Werlinich Asset Management, LLC
400 Columbus Ave.
Valhalla, NY 10595

September 20, 2006 Comments   |   Refer A Friend   |   Sign Me Up   

The Black Book on Personal Finance, which I co-authored with a chapter entitled "Sector Rotation Investing", can be purchased at or Barnes & The book is also available at selected bookstores around the country. 

Current Market Analysis
Last Month's Results
What I'm Doing Now
Statistics to Watch
Trends To Watch
Monthly Tip
Personal News and Notes

Current Market Analysis

Well, when you're wrong you're wrong. In my July newsletter I wrote that I thought that we had seen the highs for the year and that I expected the Dow, which was then trading right around the 11,000 point mark, would likely decline to test the June lows. I was only off by about 1,000 points. What happened instead? As you can see below, the Dow has surged to around 11,600, which places it within shouting distance of its record closing high of 11,723. The market appears to be very overbought right now and in a screaming uptrend. I would expect it to take a little breather sometime soon, but end-of-quarter window dressing could take the market even higher.

I must admit, I am very surprised by the strength of the market right now, and honestly not sure why it's going up so much in the face of so many negative factors. Obviously the market likes the fact that the Federal Reserve finally stopped raising rates and that oil prices have fallen. I'll talk more about that later in this letter.

I guess a negative yield curve, a terrible housing market, worsening foreclosures, deepening personal debt, a slowing retail sector and deflating commodity prices do not worry this market. Well, it worries me. I think we may be in the midst of a "blow-off" after which the broad market may turn sharply lower. I'm sure this opinion puts me in the minority of stock market observers right now. But hey, contrary opinions are what makes a market.

Let's take a look at how the DJ Transports are doing. After falling over 21% in less than four months, the Transports have jumped about 8% this month. Whereas the steep drop suggested further economic weakening as the sale of mined and manufactured goods was expected to slow, recent activity may contradict that. Or it just may mean that "a rising market tide is lifting all boats". Either way, this index certainly bears watching.

And what is the bond market telling us? The most important message is that yields continue to fall. In July I wrote that I expected yields to continue to fall for a while - and I was right about that one. I left the lines from the last chart intact to demonstrate that the falling yield has broken below the channel.

The spread between the 10-year Treasury and the TIPS has fallen to 2.42%, which is its lowest point since January. This suggests that the bond market is not concerned about future inflation right now. I remain convinced that an economic slowdown, if not an outright recession, is looming in the not-too-distant future, possibly by the end of this year, or more likely in the first quarter of next year. If I'm right, rates will fall even further.

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 evident by the chart below, August was a solid month, following a mixed bag in July. As has been the case for most of the year, value stocks continue to lead the way. As I write this, we are now most of the way through the market's "worst six months" (May to October), and after a rough start, things have improved significantly. October is around the corner though, and I'll hold off on any cheers until we get through that month unscathed.

Name of Index





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

I have to admit that the past two months have been a difficult period in the market for me as my core sectors of energy, commodities and precious metals have endured severe corrections. I have used this pullback to establish positions in favored stocks at reduced prices for new clients. I cannot stress enough that one cannot panic during difficult periods. If the investment thesis for your holdings remains true, then you must be willing and able to stick with those securities through the bad times. That doesn't mean take huge losses, or give back all of your gains. It does though mean that to be an investor, you must be willing to ride out the inevitable rough patches that crop up as nothing goes up in a straight line. So as always, I'm being patient, watchful and disciplined; I suggest you do the same.

