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Valhalla, NY 10595

June  10, 2005 Comments   |   Refer A Friend   |   Sign Me Up   

As a reminder, the chapter entitled "Sector Rotation Investing" that I contributed to The Black Book on Personal Finance is available for sale. If you haven't already downloaded a copy, please take a moment and check it out. The suggested retail price for the e-book is $19.95. As a special accommodation to my readers, I have negotiated a 20% discount off the list price. To purchase the chapter, please click here to visit the publisher's website. When you are asked for a priority code, type in "WAM" (this must be in all caps). From there, just click the "buy now" button and follow the instructions.Thank you.

Market Analysis...The Roller Coaster Ride Continues
Last Month's Results - Better
What I'm Doing Now...Watching and Waiting
Statistics...Half Full or Half Empty?
Trends To Watch
Personal News and Notes

Market Analysis...The Roller Coaster Ride Continues

Through the end of May, we have had two up months and three down months, leaving most of the major averages in negative territory for the year. That means that most investors are down so far this year. (If you'd like to find out how most of WAM's clients are making money this year, give me a call). I said last month that the action so far this year doesn't bode well for the rest of the year, and even with the gains from May, I still think the market will be down for the year come December. 

The Dow closed yesterday 10,503, or about 160 points higher than when I wrote to you last month. The good news is that the average is up solidly from its flirtation with 10,000 a few weeks ago. Our trading range remains intact. I would expect this pattern to continue for most of the year, although as I said before, I still believe the broad averages will all be down for the year. The trick then is to find those areas of the market that continue to outperform, and invest the majority of your money in those sectors.  

Oil prices continue to be amazingly volatile. After falling as low as about $47 per barrel in late April, the price has strengthened again. As I write this, oil is trading for over $54 per barrel. The chart below clearly shows the meteoric rise in prices since the beginning of 2004. It also shows the extreme price volatility since March 1st of this year. It wouldn't surprise me to see prices cool off a bit in the short run, but long term, I expect them to keep rising. The good news is that on an inflation-adjusted basis, prices are not unreasonable.

And finally, we have the remarkable story of interest rates. As the chart below shows, after peaking at about 4.7% in late March, the yield on the 10-year Treasury has plunged to below 4%. And while low yields will generally be good for the stock market, it has been a bonanza for the housing market. I'll talk more about that below. Importantly, the spread between the 10-year Treasury and the TIPS has fallen to 2.41%, its lowest spread of the year. The tightest spread that I've noticed since I began writing this newsletter almost two years ago was 2.0%, so there is still room for further contraction. And what does this mean? It suggests that inflation fears continue to subside and that the Fed may be nearing the end of its schedule of rate hikes. I wrote last month that I thought "that we have one or two more rate hikes left before the Fed pauses to reassess things." I stand by that prediction.

Last Month's Results...Better

As always, I provide the following chart to show the raw results for the month, the quarter-to-date and the year-to-date. May was certainly a better month than April. Growth investors finally got some relief, but still remain the biggest losers so far this year. I don't know how technology investors can sleep comfortably at night given the tremendous volatility in their portfolios.

Interestingly, bond investors are the only ones showing full-year gains so far in 2005. I continue to suggest that every investor should be focused on safety, income and those sectors with the best chance to outperform the broad market. 






S&P 500




Large-cap stocks

Dow Jones Industrial Average




Large-cap stocks

Nasdaq Composite




Large-cap tech stocks

Russell 1000 Growth




Large-cap growth stocks

Russell 1000 Value




Large-cap value stocks

Russell 2000 Growth




Small-cap growth stocks

Russell 2000 Value




Small-cap value stocks





Europe, Australia, Far East

Lehman Aggregate




US government bonds

Lehman High Yield




High-yield corporate bonds

What I'm Doing Now...Watching and Waiting

For the most part, I'm sitting on the sidelines right now. I'm finding precious little to invest in right now. I am perfectly happy to do nothing, rather than chasing stocks at high prices. I did though use the drop in oil prices, and the corresponding drop in the prices of energy-related stocks, to add to some of my existing positions.

A few of my holdings have either split, or announced up-coming stock splits, and many of them have increased their dividends. I love that! It is usually a good indication of financial strength when a company increases its return to shareholders.

As I said last month, one of the key traits of a good investor is to buy intelligently and be patient. Own good companies that pay dividends. Don't get scared out by short-term movements. And don't be afraid of holding some cash. There is nothing wrong with bargain hunting when the opportunity presents itself. 

Statistics to Watch...Half Full or Half Empty?

