Current Market Analysis

What a difference a month makes. On the day I wrote to you last month, the Dow Jones Industrial Average closed at 13,950. On July 19th, the Dow closed for the first and only time above 14,000 (14,000.41 to be exact). On August 16, the Dow had fallen as low as 12,517.94 before recovering to close at 12,845.28. That 9% drop (or 11.8% if you take the intra-day low) was due in large part to panic selling from the sub-prime mortgage debacle and resulting credit crisis. Recent actions by the Federal Reserve to inject liquidity into the banking system have, at least temporarily, provided some support and solace to the stock market. The Dow has already recovered some of those losses and closed today at 13,236. It remains to be seen what further measures, if any, will be necessary to forestall further weakness in the days and weeks to come.

Below are two charts of the Dow Jones Industrial Average: a daily price chart and a weekly price chart. The daily chart shows the rapid plunge well below the 50-day moving average before bouncing off the 200-day moving average. The weekly chart, on the other hand, gives you a different perspective. It clearly shows three similar declines over the past year or so. The prior two drops were quickly followed by a strong rally that took the market to new highs. While I'm not suggesting that this will be the case this time, it certainly could happen. And since the general market fundamentals before this crisis were very bullish, it wouldn't surprise me. After a wave of panic selling, a nice rally would be expected. What interests me is what will happen after that initial "relief" rally subsides.

To put the recent action into even greater perspective, take a look at a monthly chart of the S&P 500 dating back to the beginning of this decade. In this context, the recent "correction" is barely a blip on the screen. So take a deep breath, review your investments with your advisor, and continue to take a long-term view of your financial goals and objectives.

The bond market has exhibited the same volatility as the stock market; maybe even more. As stocks have gone down money has flowed into bonds during the expected "flight to quality." The yield on the bellwether 10-year treasury has dropped from 5.3% to about 4.6% as investors have clamored for the safety of government debt. The corollary to this is that yields have dropped so far that equities may again be appealing. And so the cycle goes.

Last Month's Results

• According to the Department of Labor, the most recent four-week average for initial jobless claims, for the week ended August 11, was 312,500, down from 317,750 four weeks ago. At the same time, non-farm payroll employment rose by a meager 92,000 in August, after a slightly better adjusted increase of 126,000 jobs in July. We'll see if the slowdown in job growth is a real trend. Average hourly wages held steady at $17.38. This is the first month I can remember where there was no increase in hourly wages. The average workweek fell slightly to 33.8 hours.
• The number of unemployed workers grew to 7.1 million. The seasonally adjusted number of people, who for economic or business reasons, could only find part-time work, increased to 4.5 million and the number of marginally attached workers fell to 1.4 million. The number of people holding multiple jobs rose slightly to 7.64 million. My Comprehensive Labor Index™ rose to 8.91%, while the unemployment rate reported by the government inched up to 4.6%. While one or two months do not make a real trend, these bad employment numbers are a little ominous.
• According to the CBO, the government posted a budget deficit of $37 billion in July, which brings the deficit for the first ten months of the fiscal year to $158 billion, which was $81 billion less than a year ago. Government receipts are up across the board, which is helping reduce that deficit.
• According to the Census Bureau, the U.S. trade deficit in June was $58.1 billion, down from a revised $59.2 billion in May. The deficit really hasn't changed much this year. Our trade deficit with China alone rose to $21.2 billion for the month. Interestingly, China's foreign reserves have hit $1.33 trillion and they had a trade surplus of almost $27 billion in the last month alone.
• The Census Bureau reported that privately owned housing starts fell 6.1% in July from a revised upward June figure, and was down 20.9% from a year ago, to a seasonally adjusted annual rate of 1.38 million units. New building permits were down about 2.8% from last month and down 22.6% from last year, so the outlook for future housing starts remains poor.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in July fell 6.6% from revised lower June levels, and down 22.3% from the same period last year, to a projected 834 million units. New home sales have been down six of the last seven months, with the one up month seemingly due to builders slashing prices to move inventory. The estimate of homes for sale is now 537,000, which represents 7.8 months of supply at the current rate of sales. The median sale price is only $237,900, below the 12-month average of $244,400.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in June slid 3.8%, and were 11.4% lower than the same period last year, to a projected 5.75 million units. This marked the fourth straight month in which fewer homes were sold than the prior month. The estimate of homes for sale, at 4.2 million, represents a whopping 8.8 months of supply at the current rate of sales. The median price of homes sold increased to $230,100, the fifth straight monthly increase, which I have to admit is a bit puzzling.
• According to RealtyTrac, foreclosure filings rose 9.1% in July and up an incredible 93% from a year ago. Nevada, Georgia and Michigan had the highest foreclosure rates, while California, Florida and Michigan had the highest absolute number of foreclosures.
• The Institute for Supply Management (ISM) index of manufacturing activity was 53.8 in July, down from 56.0 in June, ending a streak of five month in a row in which the index had increased. One month certainly does not make a trend, but it does support my belief that the economy is slowing.
• The Conference Board reported that it's index of Leading Economic Indicators increased 0.4% in July, reversing the decline in June. The Leading Index has grown by 0.1% over the past seven months, suggesting very slow economic growth in the near future.
• The Bureau of Economic Analysis announced that the "advance estimate" of GDP growth for the second quarter of 2007 was a robust 3.4%. This follows the anemic first quarter GDP growth of 0.6%. Remember, there are two more revision to come, so this estimate is likely to change.
• The Federal Reserve reported that the amount of outstanding consumer credit increased by 0.5% from the prior month (or 6% annualized) in June, to $2,460 billion. So the American consumer continues to do his and her part to buttress the economy by borrowing to spend.
• According to the Census Bureau, retail trade and food service sales rose 0.3% in July from the prior month and were up 3.2% from a year ago.
• The Fed increased M-2 by 0.3% in July after a 0.2% increase in June. The supply of M-2 has increased by 3.5% in the last three months and 6.1% in the last twelve months. The constantly increased supply of money is one of the reasons why the value of the dollar keeps falling.

