WAM, Werlinich Asset Management, Independent, Fee Only, Investment Advisor, Money Manager, RIA, Financial Planner

September 27, 2004 Comments | Refer A Friend | Sign Me Up

Market Analysis...Trending Down
What I'm Doing Now...Adding Defense
Current Trends...Energy Prices and Interest Rates
Statistics...Mixed Bag
Monthly Tip...Healthcare Savings Accounts
Personal News and Notes

Current Market Analysis...Trending Down

The stock market has traded sideways for most of the two months since my last newsletter. While the Dow Jones Industrial Average hit a low of 9,814 on August 12 and a high of 10,343 on September 7, looked at from the date I last wrote to you, the Dow is only down about 1.4% at today's closing price of 9,988. This is the first day the Dow has closed below 10,000 since mid-August. Barring a strong rebound this week, most of the equity indices will be down for the month after a basically flat month in August.

Earlier this month, the Fed continued to make good on its commitment to raise their short-term lending rate at a measured pace when it boosted the Fed Funds rate by 25 basis points. That makes three 25 basis point increases so far this year. It is widely expected that they will increase the rate by another 25 basis points at their November meeting. It remains the accepted wisdom that over the next year or two the Fed will continue to nudge the rates higher until the Fed Funds rate reaches a "normal" level of between 3% and 3.50%. Then, if all is ok in the world, we could expect further increases until a rate of around 5% was reached. The November rate hike is already "baked in" to the market, and it would be a very negative signal to investors if they didn't follow through on it. After that, the Fed can judge whether or not the economy has gained enough traction to continue the rate hikes.

My prediction that the Dow would trade between 10,000 and 11,000 for most of this year continues to hold true, although I'm increasingly fearful that we will close the year below 10,000. We have already recovered from two sub-10,000 breaches, and today marks the beginning of the third. I was pleased to see the Wall street Journal today print the very same chart that I've been sharing with you for months, showing the lower highs and lower lows of the Dow. In my last letter I suggested that the next high for the Dow would be made at around 10,350 or so. I was only off by seven points! So I'll make another prediction. Based on the chart, it would seem that the Dow should touch down at around 9,750 before staging another recovery. Also keep in mind that it is generally bearish for the Dow to remain below both its 50-day and 200-day moving averages.

Often lost in the discussion of "the market", which usually focuses on the Dow or the S&P 500, is the miserable performance of the Nasdaq. As you can see below, the Nasdaq was already down more than 10% for the year in August, and will surely add to that dismal performance by the end of September. So all of the technology investors are again taking a pounding. Those of you who continue to own and buy tech stocks should be very careful and review your investment strategy.

The bond market action continues to be a stunning surprise. After hitting a high of almost 4.9% earlier this year, and falling to about 4.45% in early August, the yield on the benchmark 10-year treasury bond closed today at a remarkably low 3.99%. While I'm not entirely sure how to interpret that action, my gut feeling is that the bond market is worried about something and is therefore keeping rates low. I suppose we'll know more in the next few months. But it is certainly important to keep an eye on the flattening yield curve as short rates rise and long rates fall. The good news is that the low yields have been a boom to the housing market which is once again enjoying record low mortgage rates. So to all of you who missed the last refi boom, now's your chance to jump in.

Index

Aug

QTD

YTD

Description

S&P 500

0.23

-3.21

-0.69

Large-cap stocks

Dow Jones Industrial Average

0.34

-2.50

-2.68

Large-cap stocks

Nasdaq Composite

-2.61

-10.24

-8.25

Large-cap tech stocks

Russell 1000 Growth

-0.49

-6.11

-3.55

Large-cap growth stocks

Russell 1000 Value

1.42

-0.01

3.93

Large-cap value stocks

Russell 2000 Growth

-2.15

-10.94

-5.88

Small-cap growth stocks

Russell 2000 Value

0.98

-3.67

3.88

Small-cap value stocks

MSCI EAFE

0.46

-2.78

1.95

Europe, Australia, Far East

Lehman Aggregate

1.91

2.92

3.07

US government bonds

Lehman High Yield

1.96

3.35

4.75

High-yield corporate bonds

What I'm Doing Now...Staying Defensive, Literally

Earlier this month I added a new position to my defense sector holdings. Other than that, I haven't made any substantial changes to my portfolios over the past two months. Most of my core sector holdings are doing very well, with the exception being some of my small-cap "special situations". As it is rare that all of ones investment ideas work at the same time, I'm encouraged by the action in the bulk of my positions. I am still focused first on the preservation of capital, second on the creation of a reliable stream of current income and third on achieving a reasonable measure of long-term growth.