  • May was a very weak month for job creation, as a meager 78,000 new jobs were added. The five month average is 174,000 which is ok. Average hourly wages continued to rise slowly, hitting $16.03. The average workweek decreased slightly to 33.8 hours.
  • The number of unemployed workers dropped slightly to 7.6 million. The number of part-time workers ticked up to 4.4 million while the number of "marginally attached" workers continued to fall, hitting 1.4 million. These figures caused my "underemployment rate" to fall to 9.47%, while the official unemployment rate reported by the government dipped to 5.1%. No matter how you look at it, IF the numbers can be trusted, unemployment seems to be falling.
  • There were 7.4 million people holding more than one job in May, the same number as April.
  • The four-week average for initial jobless claims rose slightly to 333,500. This figure has been rising for the past four weeks and will bear further attention if this trend continues.
  • The University of Michigan Consumer Confidence Index dropped again to 86.90, again marking the lowest reading since I've been tracking it.
  • According to the CBO, the federal deficit for the first eight months of fiscal 2005 was $273 billion after posting a preliminary deficit of $36 billion in May. The White House claims that the full year budget deficit will come in at $350 billion, rather than the earlier projection of $427 billion.
  • According to the Census Bureau, the U.S. recorded a trade deficit of $57.0 billion in April, up a bit from March, but down slightly from the revised record deficit of $60.6 billion set in February. 
  • The Labor Department reported that the CPI, which measures changes in the prices paid by urban consumers for a representative basket of goods and services, ebbed a bit, rising a slower 0.5% in April on a seasonally adjusted basis, while the "core" CPI, which excludes food and energy, was flat. These numbers eased inflation fears a bit.
  • The Federal Reserve reported that total outstanding consumer credit rose continued to slowly rise, hitting another new record of $2.131 trillion in April. This growing indebtedness is the needle that will likely pop the retail balloon at some point in the near future.
  • The American Association of Individual Investors' (AAII) bullish sentiment continued to rise over the past month, concurrent with the latest market rally, hitting 48.60%.
  • The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in April rose a nominal 0.2% to a projected 1.316 million units.
  • The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes rose a strong 4.5% in April to a projected 7.18 million units.
  • The Institute for Supply Management (ISM) index of manufacturing activity measured 51.4 in May, down from 53.3 in April. This marked the sixth straight monthly decline and the tenth consecutive month that the index remained below 60.0. As the index approaches 50, it indicates a slowing economy.
  • The NYSE reported that a membership seat was sold recently for $2.5 million, which is near the all-time high of $2.65 million, established in August of 1999. Bubble anyone?
  • The Census Bureau reported that factory inventories hit a record of $485.2 billion in April, and have increased for 17 consecutive months. That cannot be good news for business.

So what does all this mean to you? It appears that the economy, outside of the white hot housing market, may be slowing down. I expect the Fed to raise rates again in June. After that? We'll see. Jobs continue to be created, and income keeps creeping up, but so does personal indebtedness. Business seems to be slowing. Will we see a hint of that when companies report their 2nd quarter results? Or maybe not until the 3rd quarter? I suppose this is a case of seeing the glass half full or half empty, and investing accordingly. My outlook for the year continues to be "cautious pessimism."

Trends To Watch

The trading range of 10,000 to 11,000 for the Dow continues to hold. As I write this, the Dow is trading at 10,477. Just keep watching.

Gold is also holding within its trading range of about $420 - $440.

After hitting a dismal low of 10 new highs for the week ended April 25, the number of new highs made by stocks traded on the New York Stock Exchange for the week ended June 3 zoomed up to 135. Investors are more bullish with the Dow around 10,500 than at 10,000. Big surprise. 

The M&A theme continues. Sun Microsystems agreed to acquire Storage Technology for $4.1 billion in cash. Duke Energy will buy Cinergy for $9 billion while Midamerican takes over Pacificorp for $5.1 billion. Pro Logis agreed to buy Catellus Development in a $3.6 billion REIT merger. Washington Mutual is buying credit card issuer Providian for $6.4 billion. And the Maytag repairman is being taken private in a $1.125 billion leveraged buyout. And don't forget the proposed merger of US Air and American West, as the latter tries to keep the former from closing its doors forever.

In another sign of a potential market top, merger wars are breaking out among the rival stock exchanges as the New York Stock Exchange attempts to join forces with the computerized trading system Archipelago, and the Nasdaq attempts to merge with Instinet. Soon, there will be only two major trading platforms in the United States.

The dollar continues to strengthen, trading today at 1.2119, up from 1.2954 vs. the Euro last month.

Oil prices have risen, with the June contract selling for $53.60. What happened to oil going back to below $40? It's not going to happen.

The yield on the 10-year Treasury closed at 4.03%, after getting down to 3.8%.

Average home prices have skyrocketed; up 2.2% in the first quarter and 12.5% in the past year. Homes in Nevada have increased in value by 31.2% and California by 25.4% in the past year. And, according to a May 30 article in Forbes magazine,  "real estate clubs" a new twist on investment clubs, have grown from 44 at the end of 2002 to 177 now. But, don't worry, there's no real estate bubble. Hmmmmm.

Monthly Tip

This month article is written by Michael Guerin of Insight Financial Strategies. He's going to discuss a relatively unknown segment of retirement planning: the Roth 401(k). I hope you find this interesting.

