Current Market Analysis

While the broad market averages are lower today than they were a month ago when I last wrote to you, I believe the overall picture may be brightening a bit. Last month I suggested that "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." I may have been a few weeks too early, but I may have been right with the sentiment. After a scary blow-off surrounding the Bear Stearns and Carlyle Group hedge fund crises, followed by massive intervention by the Federal Reserve, the market may have finally discounted all of the bad news and is starting a longer-term rise.

It's interesting how market sentiment works. The more bearish investors and pundits get, the more likely it is that things are already getting better. The best investors usually trade opposite the crowd because that's how the big money is made. When everyone is saying the same thing it's usually time to look the other way. So when investors are putting all of their money in cash and bonds, even when those instruments are yielding less than inflation, and the experts are predicting the end of the banking system as we know it, smart investors are putting their money back to work in equities.

So has the "bottom" been made? Is the worst now behind us? While I don't know for sure if the market bottom was made a few weeks ago, I do believe that, although it is far from over, the very worst of this credit/lending crisis is likely behind us. It may take years for the full extent of the housing crisis to run its course and for prices to move up again but I think this has already been discounted in the market. The Federal Reserve has used a number of different methods at its disposal to stimulate the economy, including lowering the Fed Funds rate, the inter-bank lending Discount Rate and opening that lending window to the investment banks. This basket of stimulus will likely help pull the economy out of the recession a little sooner than it would otherwise have done on its own.

Now let's see what the charts are telling us. I'm going to start with an updated version of the very busy daily chart of the Dow Jones Industrial Average that I showed you last month. Importantly, you'll notice the January and early March violations of the lows set last March. It is very important that the Industrials are trading well above the recent lows and that the Transports (shown below) never violated its lows and are now trading well above those low levels. The Industrials are now trading higher than the 50-day moving average and moving up towards major support levels around 12,750. If that support can be breached, the market could move significantly higher.

I've also included a monthly chart to give you a little more perspective. You'll note that the prior two bear markets/corrections took the industrials down 41% and 31%, respectively, versus a more modest 17% loss in the current correction. This suggests that the market could still go much lower. On the other hand, the market has managed to work off the highly overbought status and yet not violate a 22-year rising trendline. Again, if this trend can hold, it would be very bullish.

This may be one of the most important charts of the market, yet almost nobody is talking about it. Not only did the Transportation average not confirm the March lows along with the Industrial average, but it has managed to move steadily higher, suggesting a strong future for the economy. Somehow the Transports managed to move higher in the face of tremendous negative news and sentiment. Should this index manage to move above support at 5,000, that would be very bullish. I would also like to see the 50-day moving average move above the 200-day average

It's been a while since I showed a chart of the S&P 500 but I thought it would be instructive since it is the most widely used proxy for the stock market. After a massive breakdown in a head-and-shoulders pattern followed by the same double-bottom as the Dow Industrials, the S&P is consolidating and is now midway between that bottom and a rising support just north of 1,400.