Trends...Rising Energy Prices and Falling Interest Rates

My monthly discussion on ever-rising oil prices is starting to sound like a broken record. The greatest bull market in the stock market today continues to be in the energy sector. Oil prices are now hovering around the magic number of $50 per barrel. When I wrote to you last time, oil was at a then high price of $44 per barrel. At the time I said that "I believe that it is more likely that oil prices will rise to $50 per barrel than fall back to $30 again, thanks to the "war premium" and the basic laws of supply and demand." That forecast has proven to be correct. At the same time, natural gas prices have also soared to a new high of around $6.20 per MCF, a price which hasn't been seen in more than two decades. Coal prices also continue to rise and hit new highs, along with uranium, the key component of nuclear energy. No matter where you look, energy prices are universally high and rising with no end in sight.

At the same time, and much to the surprise of almost every analyst (including myself), long-term interest rates have fallen sharply. From their peak this summer, the yield on the ten-year treasury has dropped almost a full percentage point. So while short-term rates have been rising, long-term rates have been falling. This has resulted in a flattening of the yield curve. Pay careful attention to the yield curve. If this curve were to invert, meaning that short-term rates become higher than long-term rates, we would almost certainly be headed into a recession within a few months. In the meantime, as I said earlier, enjoy the low rates.
What does that mean to you? Basically rising energy costs are a consumption tax that effects everyone, and this "tax" will continue to act as a drag on economic growth. As we spend more on energy, we'll naturally have to spend less on other things. On the other hand, the low short- and long-term interest rates stimulate the economy by making it less expensive to borrow, and therefore spend. It also keeps mortgage rates low, which drives the housing market.

In the short run, I think the advantages of low interest rates will outweight the disadvantages of rising energy prices. But that won't last forever. The Federal Reserve is committed to raising short-term rates. That will eventually cool off economic growth somewhat. If energy prices continue to rise unchecked, it will be very harmful to the economy. And keep your eyes on the yield curve. If it flattens or inverts, watch out.

Statistics to Watch...Mixed Bag

After a paltry 32,000 jobs were added in July, the labor department announced a still rather small increase of 144,000 non-farm payroll jobs in August. Average hourly wages increased by $0.06 in July and another $0.05 in August to reach $15.77. The average workweek remained steady at 33.8 hours.
The total number of unemployed workers fell from 8.25 million in June to 8.20 million in July and 8.02 million in August. The number of part-time workers held firm at around 4.5 million. The number of "marginally attached" workers also remained constant at 1.5 million. That means with a labor force of 139.7 million, my "underemployment rate" dropped slightly to 10.11%, whereas the official unemployment rate reported by the government fell slightly to 5.4%.
The four-week average for initial jobless claims has increased slightly to 341,000.
The University of Michigan Consumer Confidence Index remained steady at 96.7. People continue to be upbeat about the economy.
According to the Congressional Budget Office (CBO), eleven months into their fiscal year, the federal government has rung up a $435 billion deficit. They expect a full year deficit of about $422 billion.
According to the Census Bureau, the federal trade deficit in July was $50.1 billion, down from a revised $55.0 billion in June.
The Labor Department reported that the Consumer Price Index, which measures changes in the prices paid by urban consumers for a representative basket of goods and services, rose 0.1% in August after falling 0.1% in July. The "core" CPI, which excludes food and energy, rose 0.1% both months.
The Labor Department also reported that the Producer Price Index (PPI), which measures the average change over time in the selling prices received by domestic producers for their output, rose 0.1% in July then fell the same 0.1% in August. The "core" PPI was the same in both months.
The American Association of Individual Investors' (AAII) bullish sentiment rose strongly from 34% for the week ended July 30 to 51.20% in the week ended September 24. Investors have been getting more optimistic.
According to a survey of 70 retail chain stores by the Bank of Tokyo-Mitsubishi, same store sales were up 1.5% on a year over year basis in August. This represents the lowest year over year increase in 2004, and the worst performance since March of 2003. That is not a good sign.
According to the Commerce Department, sales of new single family homes in August rose a robust 9.4% from July to a seasonally adjusted annual rate of 1.184 million units. I would expect that trend to continue in September thanks to falling mortgage rates. On the other hand, sales of existing homes has slumped badly over the last two months, falling 2.9% in July and another 2.7% in August.
The Institute for Supply Management (ISM) index of manufacturing activity fell to 59.0 in August, breaking a streak of nine consecutive months over 60.0. According to the survey, the ecomony is still growing, so one month doesn't appear very troubling.
The Bureau of Economic Analysis said the national GDP grew at an annualized rate of 2.8% in the second quarter, down from an earlier estimate of 3.0%. Estimates of 4.4% growth in the third quarter and 4.2% in the fourth quarter will likely be revised downward.

