Current Market Analysis

The good news is that at least temporarily, the market appears to have stopped its slide and is consolidating a bit. On the flip side, the economy seems to be getting worse and worse. So has the market discounted all of the possible bad news, or are we just setting up for a bigger fall to come? I admit to being torn: from a technical viewpoint it appears like we've held some important levels and the Transportation average suggests that things are looking better, but I also believe that we're not done with the bad news. That being said, I still think that the worst will be over in the first half of the year, and that we'll set up for an improved economy in the second. Therefore, I feel that, for the most part, the worst of the market action is likely over. That's not to say there won't be any more losses, but I believe those losses will be modest. I'm looking for a period of consolidation for the next few months leading to a second half rally.

Interestingly, with all of the turmoil in the past few weeks, the Dow Jones Industrial Average is almost exactly at the same level as when I wrote to you last month. The fact that the market is hanging in there in the face of increasingly bad economic news buttresses my view that the market has already discounted most or all of the bad news to come. As more and more experts admit that we are already in a recession, or at least heading towards one (a position I've been writing about for months), the more I believe it will likely be a mild one, and done before the government even gets around to admitting its existence. For investors willing to put some money to work in the right sectors, this presents an opportunity to make some money when the market recovers.

Please forgive me for showing a very busy daily chart of the Dow Jones Industrial Average, but I wanted to show a few things. First, you can see classic "head and shoulders" pattern formed between August and December last year. Next, you can see that pattern break down with the January violation of the August low. That descent crashed through a second support level of around 12,000 set last March. The good news is that while that support level was clearly broken, it quickly recovered and is now consolidating between 12,000 and 12,750. If we can stay in this range for a while, allow the 50-day moving average to move back up towards the 200-day average, and allow relative strength to recover a bit, I think the stage will be set for a good rally.

The next chart is a weekly picture of the Industrials since the beginning of the bull run in 2003. What you'll notice here is that RSI and MACD are oversold but recovering, and that while the basic trendline has been violated, it isn't clear which way the trend is headed. Rather than guess, let's just watch what happens over the next few months.

The positive action of the Transportation average is a bit of a mystery given all of the negative sentiment swirling around today, yet according to Dow Theory, offers a lot of hope for the future of the market. The Transports are now about 670 points above the lows set less than a month ago. And as this average is very economically sensitive, it suggests that the forward looking mechanism of the market is telling us that things will be getting better rather than worse.

As the equity markets cratered, the bond market boomed, reducing yields on the 10-year Treasury to historic lows. The yield on the 10-year note fell to as low as 3.28% about a month ago at the nadir of the stock market collapse. As stocks have recovered, money has naturally flowed out of bonds, lifting yields a bit. These low yields could go a long way towards helping the crisis in the housing sector, giving homeowners a chance to refinance adjustable rate mortgages into reasonably priced 30 year fixed loans. I don't think that the top has been made yet in the bond market. I wouldn't be surprised to see yield approach 3% before the recovery in equities begins in earnest.

Last Month's Results

• According to the Department of Labor, the most recent four-week average for seasonally-adjusted initial jobless claims, for the week ended February 9, was 347,250, an increase of almost 20,000 from three weeks ago. I expect this number to continue to increase for a few months.
• Non-farm payroll employment fell by 17,000 in January. This was the first time payrolls dropped in more than four years. This followed a revised gain of only 82,000 in December. Goods production, manufacturing and production continues to lose jobs with lower paying retail and service jobs showing the majority of the growth. There have been 284,000 construction jobs and 269,000 manufacturing jobs lost over the past year. Average hourly wages grew a bit to $17.75 while the average workweek fell to 33.7 hours.
• The number of unemployed workers fell to 7.6 million. The seasonally adjusted number of people who could only find part-time work rose to 4.8 million and the number of marginally attached workers rose to 1.7 million. The number of people holding multiple jobs fell to 7.40 million. My Comprehensive Labor Index™ rose to 10.21%, while the unemployment rate reported by the government rose fell to 4.9%.
• 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. This calculation over-estimates job growth during slow times (like today) and under-estimates growth during boom times. What this means is that the real job numbers are much worse than most people realize. 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 $15 billion in January, which was $23 billion less than a year ago. The deficit for the first four months of the fiscal year is running about $48 billion more than the prior year.
• According to the Census Bureau, the U.S. trade deficit in December was $58.8 billion, less than the $63.1 billion reported in November. The December figure is basically in line with the average result from the past year. Our trade deficit with China dropped to $18.8 billion.
• 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 4.7% from the prior month and 40.7% from the same period last year, to a projected 604 million units. That is by far the lowest figure in the four years I've been tracking new home sales. The estimate of homes for sale is now 495,000, which represents a whopping 9.6 months of supply at the current rate of sales. The median sales price plunged to $219,200, while the ever-shrinking 12-month average dropped to $242,383.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in December fell 2.2% from the prior month, and 22.0% from the same period last year, to a projected 4.89 million units. The estimate of homes for sale, at 3.91 million, represents a smaller 9.6 months of supply at the current rate of sales. The median sales price fell slightly to $208,400, which remains below the 12-month average of $216,758 and was down 6.6% for the year.
• According to RealtyTrac, foreclosures increased 6.8% in December to 215,749. Foreclosure filings were up a huge 75% from a year ago. Nevada, Florida and Michigan, respectively, reported the highest foreclosure rates in the country.
• The Institute for Supply Management (ISM) index of manufacturing activity was 50.7 in January, breaking a streak of six straight months in which the index had decreased. That is potentially very good news. On the other hand, the ISM index of non-manufacturing activity plunged to 44.6%, the lowest reading since 2001. And since the service sector represents about 90% of our economy, this is very worrisome. 
• The Conference Board reported in November that it's index of Leading Economic Indicators decreased for the third consecutive month, and had been down five of the last seven months. The leading index fell 1.2% for the past six months and 1.8% for the year. 
• 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.

