Current Market Analysis

Looked at through the prism of day-to-day activity, it has been a very volatile and noteworthy past month in the market, with a number of 100+ point daily gains and losses. Yet looked at as part of a bigger picture, not much has happened at all. The DJ Industrial Average is trading almost exactly where it was on June 22 when I last wrote to you. In both instances, we find the DJIA teetering precariously close to the 11,000 point mark.

So what's going on in the market? Well, bellwether technology stocks are getting creamed (see Yahoo, Dell, EMC, Cisco and Intel, just to name a few). The homebuilders are doing even worse. Market "experts" are relieved that oil prices have backed off from almost $80 per barrel to "only" $75 or $76. Gold prices are swinging wildly as they consolidate. The US economy is increasingly showing signs of slowing down. The Middle East is plunging further into war and chaos. South America is moving farther to the political left. North Korea is arming itself. Russia is growing more and more nationalistic. China continues to grow at a breakneck pace. The world's weather patterns are growing increasingly problematic and dire, and the "official" hurricane season has just begun. And yet, Barron's tells us this week that it's "Time To Buy". Buyer Beware!

Last month I told you that while I wasn't sure about the short-term direction of the market, I felt that "we've already seen the highs for the year, whereas we have not yet seen the lows." I'll stand by that statement for the rest of the year.

I find the chart below very interesting. It suggests to me that to break out of the current downward trend, the DJIA would need to rally above 11,150 in order to move even higher. I suspect though that we'll test the lower range of this trend at around 10,500 before too long. August tends to be a relatively dull month in the market as many traders and other participants enjoy a summer vacation. So we'll just have to wait and see what happens.

This month I want to bring back the chart of the DJ Transports because I think we're at an important juncture; one that could be telling us something very important about the status of the economy. The transportation average has fallen dramatically this month, from about 5,000 to about 4,400 - a 12% drop. As this index can be considered a proxy for business getting done in this country, this sell-off bears close scrutiny. While the transports "should" rally from this highly oversold position, it could also be presaging bigger problems ahead.

Now let's take a quick look at the broader market, as represented by the Wilshire 5000. As you can clearly see, the chart looks very similar to the chart of the DJIA. And as with the DJIA, I expect this overall trend to remain downward.

And what is the bond market telling us? Interestingly, bond yields have gone down a bit, after peaking at 5.25%. The overall trend, as evidenced below, continues unabated, and I expect this trend to continue for a while. The spread between the 10-year Treasury and the TIPS has fallen to 2.55%, which is its lowest point in three months. This suggests that the bond market is even less concerned about future inflation. I am growing more firmly convinced that an economic slowdown, if not an outright recession, is looming in the not-too-distant future, probably by the end of this year, or early in the first quarter of next year.

Last Month's Results

As always, I provide the following chart to show the raw results for the month, the quarter-to-date and the year-to-date. As is clearly evident by the chart below, June was a mediocre month with value again leading the way. As I write this, we are about halfway through the market's "worst six months" (May to October), and they have indeed been bad. Maybe we should all just take the rest of the summer off to work on our golf games and tans, then reconvene after Labor Day to assess the damage. Well, it's a nice dream anyway.

What I'm Doing Now

Over the past month I have been raising cash. I have basically liquidated my emerging market and high-yield mutual fund holdings. I have substantially reduced my retail sector holdings. I have sold or been stopped out of some smaller, non-core, stocks. And I have reduced my exposure to some of my riskier small- or micro-cap stocks. I do not like the direction of the broad market right now, so I'm really paring down to the core holdings, then I'm going to sit and wait and watch. And in the meantime, I'm happy to hold more cash. I am by no means in panic-mode right now. I prefer to think of it as being cautiously pessimistic.