So what does all this mean to you? The economy continues to grow, albeit more slowly than earlier in the year. Jobs continue to be created, but not fast enough. The housing market continues to boom. Yet the stock market continues to move persistently downward in the face of all of the good economic news. And the bond market also seems to be warning of problems down the road. I remain "cautiously pessimistic", and I would recommend you do the same.

Monthly Tip - Healthcare Savings Accounts

This month's tip is a little longer than usual, but I think it's worth it. I've asked Lin Osborn, a health care specialist, to share with you some important information on healthcare savings accounts.

The newly created Health Savings Accounts (HSAs) have hit the health insurance market after being signed into law on December 8, 2003. An HSA is a tax-sheltered savings account similar to an IRA, but earmarked specifically for medical expenses. Deposits are 100% tax-deductible for the self-employed and can easily be withdrawn to pay for routine medical bills with tax-free dollars. Larger medical expenses are covered by purchasing a low-cost, high deductible health insurance policy. Any funds not used in a particular year are rolled over into the following year, so unused funds are never lost.

Features and Benefits:

First, you and/or your employer fund an HSA with pre-tax dollars placed in a special account. You can do this on a monthly basis, or in a lump sum. The current maximum is $2,600 for an individual, or $5,150 for a family. There is a modest set-up fee and nominal annual administrative costs. Also, because these are such new products, there are currently some restrictions on the types of investments eligible to be used within the accounts.

Simultaneously, you and/or your employer purchase a High Deductible Health Plan (HDHP). To qualify, the HDHP must have an annual out-of-pocket maximum of either $5,000 for an individual, or $10,000 for a family. Not all high deductible plans are considered HDHP, so you must make sure that whatever you purchase meets the federal requirements. Predictions are that, on average, premiums for these should be about 40% less than current managed care products.

You will be issued a special debit card and a checkbook to pay for any qualified medical expenses until your deductible is met. These distributions are tax-free. Any funds left in your account will roll over into future years and continue to grow tax-free.

Qualified medical expenses include (but are not limited to) the following: vision services, dental care, OTC medication, chiropractic care, birth control pills, addiction services, some home improvements, long-term care and Medicare premiums. IRS Publication 502 lists all the qualified expenses.

The HSA is considered the property of the insured and is both portable and private. The owner, not the employer, therefore bears the responsibility for keeping track of costs and receipts, and filing paperwork so that the HDHP can determine when the deductible is met. When you qualify for Medicare, you can continue to spend the money in your account on medical expenses, including Part B premiums, again tax-free.

HDHPs are not managed care, but they still may have some cost controls. You may have in-network and out-of network payment structures, both before and after your deductible has been met. There are no co-payments below the deductible, but there may be afterwards. Prescription benefits may be tiered. Also, depending on the plan, you may pay a percentage of all costs up to another specified limit.