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, and again a few weeks ago, at the height of the Bear Stearns mess. As stocks have recovered, money has naturally flowed out of bonds, lifting yields a bit. Yet this chart shows an almost perfect series of lower highs and lower lows, suggesting that trend is not over yet. As I said last month, "I don't think that the top has been made yet in the bond market. I wouldn't be surprised to see yields 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 March 15, was 365,250, an increase of almost 18,000 from five weeks ago. These numbers continue to increase slowly but surely.
• Non-farm payroll employment fell by 63,000 in February. This was the second month in a row that payrolls dropped, as 22,000 jobs were lost in January. I'm confident that these numbers, when revised in the future, will end up being far worse than the current estimates. Average hourly wages grew a bit to $17.80 while the average workweek held steady at 33.7 hours.
• The number of unemployed workers amazingly fell to 7.4 million, leading to a lower unemployment rate of 4.8%. It's impossible to believe these numbers. It's likely that the unemployment rate is falling because fewer people are bothering to actually look for work. The seasonally adjusted number of people who could only find part-time work rose to 4.9 million and the number of marginally attached workers fell to 1.6 million. The number of people holding multiple jobs rose to 7.60 million. My Comprehensive Labor Index™ fell to 10.07%.
• It is estimated that the number of jobs lost was revised lower by 196,000 in just the past three months. Yet that includes 135,000 jobs that were "created" by the birth/death ratio (discussed last month). As these figures are revised later this year, expect the number of jobs lost to be revised much lower than anyone expects.
• According to the CBO, the government posted a budget deficit of $174 billion in February, which was $54 billion more than a year ago. Part of this deficit was simply a factor of timing, moving certain outlays to February rather than March. The deficit for the first five months of the fiscal year is running about $100 billion more than the prior year, mostly thanks to the war efforts.
• According to the Census Bureau, the U.S. trade deficit in January was $58.2 billion, more than the revised lower deficit of $57.9 billion reported in December. Our trade deficit with China moved back up to $20.3 billion after a big drop to $18.8 billion in December.
• The Census Bureau reported that privately owned housing starts fell 0.6% in February, after increasing by 7.1% in January, and was down 28.4% from a year ago, to a seasonally adjusted annual rate of 1.065 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. Housing starts and permits are down to 1991 levels.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in January fell 2.8% from the prior month and 33.9% from the same period last year, to a projected 588 million units. That is the lowest figure in the four plus years I've been tracking new home sales. And this follows a 4.6% drop in December. The estimate of homes for sale is now 482,000, which represents a whopping 9.9 months of supply at the current rate of sales. The median sales price plunged to $216,000, while the 12-month average dropped further to $239,183.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in February rose 2.9% from the prior month, but were still down 23.8% from the same period last year, to a projected 5.03 million units. This was after a 0.4% decline in January. The estimate of homes for sale, at 4.03 million, represents 9.6 months of supply at the current rate of sales. The median sales price fell to a very low $195,900, which remains below the falling 12-month average of $214,233, and was down 8.2% for the year.
• According to RealtyTrac, foreclosures decreased 4.0% in February to 223,651 after an 8.0% increase in January. Foreclosures are still 60% higher than a year ago. Nevada, California and Florida, respectively, reported the highest foreclosure rates in the country.
• According to the S&P/Case-Shiller home price index, home prices in 20 metropolitan areas fell in January by the most on record. The index dropped 10.7 percent from January 2007, after a 9 percent year-on-year decrease through December 2007. The gauge has fallen for 13 consecutive months. Price declines will continue as foreclosures add to a glut of unsold properties, and stricter lending rules make it harder to get financing.
• The Institute for Supply Management (ISM) index of manufacturing activity was 48.3 in February, marking the second out of the past three months in which the manufacturing sector failed to grow. The ISM index of non-manufacturing activity increased to 49.3% from the horrible 44.6% level in January. So both the service and manufacturing sectors are contracting.
• The Conference Board reported that in February it's index of Leading Economic Indicators fell 0.3%, marking the fifth consecutive month that the index has declined. The leading index fell 1.5% for the past six months, or 3.0% annualized.
• I wrote last month that the 4.9% rate of GDP growth in the third quarter was misleading and would fall in the fourth quarter. Sure enough, the Bureau of Economic Analysis announced that the "preliminary estimate" of GDP growth for the fourth quarter of 2007 was only 0.6%. I don't expect subsequent revisions to move this figure much higher, and could in fact nudge it even lower.
• The Federal Reserve reported that the amount of outstanding consumer credit increased by 0.3% from the prior month in January, to $2,524 billion. Consumer credit increased by 5.5% in 2007.
• According to the Census Bureau, retail trade and food service sales fell 0.6% in both January and February, but remained 2.6% better than a year ago. These sagging retail figures reinforce the poor near-term economic outlook.
• The Fed increased M-2 by a whopping 1.4%% in February, the largest single one month increase I can remember. The supply of M-2 has increased by 10.3% in the last three months and 6.9% in the last twelve months. According to John Williams on his website "Shadow Government Statistics" (www.shadowstats.com), the increase in M-3 now approaches 17% as the Fed tries to inflate us out of this recession.
• Consumer confidence has plunged to the lowest level since the oil embargo of 1973. According to the American Bankruptcy Institute, personal bankruptcies are at the highest levels since 2005. Wholesale prices are rising at faster than expected rates. In other words, the economy is in terrible shape. Indeed, things could be just about as bad as their going to get. I look for things to start improving in the next month or so.

