Current Market Analysis

It's madness I tell you!! When I wrote in July the Dow Jones Industrial Average was at 13,950 on the way to 14,000. By August 16, the Industrials had plunged to an intra-day low of 12,518 before closing at 12,845. Five weeks later we see the index within shouting distance of 14,000 again. If you were away without a newspaper or an internet connection for a two month vacation, you might think that nothing much happened in your absense. In a way, you'd be right, while at the same time, you'd be very wrong. As I write to you one hour before the close, the Industrials are holding at 13,800. So what's going on?

Last month I asked "what further measures, if any, will be necessary to forestall further weakness in the days and weeks to come." It didn't take very long to find out. The Federal Reserve last week reduced the Fed Funds rate (which is the Fed's target rate for overnight lending between banks) by 0.50% in an effort to stave off further economic weakening in the aftermath of the subprime lending mess. This follows earlier efforts by the Fed to inject liquidity into the banking system by reducing the discount rate at which they make very short-term loans directly to banks. This 50 basis point rate drop was a positive "surprise" to Wall Street and led to wave of buying which drove the market straight up. To me, the reality of the situation isn't quite so euphoric. The real estate crisis is still getting worse; more borrowers will end up defaulting on the mortgages and losing their homes over the next six months or so. It will take a few months before the rate reductions have any meaningful impact on the market and the lower rates may drive inflation even higher than it is already. All of that being said, the trend of the market continues to be bullish, so as they used to say, "don't fight the tape".

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 then consolidating a bit before rising strongly again. 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. As I suggested last month, it now looks as though history may again repeat itself as the Industrials are poised to attack the high of 14,000. While I don't think it will happen in a straight line, I think that within a month or two we'll again surpass 14,000.

We know how the Industrials are doing, but how are the Transports faring? Not quite as well I'm afraid. The transportation index is farther from its high than the Industrials and yet I think that the bullish trend is still in force. Notice the ever higher lows (the red circles) over the last 12 months. And notice that the current price remains higher than the closing price of 4,672 set on August 16, the day of panic selling. I would like to see the Transports move up a bit to confirm the move in the Industrials, but overall, this picture doesn't bother me too much.

Who ever said that the bond market is "safer" than the stock market? If anyone believes that, this chart should disabuse them of that notion. The bond market has exhibited the same volatility as the stock market; maybe even more. When stocks plunged, money 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. Now the reverse is happening as money is flowing away from bonds, back into equities, causing yields to rise. Given the decline in the value of the dollar, I expect rates to rise further to compensate investors for owning dollar-denominated debt.

Last Month's Results

• According to the Department of Labor, the most recent four-week average for initial jobless claims, for the week ended September 15, was 320,750, up 8,250 from four weeks ago. At the same time, non-farm payroll employment fell by 4,000 jobs in August, after an anemic 68,000 jobs added in July (revised down from the 92,000 jobs previously announced) and 69,000 in June (revised down from 126,000 previously announced). This is the first drop in payrolls in over four years. The deterioration in job growth looks very real. Average hourly wages grew $0.05 to $17.50. The average workweek remained steady at 33.8 hours.
• The number of unemployed workers remained at 7.1 million. The seasonally adjusted number of people, who for economic or business reasons, could only find part-time work, stayed at 4.5 million and the number of marginally attached workers held at 1.4 million. The number of people holding multiple jobs fell to 7.64 million. My Comprehensive Labor Index™ held at 8.92%, while the unemployment rate reported by the government remained at 4.6%. This is a bad market that is getting worse.
• According to the CBO, the government posted a budget deficit of $115 billion in August, bringing the deficit for the first eleven months of the fiscal year to $272 billion, which was $33 billion less than a year ago.
• According to the Census Bureau, the U.S. trade deficit in July was $59.2 billion, essentially unchanged from $59.4 billion in June and $59.2 in May. Our trade deficit with China continues to grow, hitting $23.8 billion for the month. You can be sure that China will grow increasingly assertive with their massive surpluses, and begin to buy U.S. assets.
• The Census Bureau reported that privately owned housing starts fell 2.6% in August from a revised downward July figure, and was down 19.1% from a year ago, to a seasonally adjusted annual rate of 1.33 million units. New building permits were down 5.9% from last month and down 24.5% from last year, so the outlook for future housing starts remains bleak and is getting worse.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in July rose 2.8% from the prior month, but were still down 10.2% from the same period last year, to a projected 870 million units. New home sales have fallen five of the last seven months. The estimate of homes for sale is now 533,000, which represents 7.5 months of supply at the current rate of sales. The median sale price of $239,500 is below the 12-month average of $244,142.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in July slid 0.28% from the prior month, and were 9.0% lower than the same period last year, to a projected 5.75 million units. This marked the fifth straight month in which fewer homes were sold than the prior month. The estimate of homes for sale, at 4.59 million, represents a staggering 9.6 months of supply at the current rate of sales, and was reported to be the largest supply of homes for sale since 1991. The median price of homes sold fell slightly to $228,900.
• According to RealtyTrac, foreclosures rose a whopping 36% in August, and up an incredible 115% from a year ago, to 243,947 filings. Nevada, California and Florida had the highest foreclosure rates, while California, Florida and Ohio had the highest absolute number of foreclosures.
• The Institute for Supply Management (ISM) index of manufacturing activity was 52.9 in August, down from 53.8 July, marking the second straight month in which the index has decreased. This is just one of a growing number of examples of a slowing economy.
• The Conference Board reported that it's index of Leading Economic Indicators decreased 0.6% in August. The Leading Index has grown by 0.5% over the past seven months, again suggesting very slow economic growth in the near future.
• The Bureau of Economic Analysis announced that the "preliminary estimate" of GDP growth for the second quarter of 2007 was a robust 4.0%, better than the "advance estimate" of 3.4%. This follows the anemic first quarter GDP growth of 0.6%. Remember, there is one more revision to come, so this estimate is likely to change. This growth is misleading as the primary contributors are government spending and a decrease in imports (thanks to a weaker dollar).
• The Federal Reserve reported that the amount of outstanding consumer credit increased by 0.3% from the prior month (or 3.6% annualized) in July, to $2,456 billion. This growth has been very steady all year. The problem is, according to CNNMoney.com, Americans are defaulting on their credit cards at a sharply higher rate when compared to last year, and late payments are up too.
• According to the Census Bureau, retail trade and food service sales rose 0.3% in August from the prior month and were up 3.7% from a year ago.
• The Fed increased M-2 by 0.9% in August after a 0.3% increase in July. The supply of M-2 has increased by 5.8% in the last three months and 6.7% in the last twelve months. These increases in the money supply keep getting bigger as the Fed tries to keep the economy afloat.