My statement last month proclaiming "next step: $80 per barrel" was obviously a little premature. The price of West Texas crude has again dropped below $70 thanks to the recent indiscriminate panic selling and the fact that Hurricane Dean spared the Gulf Coast, eliminating the temporary "storm premium". I remain very confident in the long-term upward trend for oil prices, but they can do anything in the short-term. If the price slips much further, I will be a buyer.

Like oil, and many of the non-precious metals, the price of gold has slipped over recently. The price of gold is sitting right on its 50-day moving average and just above the 200-day average. If it makes a low here it will continue its trend of making ever higher lows, and probably every higher highs. Like oil, I expect the price of gold to continue to rise over time and would be a buyer on weakness.

There is no clear trend apparent to me in the Dow Jones Commodity Index (which represents 19 physical commodities). What I do find interesting is that the last two times the RSI fell below 30 into an oversold position (see the blue circles) a strong rally followed. I expect similar action this time. Again, I would be a buyer here.

Unlike oil, precious metals and commodities, the chart of the dollar is not just bearish, it's downright depressing. Below I've presented a chart showing the dollar index for the past 20 years. I've been saying for the past year or so that the future of the dollar looks bleak (thank you Federal Reserve). The dollar now hangs on the precipice of its historical low. What does this mean to you and me? It means the continued erosion of the purchasing power of the green stuff in our wallets. It means that it keeps getting more expensive to travel overseas. It also means that our trade deficit will continue to shrink as it gets cheaper to send our goods overseas and more expensive to bring their goods into our country. This is hardly the picture of an economic superpower. If/when the Fed cuts rates below 5%, I think the dollar index will fall below 80.

We can thank the housing debacle, which I've been predicting for more than a year, for the deterioration of the market over the past month. The chart of the housing index is very ugly. The plunge over the past three months is horrifying, and it was predicted somewhat by the crossing of the 50-day and 200-day moving averages (see the blue arrow). I wouldn't be surprised to see a short-term recovery based upon the highly oversold situation. But I also believe that the worst is yet to come, despite the efforts of the Fed. I believe it will likely be at least another year before the housing sector gets appreciably better.

As noted in prior months, the curve is no longer inverted. Historically, this typically means a stronger economic outlook, a little more risk of inflation and a stronger dollar. This really isn't the case right now. The spread between the 10-year Treasury and the 10-year TIPS has fallen to 2.16%, which suggests virtually no fear of inflation in the bond market. And as noted earlier, the dollar is at an historically low valuation. I thought that we'd sink into a mild recession in second half of this year. While that may or may not happen, I do believe that the economy is slowing and that rates will be falling soon.