Statistics To Watch

  • The most recent four-week average for initial jobless claims, for the week ended September 15, fell slightly to 313,250.
  • Non-farm payroll employment rose by only 113,000 in July and 128,000 in August, marking the fifth 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 $16.79 from $16.77. The average workweek edged down to 33.8 hours. The number of people holding multiple jobs inched up to 7.49 million from 7.46 million. On the whole, a very tepid employment picture where most of the new growth is in health, education and food services industries.
  • The number of unemployed workers was 7.1 million in August. The seasonally adjusted number of people, who for economic or business reasons could only find part-time work, has fallen to 4.1 million. The number of marginally attached workers held steady at 1.6 million. My adjusted Comprehensive Labor Index™ was down slightly to 8.85%;while the official unemployment rate reported by the government remained steady at 4.7%.
  • The Conference Board reported that it's index of Leading Economic Indicators, which now stands at 138.1, declined 0.1% in July and is down 0.7% over the past six months.
  • The University of Michigan Consumer Confidence Index fell over the summer to 82.0 in August.
  • According to the CBO, the government posted a budget deficit of $67 billion in August, which brought the deficit for the eleven-month period to $306 billion, or $47 billion less than for the same period in fiscal 2005. The anticipated full-year deficit is $260 billion.
  • According to the Census Bureau, the U.S. trade deficit in July rose to $68 billion, which is the second highest deficit ever recorded. On a related note, China's trade surplus in August was a record $18.8 billion, up 33% from a year ago, and almost $100 billion after only eight months.
  • The Labor Department reported that on a seasonally adjusted basis, the CPI for urban consumers rose only 0.2% in August while the "core" CPI, which excludes food and energy, was also 0.2%. I continue to believe that the CPI figures are grossly distorted and have minimal value.
  • The Federal Reserve reported that the amount of outstanding consumer credit grew again in July and has reached a new all-time high of $2.35 billion.
  • According to the Census Bureau, retail trade and food service sales rose only 0.2% after a 1.4% increase in July. Going back to a slow May and June, retail sales seem to be clearly slowing.
  • The Census Bureau reported that privately owned housing starts fell 6.0% in August, and was down 19.8% from the same period last year, to a seasonally adjusted annual rate of 1.67 million. This was the lowest monthly figure since April 2003 and marked five out of the last six months in which housing starts were down.
  • The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes fell 4.3% in July, and was down a whopping 21.6% from the same period last year, to a projected 1.07 million units. The estimate of new homes for sale, at 568,000, represents 6.5 months of supply at the current rate of sales. The median sale price fell to $230,000.
  • The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes fell 4.1% in July, after dropping 1.6% in June, and was 11.2% lower than the same period last year, to a projected 6.33 million units. The estimate of homes for sale, a new record at 3.86 million, represents a staggering 7.3 months of supply at the current rate of sales. The median price of homes sold remained steady at $230,000.
  • In their latest US Foreclosure Market Report, RealtyTrac reported that 115,252 properties nationwide entered some stage of foreclosure during August, a 24% increase from July and over 50% from a year ago. It seems clear that this trend is likely to increase as home sales slow and home values diminish.
  • The Institute for Supply Management (ISM) index of manufacturing activity measured 54.5 in August, which was roughly the same as July. This marked the 39th 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 "advance estimate" of the annualized rate of GDP growth for the second quarter of 2006 was 2.5%. They subsequently announced that the "preliminary estimate" was higher, at 2.9%. This is down from 5.6% in the first quarter.
  • Also according to the BEA, personal savings was estimated to be negative $83.5 billion in July, as compared with a revised (downward) negative $67.6 billion in June. The July figure means that Americans are saving a negative 0.9% of personal disposable income (or spending more than they are making). This number has been negative every month this year. It shouldn't be a surprise to see foreclosures up and retail sales down.
  • According to, "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." I included this statistic last month but I thought it was worth repeating. The foreclosure numbers given above suggest this may be beginning.
  • The Fed increased M-2 by 0.3% in August. The supply of M-2 has increased by a growing 4.6% in the last three months and 4.7% in the last twelve months as the Fed attempts to stave off the possibility of deflation. Falling energy and commodity prices, and falling bond yields suggest that deflation is a possibility.
  • As of September 15, foreigners held $1.68 trillion in US debt, which sets a new record.