My statement from two months ago proclaiming "next step: $80 per barrel" looks much better today than this time last month. The price of West Texas crude has surged past $80 to set new highs. The price of crude has risen about $30 per barrel so far this year. Not too bad for investors with a heavy weighting in energy stocks. The "experts" contend that the most recent surge was due to the Fed rate cut hurting the dollar, which makes oil more expensive in dollar-terms. Just add that to the list of the many factors that are driving up the price of oil. In the short-term, I think the price is a bit over-bought and will likely drop a bit. In the long-run, I remain confident that prices will continue to move ever higher.

Last month I said that if the August lows held (which they did) then I "expect the price of gold to continue to rise over time and I would be a buyer on weakness." That timing proved fortunate. Like oil, the price of gold is surging right now. And like gold, many experts claim that this is in part to the rate cuts helping to depress the dollar. Again, while this may be true, the price of gold had been moving higher for the past six years, so whatever happened last week is hardly the underlying cause of gold prices hitting a 27-year high. The price of gold is well above its 50- and 200-day moving averages and is very oversold on RSI. I expect the price to soften a bit and consolidate for a while before continuing on its upward trajectory.

The trend in the Dow Jones Commodity Index (which represents 19 physical commodities) is now becoming more clear. Last month I wrote 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." Once again, the timing of those comments was spot on as the commodity index has zoomed up in the past month. I would expect some softness and consolidation here, proving another buying opportunity. All investors should have some commodity exposure.

I referenced the value of the dollar a few times earlier. This monthly chart of the dollar is not just bearish, it's downright depressing. I've been saying for the past few years that the future of the dollar looks bleak (thank you Federal Reserve). Last month I wrote that "If/when the Fed cuts rates below 5%, I think the dollar index will fall below 80." Well, the Fed cut rates to 4.75% and the dollar index now trades at 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. And while the dollar is likely to rally a bit in the short-term, I do believe that it is headed even lower.

The chart of the housing index just gets uglier by the month. While the rate cut provided a (very) momentary respite to this beaten down sector, more pain in on the way. Last month I wrote that "I believe it will likely be at least another year before the housing sector gets appreciably better." Because I believe this so strongly, I am amazed that the Wall Street "experts" profess to be "surprised" each time a home building company announces that their earnings will be "weaker than expected". The only surprise to me is how anyone can be shocked that homebuilders continue to produce lousy quarterly results. You'll know the worst is over when Wall Street finally slaps a "sell" rating on the entire sector and announces that they're all declaring bankruptcy. It will then be time to back up the truck and buy with both fists.

This is the first time I've shown the following chart, which is a daily view of the Shanghai Index, which is a proxy for the Chinese stock market. In the past 21 months, this index is up almost five-fold! That is simply amazing. And unfortunately, I've invested nary a dime in this market. And to me, trying to invest in it right now would be folly. This looks like a bubble to me. And as we all know, bubbles have an unfortunate history of deflating at the worst possible time. So buyer beware.

Not only is the yield curve no longer inverted, it has become more steep, which portends a better economic outlook ahead. The problem is that the current economic outlook appears quite dim. So which is right? They can both be right. I had predicted that the US would experience a recession, or at least a slowdown, this year. My guess is that we are in the midst of that recession right now, and it will be reported early next year. By then, the economy will likely be again on the upswing. The spread between the 10-year Treasury and the 10-year TIPS has increased to 2.28%, suggesting a mildly growing whiff of inflation in the bond market. I'll be keeping an eye on that spread.

What I'm Thinking and Doing

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Greg Werlinich
President

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