Market Analysis...Making Highs

After an erratic but up-trending January, the Dow has risen above 11,000 and is now at its highest level since May 2001. Helping to confirm this rally, the Dow Transports and the S&P 500 are also at or near multi-year highs. If the Dow manages to stay above 11,000 for a little while, this rally could have legs. It is interesting to me that the market continues to power upward in the face of rising interest rates, widening deficits and increased political turmoil around the globe. The market is increasingly priced to perfection and I don't think it will last. But for now, like the rest of you, I'm enjoying the ride.

Volatile oil prices, at least in part, continue to be a major catalyst for movements in the broader market. I don't think that it's a coincidence that the recent surge on the Dow is happening against a backdrop of falling oil prices. After peaking recently at around $70 per barrel, the price of West Texas Crude has fallen to around $60. Don't get too comfortable with these prices. $70 oil is likely to be back before you know it.

Treasury yields have moved up a bit this year to coincide with the increase in the Fed Funds rate. The spread between the 10-year Treasury and the TIPS has inched up to around 2.50%. While there seems to be a small whiff of inflation in the air, I believe it is strictly monetary inflation as the Fed continues to print money at an alarming rate. The government needs a certain amount of inflation in order to be able to repay its mammoth debts, so don't expect the Fed to turn of the spigots just yet.

So what do all of these charts and analysis mean to you? It means that we've had a nice start to the year, and it means that the rally could last a little while. So for now, enjoy it, but don't change investment strategies that have worked for the past three or four years trying to catch the tail of this comet. Continue to be prudent and patient.

Last Month's Results...Good Start

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 news was generally good, across the board, for the stock market in January. All of the major indices finished up for the month, with the biggest gains coming in the small-cap sector. It's also nice to note that through the middle of February, the rally has continued.

What I'm Doing Now...Buying on Weakness

It has been a very interesting year after the first seven weeks. Following three straight years of double-digit returns, January was the single best month in terms of performance in the history of WAM. Once again, this was done by successfully implementing the sector investment strategy that I have been talking about for the past few years, and written about in my book.

The problem is that as is often the case, what goes up, sooner or later goes down. Thanks to the recent drop in the price of oil, February hasn't been quite so kind as many energy stocks have dropped a bit. This has enabled me to add to some existing positions at bargain prices.

As I mentioned in last months letter, I began last year to make greater use of Exchange Traded Funds (ETFs) to implement my sector investment strategy. I have continued to add to my portfolio of ETFs so far this year, and anticipate adding still more as the year progresses.

Statistics To Watch...Generally Bullish

• The most recent four-week average for initial jobless claims fell to 297,000.
• There was an increase of 193,000 non-farm jobs in January after a weak (but revised upward) December. Average hourly wages rose to $16.41 from $16.34. The average workweek increased slightly to 33.8 hours. The number of people holding more than one job fell to 7.43 million in January from 7.84 million in December.
• The number of unemployed workers dropped to 7.0 million in January from 7.4 million in December. The greatest increase in employment were in construction, trade contractors and mining. The number of people, who for economic reasons could only find part-time work, remained at 4.1 million. The number of marginally attached workers remained at 1.6 million. My adjusted Comprehensive Labor Index™ dropped to 8.9% while the official unemployment rate reported by the government fell to 4.7%.
• The University of Michigan Consumer Confidence Index in January remained steady at 91.2.
• According to CBO estimates, the government ran a surplus of about $24 billion in January, which reduced the deficit for the first four months of the fiscal year to $95 billion. The current estimate for the full-year deficit is $355 billion.
• According to the Census Bureau, the U.S. trade deficit rose slightly to $65.7 billion in December. For the year, the trade deficit was a stunning $725.8 billion. This was a 17.5% increase from 2004!
• The Labor Department reported that on a seasonally adjusted basis, the CPI for all urban consumers jumped 0.7% in January, with an increase in energy prices accounting for 70% of that increase. The "core" CPI, which excludes food and energy, remained steady at 0.2%.
• The Federal Reserve reported that total outstanding consumer credit rose further in December to  $2.16 billion.
• The American Association of Individual Investors' (AAII) bullish sentiment remained surprisingly weak, holding around 40% for the week ended February 20. This mild pessimism doesn't match up with the consumer confidence numbers. 
• According to the Census Bureau, retail trade and food service sales rose 2.3% in January after a sluggish December.
• The Census Bureau reported that privately owned housing starts in January rose 14.5% from December to a seasonally adjusted annual rate of 2.276 million. This was an increase of 4.0% from the same period last year.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes rose 2.9% in December to a projected 1.27 million units. The estimate of new homes for sale continues to rise, and at 516,000 represents 4.9 months of supply at the current rate of sales.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes fell 5.7% in December to a projected 6.60 million units. The estimate of homes for sale, at 2.8 million, represents 5.1 months of supply at the current rate of sales.
• The Institute for Supply Management (ISM) index of manufacturing activity measured 54.8 in January, down from 55.6 in December. This marks the 32nd 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 "advance 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 1.1% in the fourth quarter of 2005. This is quite a slowdown from the 4.4% showing in the third quarter.
• Also according to the BEA, personal savings was a negative $67.4 billion in December, compared with a negative $21.6 billion in November. Personal saving as a percentage of disposable personal income was a negative 0.7 percent in December, compared with a negative 0.2 percent in November. December marked the seventh consecutive month of negative personal savings.
• The Fed increased M-3 by $92 billion in January. The Fed has increased the supply of M-3 by 8.9% in the last three months.
• Foreigners now hold over $1.557 trillion in US debt, a new record.

Trends To Watch

Certainly the biggest trend to watch right now is the movement on the Dow Jones Industrials and the Transports. With the Industrials above 11,000 and the Transports above 4,400, a bullish trend exists. It's hard to say what the potential upside, or how long this run will last. But until there is a definitive break above 11,000, I'd say that the basic trading range that has held for some time now continues to be in force.

As can be seen clearly in the chart below, the price of gold has grown increasingly volatile over the past three months. The peak price of $575 from a few weeks ago is a 25-year high. I find it interesting that since August of 2005, every price drop has basically found a floor at the 50-day moving average, which is basically where the price is right now. So the overall trend continues to be onward and upward.

Concurrent with rising short-term interest rates and Treasury yields, the value of the dollar is making a recovery. I mentioned last month that I wouldn't be surprised to see a rally, and that has come to pass. 

Finally, let's look at interest rates and the yield curve. Right now, the Fed Funds lending rate is 4.5%. 2-year Treasuries yield 4.68%, 10-year Treasuries yield 4.53% and the 30-year Treasury yields 4.49%. This is a partially inverted yield curve, as you can see from the graph below. When the Fed increases the lending rate to 4.75% at their next meeting, that will very likely create a complete inversion. And while you will likely hear many arguments how "it's different this time", I will be betting on a recession occurring in the subsequent 9- to 12-months.

Personal News and Notes

I hope you will permit me a little pat on the back for a moment. WAM was ranked, out of over 1,500 participating firms, as one of the top-performing money managers in the third and fourth quarters of the 2005 edition of Thomson Nelson Information's World's Best Money Managers.