows before rallying above the recent high of around 94. The housing numbers are so bad, it's hard to make a bullish case for the sector just yet.

The price of West Texas Crude has continued to fall thanks to worldwide demand destruction. Even massive supply cuts by OPEC can't stem the price erosion. The price of oil has fallen to four-year lows. There is talk that prices could fall to around $30 in the short-term. The current price has effectively killed the alternative energy movement. Nobody is talking about solar, wind or ethanol any longer. Future projects are being mothballed. But mark my words, we are setting up for a massive price increase when demand returns as there won't be enough supply to meet that demand.

The price of gold has been quietly trending higher for about three months. Last month I said that the price of gold could again, with some fits and starts, head north of $900 per ounce on its way to test that $1,000 level. As you can see below, we're slightly north of $900 right now. But remember, I don't recommend that you trade gold. It's better to establish a position and simply sit with it. Part of why we own gold is for "portfolio insurance". And part is to protect us against future inflation and the debasement of our currency. If I'm wrong about the general upward trend of gold, it will likely mean the stock market is headed much higher, and we would be more than compensated for our "losses" in our gold positions by higher equity prices. So if you own gold, just sit tight. If you don't, consider buying during times of weakness.

The price of copper, which is often thought of as a proxy for the economy, has temporarily halted its downward spiral. After falling almost 70%, Dr. Copper has shown a bit of resiliency over the past month. We'll see if this is a short-term correction or a glimpse of better news in the future. 

Another example of worldwide economic activity is the Baltic Dry Index. The BDI measures the demand for shipping capacity versus the supply of dry bulk carriers and indirectly measures global supply and demand for the commodities shipped aboard dry bulk carriers, such as cement, coal, iron ore and grain. Because dry bulk primarily consists of materials that function as raw material inputs to the production of intermediate or finished goods, the index is also seen as a good indicator of future economic growth and production. As such, it appears that the prospects for future economic growth look dim indeed as the index has fallen more than 90%. Two months ago I wrote that I expected at least a short-term bump because this index was massively oversold. That seems to have happened. I expect this index to continue to suffer for a while, but longer-term, I would expect a tremendous recovery here as the price of hard assets inevitably go back up. This is not the end of global commerce.

The price swings in the dollar index is beginning to look more like the VIX (see below). Going forward, will the world continue to view the dollar as a safe harbor or will the world grow wary of our nation's growing deficits and what that will mean to our currency? The answer to that question must be viewed in a global context as other nations struggle with similar problems. So where is the dollar headed? Short-term, it could strengthen; long-term, I think it's headed lower.

Foreign markets, as represented by the MSCI EAFE index, continue to be very weak, but seem to have formed a trading range. The U.S. markets continue to outperform their foreign counterparts.

I haven't shown the Chinese market in a little while. It still isn't a pretty picture, but at least for now, it has stopped going down. Rest assured, if we break to new lows, we'll drag the Chinese market with us.

Volatility in the market, as measured by the VIX, sometimes known as the "investor fear gauge", continues to abate. The VIX has fallen by more than 50% from the high, and is almost back to "normal" levels. This means a much calmer market, which is exactly what we need right now.

What I'm Thinking and Doing

Greg Werlinich
President

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