Current Market Analysis

The stock market has been a disaster since I wrote to you last month. After a rallying strongly from the end of March through mid-May, the broad averages have plunged in the last four weeks in the face of sour economic news and record high oil prices. The Dow Jones Industrial Average dropped over 350 points, or 3.03%, yesterday, making it the second worst single-day loss this year. It also left the Industrials down 9.4% this month and 13.6% for the year. If the market stays at this level, it will be the worst single month since sometime in 2002 and the worst June since 1930. In addition, many technical levels have been violated on the downside leaving many market observers worried that the worst is not over yet. I wrote last month that "it wouldn't surprise me to see this pullback extend a bit longer before leveling out a bit." I was right in the direction, but I didn't anticipate the magnitude of the pullback. I have the feeling that we are nearing a capitulation, or blow-off bottom, that will be followed by a period of consolidation lasting through the summer. The market must continue to digest the lousy housing and financial markets, soaring energy and food prices, anemic economic growth and an uncertain political landscape.

It's not going to be pretty, but let's take a look at the charts to see what the market is telling us. Below is a weekly chart of the Industrial Average since 2006. The most important thing to notice is that yesterday the Industrials broke below the March support levels. This is a very bad technical indicator. The next level of support would appear to be around 10,750. Another worrisome fact is that the Industrials have given back more than 50% of the gain from the low set in July 2006 to the high set in October 2007. It will be very important to remain above the next support level of 10,750.

The Transportation average could be the salvation for the stock market. While the Transports have fallen more than 10% from their recent highs, the index remains well above the January low. According to Dow Theory, the Transports and the Industrials must make new lows (or highs) at the same time to confirm the trend. Therefore,this lack of confirmation suggests that the market may not be headed for a total wipe-out. Two months ago I wrote that "it wouldn't surprise me to see a little correction and consolidation before it attempts to revisit the high set last summer." Well, we did in fact beat that high, after which I wrote that "now I think we'll get that correction and consolidation." We're certainly correcting now. The key is to remain above the January low. Stay tuned.

The S&P 500 has edged dangerously close to the bottom of its trading range, as shown in between the blue lines below. It would be a bearish indicator should the index fall below 1,256 (and it is trading at 1,275 as I write this). 

Bonds broke out of their five-month trading range as yields rose to 4.3%. It made sense that bonds would sell off as equities soared, yet they continued to trade down as equities fell earlier this month. It made more sense that investors moved strongly to the "safety" of treasuries as equity prices cratered. This caused yields to drop to just below 4.0% today which is almost right on par with both moving averages. Looking ahead, I expect to see yields slowly rise in step with inflationary fears.

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 June 21, was 378,250, an increase of about 6,250 from the prior month, and 2,250 from the prior week. These numbers continue their inexorable path upward.
• Non-farm payroll employment fell by another 49,000 in May. This was the fourth month in a row that payrolls dropped, with 233,000 jobs being reported as lost since February. As these statistics are revised in the future, you can be sure that the real number of jobs lost could be more than twice than figure. Average hourly wages grew a bit to $17.94 while the average workweek fell slightly to 33.7 hours.
• The number of workers reported in May as unemployed jumped to 8.5 million, leading to an unemployment rate of 5.5%, much higher than the 5.0% reported in April. The seasonally adjusted number of people who could only find part-time work rose to 5.2 million and the number of marginally attached workers held steady at 1.4 million. The number of people holding multiple jobs increased to 7.65 million. My Comprehensive Labor Index™ rose to 10.99%, the highest level since the end of 2005.
• According to the CBO, the government posted a budget deficit of $165 billion in May, which was $97 billion more than a year ago. About half of that deficit was due to the tax rebates. The deficit of $317 for the first eight months of the fiscal year billion is running about $174 billion more than a year ago.
• According to the Census Bureau, the U.S. trade deficit in April was $60.9 billion, up from a revised lower March figure.
• The Census Bureau reported that privately owned housing starts dropped 3.3% in May, after a small decrease in April, and was down 32.1% from a year ago, to a seasonally adjusted annual rate of 975 million units. New building permits were down 1.3% from last month and down 36.3% from last year. This suggests that the future of the housing market continues to look bleak.
• The National Association of Homebuilders/Wells Fargo Confidence Index has fallen to a record low of 18. This equals the all-time low set in December 2007 for an index started in 1985.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in May fell 2.5% from the prior month and 40.3% from the same period last year, to a projected 512 million units. That is the lowest figure in the four plus years I've been tracking new home sales. The estimate of homes for sale is now 453,000, which represents a whopping 10.9 months of supply at the current rate of sales. The median sales price fell to $231,000 and is below the 12-month moving average price of $236,817.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in May actually increased 2.0% from the prior month, but were down 15.9% from the same period last year, to a projected 4.99 million units. The estimate of homes for sale, at 4.485 million, represents 10.8 months of supply at the current rate of sales. The median sales price rose to $208,600, which remains below the falling 12-month average of $210,042.
• According to RealtyTrac, foreclosures increased 7.4% in May to 261,255, marking the third straight monthly increase. Foreclosures are 48% higher than a year ago. Nevada, California and Arizona, respectively, reported the highest foreclosure rates in the country.
• The Institute for Supply Management (ISM) index of manufacturing activity was 49.6 in May, marking the fifth out of the past six months in which the manufacturing sector failed to grow. The ISM index of non-manufacturing activity increased to 51.7, suggesting that the service sector is growing a bit.
• The Conference Board reported in May that it's index of Leading Economic Indicators rose 0.1%, making this the third straight month of a 0.1% gain. Part of this month's gain was due to strong stock prices. Surely that will not be the case next month. The six-month rate of decline has slowed to -0.7% (or -1.4% annualized). The economy remains weak, but isn't getting weaker.
• According to the Bureau of Economic Analysis, the "final" estimate of GDP growth in the first quarter was 1.0%, up from the "preliminary estimate" of 0.9%. Remarkably this was an improvement over the 0.6% GDP growth reported in the fourth quarter. Personally, I find that almost impossible to believe. I'm convinced we've been in a recession since the fourth quarter of last year and that it continues today.
• The Federal Reserve reported that the amount of outstanding consumer credit increased by 0.4% from the prior month in April, to $2,565 billion. Amazingly, the American consumer continues to borrow and spend. I maintain that this MUST stop sometime in the coming months.
• According to the Census Bureau, retail trade and food service sales rose 1.0% in May and were 2.5% better than a year ago. Retail sales are holding up amazingly well, all things considered.
• The Fed increased M-2 by a modest 0.1% in May. The supply of M-2 has increased by 5.4% in the last three months and 6.3% in the last twelve months. It appears that the Fed has actually decreased the rate of increase in the money supply in the past two months.
• Consumer confidence continues to decline. The June Conference Board Consumer Confidence Index fell to its fifth lowest figure ever. Looking ahead, consumers' economic outlook is so bleak that the Expectations Index has reached a new all-time low.