In my opinion, the overall economic picture continues to worsen, as evidenced by the weakening retail and housing sectors. The American consumer is tapped out, over-leveraged, saving nothing and worried about an increasingly dangerous world. I believe most of the good economic news is behind us and that difficult times lie ahead. It's time to batten down the hatches and prepare for rough waters ahead.

Trends To Watch

I'm going to show you a bunch of charts this months, so bear with me. There is a method to my madness. A picture is truly often worth a thousand words.

In July, I showed a chart of the S&P 500 dating back to 1999 to demonstrate that the S&P, which is often viewed as a proxy for the entire market, seemed to be at a major inflection point, much like 2000 and 2003. Virtually nothing has changed since then, so I'm returning to a shorter-term chart. Here we see that the S&P 500 is trading above the 50- and 200-day moving averages and is in a solid uptrend. Everything looks great here for the bulls.

The chart below, which shows the price action of West Texas crude, has been giving me a lot of agita for the past few months. The price has clearly broken down below support and has fallen below the moving averages. The RSI and MACD indicate that oil is very oversold and due for a bounce. The question is how long will this selloff last and how low will the price go. Interestingly, WTIC is now trading about $16 below the peak. The three major breakdowns in the chart had spreads of $10, $14 and $10, so this is the biggest downward move.

I have been a bull on energy prices for more than four years, and benefited greatly from the high prices. It isn't surprising that I'm now suffering with my energy holdings. That being said, I still believe that energy prices will be higher in the long run, so for now, I'm holding tight.

The tremendous volatility in the price of gold continues today with most of the action being down. The price of gold today is around $580 per ounce, which places it below both moving averages and in a clear downtrend. I've written before that gold appears to be in a lengthy consolidation and I stand by that. Oftentimes this period will shake out the short-term investors, the traders and the hedge fund speculators. I still have no doubt that long-term, the price of gold will be much higher. What I don't know is exactly when that will be. Since I consider my investments in gold to be "portfolio insurance" or hedges against "what if?", I'm perfectly happy to sit with my positions for the foreseeable future, regardless of the short- or medium-term moves.

I've included the following chart on the Dow Jones Commodity Index because it dovetails very nicely with the movement in oil and gold. All three show severe corrections below trendlines, below moving averages and very oversold. So what's the message? I'm showing these charts because I believe that the greater problem facing the US economy right now is not inflation, which is quiescent right now, but rather deflation. With oil, gold, commodities and interest rates all down, that suggests that the market is more concerned about an economic slowdown than excessive growth.

The dollar continues its five month consolidation around $85.50. Now that the Fed has stopped raising interest rates one of the pillars of its strength has been removed. I think it's likely that the dollar will begin to slide again due to the coming economic weakness.

Given the worsening picture in the housing market that I covered in depth in the Statistics section above, I would describe the chart below as either a "Dead Cat Bounce" or a "Suckers Rally". Value investors are scooping up the stocks of Toll Brothers, Lennar and others because they appear "cheap" on a trailing earnings basis. The problem is that going forward, if/when those earnings drop, or disappear, these stocks will no longer seem as appealing. With loan applications down, builder confidence down, foreclosures up, housing starts down and inventories of unsold homes at record levels, there is nothing to suggest that the housing sector is ready to move up as the bottom has not been reached yet.

Finally, let's look at the yield curve below (the green line is the current one). The Fed Funds lending rate is still 5.25% as the Fed left rates unchanged today. 6-month t-bills yield 5.08 (down from 5.24% two months ago), 2-year Treasuries yield 4.81%, 10-year Treasuries yield 4.73% and the 30-year Treasury yields 4.84%. So we continue to have a fully inverted, if imperfectly so, yield curve. The longer the inversion lasts, and the wider the spread between short and long rates, the greater the likelihood that we will have a recession by the first quarter of next year.

There is no Monthly Tip this month. This feature will certainly return next month.

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 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 will be in the San Diego area in late October for a few days while I attend a conference hosted by one of my venture capital companies. If you live in the area and would like to meet with me, please let me know.

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.

Best regards,

Greg Werlinich

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