Below is the graph of the Financial Spyders Index. After a powerful rally in late January (maybe a "dead cat bounce"?), the financials have sold off again so far in February. The overall trend is still highly negative. I don't think all the bad news is out yet by a long shot. And while I do believe the day to again invest in the financial stocks is coming, I don't believe it is here just yet because I think there will be one more big blow-off that will set the stage for a big rally.

While the price of West Texas Crude corrected strongly after breaking the magic $100 per barrel barrier at the end of 2007, yet it still remains within a trading range, and has started to move back towards the old highs. As I have said repeatedly, I believe that the price of oil could consolidate for a while, and possibly get as low as $80 per barrel, but I'm confident that demand and other forces will again drive oil above $100 per barrel.

So let's look at one of my other favorite sectors - gold. I've been beating the drum for owning gold since late in 2001 when it wasn't nearly as fashionable as it is today. In fact, gold was about as hated as it could possibly be. And even today, after the price of gold has risen from about $250 an ounce to about $925 an ounce, there is still a lot of disagreement as to the virtues of owning gold, and therein lies the opportunity. Last month I suggested that gold needed to consolidate a bit and could fall as low "as $850 before beginning the next phase of this bull run." It was obviously lucky that gold bottomed out at $849.50 before moving higher again. Still, the trend is undeniable. 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.

So what is Dr. Copper telling us about the economy? Interestingly, the price of copper, which like the Transportation average, is highly sensitive to the economy, has shown a very favorable trend for the past few months. This also suggests that better times are ahead of us. 

The chart of the dollar looks interesting to me. After a seemingly endless drop since peaking in 2001, the dollar index hit bottom in November and has formed a triangle pattern for the past three months. I admit that I have been consistently bearish on the dollar for a few years now, and I'm not ready to call a bottom yet. It will be interesting to see how the dollar breaks out of the triangle - up or down. The impending Fed rate cuts are likely to weaken the greenback even further, but that could also be cooked into the price right now, so I'm not sure. We'll just have to wait and see.

There have been many false "bottoms" made in the housing sector that have sucked investors back in, only to leave them with big losses as the sector continued its downward spiral. So I'm not ready to call an end to the housing crisis. In fact, I think it will likely last another few months. That being said, the worst may be known, setting the stage for a big rally. I'm just not ready to invest yet in that possibility. 

The Shanghai Index, which I use as a proxy for China, dropped about 30% from the October peak before recovering a bit this month. This is not a good looking chart. The 50- and 200-day moving averages are converging, RSI and MACD look bad, and the trendline has clearly been violated and the index is trading below both moving averages. I would be very wary of putting money into China right now.

The yield curve continues to steepen as the spread between the 2-year and 30-year notes widens. This suggests stronger economic outlook. In December 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%." Well, the Fed cut rates 1.25% in the last month, bringing their target rate to 3.0%. It is likely that they'll cut again next month, although I'd be surprised if they cut more than .25%. This will further steepen the yield curve and help stimulate the economy even more.

What I'm Thinking and Doing

Personal News and Notes

Greg Werlinich
President

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