Given how many segments of the economy are in crisis right now, it's hard to say that any one is the most important, yet I suggest that the financial sector may be the leading indicator of the economy and the stock market. If that premise is correct, things don't bode well for the near term future of the market. With banks losing hundreds of billions of dollars and laying off tens of thousands of workers, their financial picture continues to deteriorate. Citigroup is trading at a ten-year low and Bank of America is at a six-year low. And I don't think the financials are out of the woods yet. More pain is on the way. It's likely that one or more major commercial bank and investment bank will lose their independence before the year is over. Now is not the time to be bottom-fishing in bank stocks.

The other disaster of this economy is the housing market. For months I've been writing that I didn't believe the worst was over and that I thought that we'd seen a bunch of "false bottoms". Well, the trap door has been opened and housing has fallen through that floor. Like the financials, I wouldn't put any money to work in this sector just yet.

I think Buzz Lightyear's famous tagline from "Toy Story" - To Infinity And Beyond! - is the perfect description for the oil market right now. As you can see in the chart below, the price of oil has been on an almost parabolic rise that has almost tripled the price of oil in the past eighteen months. Last month I suggested that before we see $150 per barrel, "I expect the price to correct back below $120." Well, the price fell to $121.61 before continuing its remarkable rise to above $140 today. It's time to dust off those bicycles my friends.

The big pictures shows the price of gold continuing to consolidate between $850 and $1,000. Looked at more closely, you'll see gold explode upward in the past couple of days. Yesterday gold surged $33.10 per ounce, which was the largest one-day move in twenty-three years. The yellow metal is up another $16 so far today. This is panic buying, and if the market settles a bit next week, I expect gold to settle down a bit. I'll say it again, 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 rampant 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.

Amazingly, in the face of all the dire economic news, the price of copper is rising. Is the Doctor telling us that the economy will be improving in the future? Or is simply a factor of a commodity price reacting to inflationary pressure? Either way, the double-top formation has been broken, which is a good technical indicator. It's also positive the the price remains above both moving averages. So mark this down as positive.

After a gain of more than 5% over the last three months, the dollar has again rolled over and fallen steeply after the decision by the Federal Reserve this week to hold rates steady. If the dollar is waiting for the Fed to raise rates before it strengthens further, I think it's going to have to wait a while. While I believe the Fed needs to raise rates to curtail inflation, they can't possibly do it until the economy has improved. Raising rates now could send this economy through a recession, right into a depression. So for now, we'll continue to live with a weak dollar.

If you think the rest of the world is doing much better, you'd be wrong, as evidenced by the chart below of the EAFE Index. The EAFE is down about 20% from its high, as is the Dow Industrial Average. The world markets are becoming more and more correlated, which makes it more and more difficult for investors to find uncorrelated assets in which to invest.

If you want to feel better, look at the Shanghai Index, which I use as a proxy for China. Here we have a drop of about 56% in just over seven months. Last month I wrote that "I'm not sure if this rally has legs though. It doesn't look like a convincing rally just yet. I'm still not ready to put any money to work in China based on this chart." I hope you didn't either.  

Last month I suggested that "there will be no changes to interest rates for the remainder of the year as the Fed would not want to be seen as impacting the election one way or another. But I believe that whenever the next change is made to interest rate policy, it will be to increase, not decrease, them." One meeting down, no rate changes. And unless the economy improves, there's no way they'll do so any time soon.

What I'm Thinking and Doing

Personal News and Notes

Greg Werlinich
President

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