Statistics To Watch

• The most recent four-week average for initial jobless claims, for the week ended July 21, has fallen to 315,500.
• Non-farm payroll employment rose by only 121,000 in June, marking the third consecutive month in which job creation trailed the estimate of 150,000 new jobs needed each month just to keep pace with population growth. Average hourly wages increased to $16.70 from $16.62. The average workweek edged up to 33.9 hours. The number of people holding multiple jobs fell to 7.4 million from 7.64 million. On the whole, a very tepid overall picture.
• The number of unemployed workers remained unchanged at 7.0 million in June. The seasonally adjusted number of people, who for economic or business reasons could only find part-time work, rose to 4.4 million. The number of marginally attached workers also rose to 1.6 million. My adjusted Comprehensive Labor Index™ rose to 8.6% from 8.3% while the official unemployment rate reported by the government remained steady at 4.6%. This was the highest CLI I've recorded this year, which is something to keep an eye on.
• After a steep plunge in May, the University of Michigan Consumer Confidence Index recovered somewhat in June, rising from 79.1 to 84.9.
• According to the CBO, the government posted a budget surplus of $19 billion in June, which brought the deficit for the eight-month period to $208 billion, or $41 billion less than for the same period in fiscal 2005. Interestingly, there has been a 22% increase on interest payments on government debt this year and 17.5% increase in Medicare expenses. Add to that an almost 85 increase in defense spending, and you can see where your tax dollars are being spent.
• According to the Census Bureau, the U.S. trade deficit in May rose fractionally to $63.8 billion from $63.4 billion in April. With a $17 billion trade surplus, China has become our largest lender. US exports have improved thanks to a weaker dollar and overall global growth.
• The Labor Department reported that on a seasonally adjusted basis, the CPI for all urban consumers advanced 0.2% in June while the "core" CPI, which excludes food and energy, remained steady at 0.3%. To be honest, while I'll continue to report these figures, I don't think the CPI numbers are especially meaningful.
• The Federal Reserve reported that the amount of outstanding consumer credit grew fractionally in May to $2.17 billion, marking another new all-time high.
• According to the Census Bureau, retail trade and food service sales fell 0.1% in June after a meager 0.1 gain in May. This is an ominous trend, and part of the reason why I've reduced my holdings in the retail sector.
• The Census Bureau reported that privately owned housing starts fell 5.3% in June, and was down 11.0% from the same period last year, to a seasonally adjusted annual rate of 1.85 million. This was the second lowest monthly figure for housing starts since November 2004 and marked four out of the last five months in which housing starts were down.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes rose 4.6% in May, but was down 5.9% from the same period last year, to a projected 1.23 million units. The estimate of new homes for sale leveled off this month, but at 556,000 represents a new high of 6.0 months of supply at the current rate of sales. The average sale price fell from $298,300 to $294,300.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes fell 1.3% in June, after dropping 0.6% in May, and was 8.9% lower than the same period last year, to a projected 6.62 million units. The estimate of homes for sale, a new record at 3.725 million, represents a whopping 6.8 months of supply at the current rate of sales and is the highest level recorded in years. The average price of homes sold rose to $277,000.
• In their June US Foreclosure Market Report, RealtyTrac reported that 88,195 properties nationwide entered some stage of foreclosure during June, down from a high in February of 117,292 and a decrease of 5% from May. But while the recent trends seems favorable, there was still a 17% increase in foreclosures from a year ago.
• The Institute for Supply Management (ISM) index of manufacturing activity measured 53.8 in June, down a bit from May. This marked the 37th consecutive 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. But it is clear that activity is slowing.
• The Bureau of Economic Analysis announced that the "final estimate" of the annualized rate of GDP growth for the first quarter of 2006 was 5.6%, which was higher than the "preliminary estimate" of 5.3% and the "advance estimate" of 4.8%. The primary engine for this exceptional growth rate was an increase in consumer spending, which represents about 70% of GDP. This rate of growth is clearly not sustainable, and therefore GDP growth in subsequent quarters will certainly be much lower.
• Also according to the BEA, personal savings was estimated to be negative $162.9 billion in May, as compared with a revised (downward) negative $153.5 billion in April. The May means that Americans are saving a negative 1.7% of personal disposable income (or spending more than they are making) and makes at least nine straight months of negative personal savings. This can't last forever and has very negative implications for the retail sector.
• According to Economy.com, "more than $2 trillion of US mortgage debt, or one-quarter of all mortgage loans outstanding, comes up for interest rate resets in 2006 and 2007" and "a recent study by First American Real Estate Solutions...projects that about one in eight households with adjustable rate mortgages that originated in 2004 and 2005 will default on those loans." My friends, that is one of the most terrifying statistics that I've read in a very long time. If this is true, or even close to the truth, it could crater the economy.
• The Fed increased M-2 by 0.5% in June. The supply of M-2 has increased by a growing 3.6% in the last three months and 4.9% in the last twelve months as the Fed is again increasing the rate of monetary growth to combat the forces of deflation, which is far worse than inflation.
• Foreigners now hold $1.633 trillion in US debt, down from the record of $1.638 trillion set four week ago.