I'm going to post a chart here for the first time. I'm borrowing this from John Mauldin's wonderful weekly newsletter, Thoughts From The Frontline, dated August 3. This shows the amount of adjustable rate mortgages that reset each month for the first half of this year and will reset for the next 18 months. Note that these reset numbers are a driving factor in the increasing rise in foreclosures, because borrowers cannot afford to pay the higher monthly payments after their mortgage rates are reset to much higher levels. Note that the largest portion of resets do not occur until next year.

As I have said to a few of my clients over the past few days, now is not the time to panic. Indeed, one of the things that my clients pay me for is to be a calming influence during volatile times in the market. Look, I don't know what's going to happen in the market tomorrow, next week or next month. I do though believe that the overall trend of the market is up and that this is a natural, if painful, correction in a long-term bullish trend. It is perfectly reasonable to get out of investments that are negatively impacted by the mortgage debacle and the liquidity crunch. And we have done that at WAM. But that doesn't mean that you should sell otherwise solid holdings just because they've gone down during a wave of panic selling. Don't let your emotions get the best of you. I've said it before and I'll say it again; investing is a marathon, not a sprint.

I still believe in the long-term investment thesis of each of my core sectors: energy, natural resources, precious metals, defense, and large-cap diversified financials, although the latter are going to tough times right now. I also think it's a good time to have solid international exposure and a smattering of other ideas like water and food. They important thing is to buy good stocks, at good prices, in the right sectors, and hold them until it no longer makes sense to do so. You should also be maximizing, wherever possible, current income through dividends and interest. That provides a buffer during difficult times like these.

This past month I sold my one mortgage related holding at a loss. While I believe this highly profitable and well run company will ultimately survive this crisis, I couldn't take the risk that the credit crunch might somehow drive them into bankruptcy. I also sold mutual funds that had broad exposure to credit sensitive holdings. I also sold a couple of broad themed mutual funds, even though they both have wonderful long term track records, because they didn't conform to my sector beliefs and it enabled me to raise a little cash.

While I was selling some non-core holdings, I was adding to core positions for new clients. It's also difficult to predict the bottom, and therefore the timing of these purchases may prove to a bit premature in the short term, but in the long run, I'm very confident that these acquisitions will be enormously profitable, as they have been for the past few years. And that, my friends, is what we're trying to do here - create wealth through a discipline of intelligent and patient investing.

Here are some other interesting tidbits I've come across over the past few weeks. According to the New York Times on July 12, a parking space in a private building in New York City was sold for $220,000. That's a good house in most of the country. China has recently passed Germany as the worlds third largest economy; only the United States and Japan are bigger. And that won't last too much longer. According to the website ml-implode.com, there have been 135 mortgage lenders that have imploded since 2006. While this may not be a perfectly accurate list, it does provide a stark picture about what is happening in the mortgage lending industry. I imagine heavy collateral damage is being done, or will be happening, to real estate brokers, appraisers, home inspectors and closing attorneys. And as the chart I provided above regarding upcoming mortgage resets shows, the worst may still be yet to come.

It's hard to believe that summer is almost over. The kids are all home from camp. The weather is already turning cooler. School starts in only two weeks. Where did the time go? I know that many of my readers are enjoying some vacation time right now. Given what's been going on in the stock market, it's probably a good time to be lying on a beach somewhere enjoying a tropical drink or two, rather than watching CNBC or reading the Wall Street Journal.

For those of you who missed my announcement last month, I'm very pleased to announce that WAM was ranked by Financial Advisor magazine as the 28th (out of 104) fastest growing investment advisory firm in 2006, among those with assets under management of less than $100 million. Our growth rate last year was 37.5%, as opposed to the average of 25% for the 471 firms in the survey. To view the survey in its entirety, please click here. We could not have achieved this growth without the continued faith and support of our clients, so thank you very much.

I wrote my first newsletter in August 2003, so I have now been writing "News and Views" for four years. I sent that first edition to fewer than 200 people. I now have over 1,000 readers. I hope my readership will continue to grow in the years to come.

Finally, I want to thank those of you who took the time to complete my survey a few weeks ago. I appreciate all of the constructive criticisms and compliments. I will take those comments and try to make "News and Views" even better in the future.

As always, I thank you very much for your continued interest and support and I look forward to writing to you again shortly.

Best regards,