HSAs have the potential to save both the employer and the employee money in the form of premiums, while also providing a triple tax-free investment vehicle. Because the HSA's owner files all paperwork, administrative costs to the health plan and the employer should be reduced. Proponents say that eventually, if enough people sign on, doctors' offices will see a reduction in paperwork too.

What are the downsides?

First of all, these accounts offer an unprecedented triple tax-free status: they aren't taxed when they are funded, while they grow, or when they're distributed. Therefore, it is estimated that HSAs will remove $6.4 billion in income tax revenues from the Federal budget over the next decade. That money will either have to be cut from some programs, or replaced some other way.

Funding HSAs may prove difficult for the working uninsured. There is concern that too many simply won't be able to afford to fund the HSA to begin with. Although early response has been encouraging, it is far too early to tell if these products can continue to attract this segment of the market. Since this population would be primarily buying individual (not group) plans, they will also pay higher premiums than an employer sponsored group rate.

People who consistently spend more than their deductible will wind up paying more for health care, not less. This may encourage older or sicker people to stay with more traditional health insurance. Critics charge that these arrangements undermine the basic concept of insurance: spreading the risk. Further fragmenting the risk pool will drive the costs of traditional plans higher. If that happens, the most vulnerable may see their premiums skyrocket, while the young and healthy instead quietly build a nest egg for their retirement years.

Advocates are also worried that when people have to pay out of pocket, they may forgo needed care, even care recommended by their physician, in order to save costs. A recent study showed that when co-payments were lowered on prescription medications for diabetic patients, more people took them. So when their chronic conditions were controlled, total health care costs actually went down. Although the health plan spent more on medicines, they actually lowered their overall costs.

HSAs, one of the first "consumer directed" health insurance vehicles, are also promoted as encouraging greater individual choice. The theory is that people will become more sensitive to the costs of care once they begin to pay out of their own pocket, which will help drive costs down. While this may be true, there are few tools consumers can access in order to compare the outcomes of one treatment over another, or the skill levels of various doctors. In order to create informed consumers, the marketplace has to become far more transparent in regards to outcomes and price. This type of competition among practitioners and hospitals will further "commoditize" the practice of medicine.

In the early 1990's, Managed Care promised better outcomes, less waste, coordinated care and lower costs. The holiday lasted only five years before costs again began spiraling out of control. HSAs, and other types of "consumer driven" health plans, have no mechanism, save the invisible hand of the market place, to actually control costs. Health Savings Accounts are not any more tested than was Managed Care when policy experts promised it was going to fix the health care system in 1989. Nevertheless, we are rushing forward into a great national experiment that may transform medical delivery in this country.

Lin Osborn is the Director of Health Plan Navigator, an organization that specializes in resolving medical bill problems and errors for individuals who are overwhelmed by medical paperwork and red tape. Health Plan Navigator can be reached at (914) 478-5055, (800) 249-8116, or on the web at www.healthplannavigator.com. You can also reach Lin at lin@healthplannavigator.com.

Personal News and Notes

I hope that all of you enjoyed the last month of summer. It's hard to believe that fall has already arrived. Children are back in school (and not a moment too soon). The leaves will soon begin to turn. The baseball postseason begins next week. Football is in full swing. Basketball is around the corner and hockey is...well, does anybody really care about hockey anway? September for me also means a return to the pool for another season of Masters swimming. I'm glad to be back in the water. I'm already looking forward to my first meet.

For those of you who missed my appearance with Neil Cavuto on Fox News last week, the clip of the show is available for viewing on my website. Just click here to view that, or any other appearance.

The chapter that I have written for The Black Book on Personal Finance is now going through the final edits and typesetting. I should have the final proofs from the editor early next week. A few weeks later I should have the chapter, entitled "Sector Rotation Investing", available for sale. I hope many of you will be kind enough to purchase this e-book; I think you'll find it quite interesting and informative. If all goes well, the entire book will be published and available in bookstores in time for year-end.

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

Best regards,

Greg Werlinich
President

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