The Economic Growth and Tax Relief Reconciliation Act of 2001 added a provision scheduled to take effect in 2006 which impacts 401(k) plans. Internal Revenue Code Section 402A allows employees to designate some or all of their retirement contributions as after-tax Roth contributions. This effectively creates a Roth 401(k) for employees wishing to choose this option for their retirement plan.[1]

For those unfamiliar with a Roth IRA, a brief review of their favorable tax treatment is worth a mention. Earnings accumulate on a tax-deferred basis, just like a traditional IRA. However, earnings can be withdrawn tax-free if the distribution is considered “qualified.” And, unlike a traditional IRA, there are no required minimum distributions (RMDs) to make once the participant reaches age 70 ½.

As one can see, the advantages to high net worth individuals covered by a 401(k) plan are striking. First, unlike the Roth IRA, there are no income restrictions for participation. And second, contribution maximums for a Roth 401(k) are significantly greater than contributing to a Roth IRA[2]. These two points make the favorable tax status of the Roth IRA available to those who normally couldn’t contribute at all (or enough to matter).

There are, however, a couple of significant points that need to be addressed. The first involves the fact that the EGTRRA is due to sunset on December 31, 2010. Quite simply, it means that the law that created the possibility of a Roth 401(k) could just as easily expire, giving participants potentially only five years to use this option. Another important point to consider is the fact that plan sponsors are not required to extend this opportunity to plan participants in the first place. Without this feature as part of the sponsored plan, participants, although allowed to use this option by law, may not receive the benefit if their current 401(k) sponsor does not include it at all. Finally, designating contributions as after-tax Roth dollars means that participants have to include these contributions as part of their earned income. This would effectively nullify one of the primary advantages of a traditional 401(k), the reduction of earned income through contributions to the plan and possible lowering one’s tax bracket for the given year.

What does all this mean for those currently contributing to a 401(k) plan? And what other alternatives are available as far as tax-favored investing for retirement?

Though there is likely to be an increasing amount of “ink” on the subject of Roth 401(k) provisions, at least initially, not much is likely to change. First of all, even if the proposed benefits of the Roth contribution option are not repealed,[3] without a plan sponsor to offer this option, investors will not be able to take advantage of the program. In the highly competitive (and lucrative) world of qualified plan sponsorship, however, it is possible to foresee increased demand for this option once enough participants become aware of the possible tax-advantage. However, the increased record keeping to track participant contributions to both the “traditional” and Roth options are likely to come at a price.

This hardly comes as a shock to anyone, but the benefits of tax-deferred investing/savings always come with a trade-off. Whether it involves income restrictions, contribution maximums, or liquidity issues, for the high net worth investor there does not seem to be much available by way of alternatives. There is one option that, for the right person, may fit into a useful strategy.[4]

A variable universal life insurance policy (VUL) has a few important features that warrant mention.[5] First, cash value grows tax-deferred.[6] Proceeds, if taken from the policy at surrender, are exempt from taxation to the extent that the withdrawal is less than or equal to the basis in the policy (the withdrawal is basically treated as a return of premium). Second, loans may be taken against the cash value build-up in the policy. This allows a measure of flexibility and liquidity, as loans are without age or time restrictions. Third, premiums are “flexible,” as they are determined by the face amount and the health rating of the person established at underwriting. This allows someone to put money into the policy without predetermined income restrictions or contribution limits.[7]

There is one downside to the strategy mentioned above, beyond the obvious issue that there must be a clear need for life insurance. VUL policies that have been under-funded (i.e. funded with the minimum premium requirement) suffer terribly during a bear market. Poor markets, coupled with the monthly cost of insurance deducted from the cash value, could lead to the choice between surrendering the policy or paying a greater premium to keep it in force.

[1] There is a catch, however, which will be detailed below.

[2] For 2006, a maximum of $15,000 can contributed to a 401(k) plan versus a maximum of $5000 to an IRA (for those aged 50 or older), or $4000 (for those aged 49 or younger).

[3] Currently, Rep. Benjamin Cardin (D_Md.) has recently introduced the Pension Preservation and Savings Expansion Act of 2005, which includes a provision to repeal the ability to designate contributions to a 401(k) as Roth contributions.

[4] The issue involves compliance; i.e. using a suitable “vehicle” for the right client. Both strategies listed in the article are clearly not intended for everyone.

[5] From a suitability standpoint, this could only be used for someone who also has a need for additional life insurance coverage.

[6] This assumes that the policy is not classified as a Modified Endowment Contract (MEC).

[7] There are minimum (set by the insurance company) and maximum (set by the IRS) premium limits established at policy issue.

Michael can be reached at 203-231-7269 or you can email him at

Personal News and Notes

My commercial is currently running every night on the Northern Westchester and Southern Westchester systems of Cablevision in New York. If you haven't seen it yet, and would like to, please click here to go to my website where you can view the clip.

Only two more weeks until school is out for my kids. Then it's two months of travel, camp and time with family. It should be a great summer. I hope you have equally good plans.

As always, I thank you for your interest and consideration, and invite you to contact me if you have any questions, any feedback on "Sector Rotation Investing" or if I can be of service to you in any way.

Best regards,

Greg Werlinich

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