Trends To Watch

I talk a lot about the DJIA because it is one of the two most recognizable, and often looked at, indicators for "the market". The other widely used proxy for the market is the S&P 500. I would like to thank Richard Russell of the Dow Theory Letters (www.dowtheoryletters.com) for this important illustration, which is a monthly chart of the S&P dating back to 1999. Please pay attention to the arrows at the bottom, in the MACD (moving average convergence/divergence). Without getting too technical, the point is that we may now have reached an inflection point, first shown in early 2000 when the market turned down, then again in early 2003 when the market started heading up. Now this particular technical indicator suggests that we may be heading down again. This is a very important trend to watch over the next few months

As I mentioned earlier, the "guru's" are breathing a sign of relief and cheering that oil prices have backed off the highs of almost $80 per barrel. It's interesting how perspective can change. Who would have thought that $75 oil would be perceived as a good thing? Unless the price of oil falls below about $67 per barrel, the uptrend will remain intact, as does the investment thesis of owning energy stocks.

The hysterical action in gold that began in March continues today, with violent up and down swings, as evidenced in the chart below. I wrote last month that the correction may have been over. It appears that I may have been a bit premature, for while there was a tremendous upward swing from $542 to $676, there has been another huge sell-off to around $618 today. I will stand by my prediction that "I expect that by the time I write this newsletter in September, the price of gold may be back in the mid-$600's." For now, and possible for the rest of the year, gold will likely consolidate between $575 and $675. This will wring out the traders, the speculators and the "get-rich-quick" guys, leaving the long-term investors like myself holding solid positions in advance of the next big move towards $800 and beyond.

The chart on the US dollar continues to look a bit muddled. Again, I've maintained my annotations from last month to show how the index is struggling to pick a clear direction above or below the support level I drew at about $85.50. Part of the recent strength in the dollar must be attributed to the rate increases by the Fed. That suggests that the dollar could see further gains over the next few months, but I believe that longer-term, the dollar is likely headed lower.

The housing picture continues to worsen, as evidenced by the action on the Philadelphia Housing Index. The index is down about 37% from the high set almost a year ago. It is trading well below both moving averages, yet it's only mildly oversold, which doesn't bode well for much of a recovery. Too add further clarity to this deteriorating situation, the Mortgage Bankers Association recently announced that its Mortgage Composite Index, a measure of mortgage loan application volume, was down 4.6% on a week-over-week basis, and down 31.3% compared to the same week a year ago. In addition, according to the National Association of Home Builders (NAHB), the NAHB/WFHM Index of builder confidence slipped to 39 in July, down from a high of 72 last June. Add to that the growth in foreclosures reported by RealtyTrac and you have a very gloomy picture indeed for housing.

Finally, let's look at the yield curve below (the green line is the current one). The Fed Funds lending rate is now 5.25%. There is a lot of debate about what the Fed will do at their next meeting in August. I have a feeling that they'll probably raise the rate to 5.50%. 6-month t-bills yield 5.24%, 2-year Treasuries yield 5.11%, 10-year Treasuries yield 5.06% and the 30-year Treasury yields 5.12%. So we now have an fully inverted, if imperfectly so, yield curve. This further buttresses my feeling that we're going to have a substantial economic slowdown, or outright recession, by the end of this year or early next year.

Personal News and Notes

I hope you have been listening to my pod casts with Bobby Ilich for his program "Ahead of the Curve", on Wallst.net. If you've missed any of these lively and informative broadcasts, I urge you to click on the link, and add it to your Favorite Places. These shows typically run about 15 minutes and are a lot of fun. I hope you will listen in each week.

I haven't decided whether or not to publish an August newsletter. So many people are away in August taking vacations, including your truly, that I may skip a month, as I have done in past years. If I am compelled to write about some breaking news or ideas, I'll pen a shorter issue and publish it earlier in the month. Either way, enjoy the rest of summer. Take some time away from work for yourself, your family or your friends. You'll be glad you did.

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

Copyright© 2006, Werlinich Asset Management, LLC and www.waminvest.com. All Rights Reserved.