So is the financial sector out of the woods yet? Has the bottom been made? Is it time to be a buyer? Good questions all. I don't think their completely out of the woods yet, and I don't know if the definitive bottom has been made, but I think it could be a time to be a selective buyer for long-term investors. Last month I wrote that "I think there will be one more big blow-off that will set the stage for a big rally." It looks like that may be exactly what happened. I used that blow-off to buy a little bit of one of the major players on what so far is its low price for the year.

The picture of the housing sector looks very similar to the financial sector. I have long been bearish on housing as there have been many false "bottoms" that have sucked investors back in, only to leave them with big losses as the sector continued its downward spiral. Even so, last month I wrote that "the worst may be known, setting the stage for a big rally. I'm just not ready to invest yet in that possibility." Maybe I should have put some money where my mouth was as there has indeed been a powerful move up. I just want to see if this rally has some legs.

As recession fears continue to mount (I called this recession late last year), and equities have begun to recover, commodities and hard assets, including gold and oil, have sold off a bit. After a brief correction early this year, the price of West Texas Crude surged to a new all-time high of $110 per barrel. Not surprisingly, it has again begun to correct, back to about $100 per barrel. With all of this volatility, oil remains well within its trading range. I expect the price of oil to consolidate for a while, and possibly drop as low as $90 per barrel, before resuming its upward path. I don't believe we've yet seen the high price for oil this year.

So let's look at one of my other favorite sectors - gold. I've beaten the drum for owning gold since late 2001 when gold was about as hated as it could possibly be. And today, after the price has risen from about $250 an ounce to over $1,000 an ounce, there is still a lot of disagreement as to the virtues of owning gold, and therein lies the opportunity. Two months ago 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. Last month I said that "I expect the price of gold to break $1,000 before the year is over, and possibly before this quarter is over." That's exactly what happened one week ago as the yellow metal soared to $1,033 per ounce. The price has now fallen about $100 in the last week. Nobody said this would be painless. Still, the trend is undeniable. Use any period of consolidation as a buying opportunity.

What about copper prices? It's a little surprising to me that copper has sold off severely the past month. I would have expected this economically sensitive commodity to have continued its positive trend, yet it seems to have sold off in sympathy with the rest of the commodity sector. I think this is simply profit-taking. I would expect copper prices to firm and move higher in coming months.

Last month I talked about the triangle pattern that had formed over the prior three months as the dollar index consolidated. I suggested that the actions by the Fed would likely cause the index to break lower, which is exactly what happened. But there may be life yet in the old greenback. Since the most recent action to cut Fed Funds rates by 75 basis points rather than 100 basis points helped prop up the dollar as it appeared the Fed wasn't yet prepared to drop rates to nothing. The resultant rally in the dollar is part of the reason for the weakness in commodity prices. While I think this rally could last for a while, I still believe the long-term trend for the dollar is lower.

Below is another chart that I haven't shown in a while; the Dow Jones Utility Average. Utilities were one of the best performing sectors in 2007. It is likely one of the worst performing sectors so far in 2008, and to be honest, I'm really not sure why. Utilities are traditionally thought to be highly sensitive to interest rates, and therefore, do well in falling-rate environments. So why are they doing so badly while rates are falling? Are they warning us of a future danger? Or is it simply the market rotating funds out of a "safe" sector into more aggressive areas? Either way, the utilities are sitting right on a major support level. It would be very bearish if this average fell below 470.

When I wrote last month, the Shanghai Index, which I use as a proxy for China, had dropped about 30% from the October peak before pausing a bit. I told you it was not a good looking chart and that "I would be very wary of putting money into China right now." I hope you listened as China has fallen further and is now down over 42% from that October high and is trading close to support around 3,500. I would still avoid putting money to work here until the index can rally from its oversold status. If not, the next support level is around 2,500.

The yield curve continues to steepen as the spread between the 2-year and 30-year notes widens. This suggests a stronger economic outlook, and better earnings potential for the banks who can now borrow cheaply and lend at higher rates. The Fed confounded my prediction last month that they would only cut by 25 basis points when they lowered the Fed Funds rate by 75 basis points to 2.25%. My guess now is that the rate cuts are either done, or there will be one last 25 basis point cut at their next meeting in May. The good news is that this will ease the lending crisis, and may ultimately help the mortgage crisis, but it will at the same time create a savings crisis because savings rates are now below the rate of inflation, which means that you actually lose money with your cash in the bank.

What I'm Thinking and Doing

Personal News and Notes

Greg Werlinich
President

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