Current Market Analysis...Slowly Declining

When I last wrote to you, the Dow Jones Industrial Average was trading just below the important 10,000 point threshold. Today, the Dow closed at 9,750, or down about 2.5% since last month. So after a mostly positive September, October will likely show a decline in most of the broad averages. Yet most observers barely seem to notice this market decline. All I read or hear about is bullishness and optimism for the market and the economy. I've gone contrary to this rosy opinion all year, and my clients are thanking me for their positive investment returns. We'll see what happens in the final two months.

I mention the closing price to the Dow today so that I can (at least temporarily) give myself another pat on the back. Last month I suggested that the "Dow should touch down at around 9,750 before staging another recovery." So here we are. Time will tell if I've again managed to call an inflection price (see my call of Dow 10,350 in the July newsletter) or if it will go down further. I'll let you know next month.

The more important point is that the Dow continues to trade at lower highs and lower lows (see the chart below). This is very ominous, and it contradicts what I consider to be a ridiculous article in the recent edition of Barron's. According to their Big Money Poll, in an article entitled "A Whole New Game", more than "56% of these professional investors call themselves bullish or very bullish about the U.S. stocks market's near-term prospects and expect share prices to climb in the next eight months. . . They see the Dow Jones Industrial Average hitting 10,724 by year end, on its way to 11,162 by June 30, 2005. I almost fell off my chair when I read that. While I hope they're right, I can't see how they can forecast a 1,000 point rise on the Dow in the next two months. I think that Barron's readers who went out and bought stock today based on this article are bound to be disappointed.

Next week Americans will (hopefully) go to the polls and vote for our next president. I think we are in for another very close election that will leave the winner without a clear mandate. I also think the winner has some huge problems to face, including: the quagmire in Iraq, the fence in Israel, unrest in many other places around the globe; and crucial domestic issues including affordable healthcare, a growing social security crisis, untenable federal deficits, joblessness, and a fragile economy. While the pundits universally claim that a Kerry victory will mean a drop in the market, and that may be true, the reality is that a win by either candidate is unlikely to change the downward tenor of this market. Don't forget, a falling stock market is decidedly bearish for the President's chances on Tuesday.

If that weren't enough, later in November the Fed will meet again to determine their monetary policy. I think another 25 basis point increase is already cooked into the market. And unless something terrible happens between now and then, I believe they will announce that increase. That would bring their lending rate up to 2%. While it is widely assumed that they won't stop increasing the rate until it reaches at least 3%, I think that they'll take a very hard look at the market and the economy before making any further rate increase decisions.

In the midst of all of this turmoil the bond market continues to surprise and impress. The yield on the benchmark 10-year treasury bond remains at a remarkably low 3.97%, which is basically the same yield as a month ago. The low rates continue to fuel a powerful housing market, although cracks are beginning to appear there as the number of new housing starts has begun to decline, hammering some of the home builders. Just pay attention to the housing numbers for any evidence of further problems.

What I'm Doing Now...Cutting Back On Drugs

Not surprisingly, I've made few adjustments to my portfolios because since they ain't broken, I ain't fixin' 'em. Seriously, the majority of my core positions continue to perform exceedingly well. In fact, I've added a bit to my energy positions. The only exception to the good news is in the pharmaceutical sector, where the news has been uniformly bad. Therefore, I have reduced my holdings a little while I wait for all of the bad news to be announced and digested. While I've said this before, I want to repeat it for emphasis: I am 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. I believe that most investors should have a similar investment philosophy right now.

Current Trend...Natural Resources Up, Dollar Down

Longtime readers of this newsletter may be getting bored of me pounding the table for the energy commodity and precious metals sectors (which I lump together in a omnibus "natural resources" group), but unless you get bored with making money, you should be paying very close attention. The greatest bull market in the stock market today is in natural resources. Everything from oil and gas, coal, gold and silver, uranium, basic metals and timber are seeing strong increases. Today, oil prices have risen to over $55 per barrel. Two months I predicted that $50 per barrel would be broached before we see $30 again. Let me now predict that we'll see $60 per barrel before we again see $40. At the same time, natural gas prices have shot right past $6 per MCF and are now around $8. Gold is back to around $430 an ounce and silver has risen to about $7.30 an ounce, a price that hasn't been seen since 1989.

A worrisome sidebar to the rising commodity prices is the falling value of the dollar. As you can see below, after gaining strength in the first quarter, the dollar has lost all of its gains and appears headed to new lows. While this may help US exporters, it isn't good for the health of our credit markets, which rely on foreigners to soak up our debt offerings. Last week the Financial Times noted the severe lack of foreign buying in the recent treasury auction. In fact, foreigners have become net sellers of treasuries for the first time in over a year. Between a falling dollar and low interest rates, there isn't much incentive for foreign governments to keep buying our debt. This has very negative implications for our credit markets. Stay tuned.

So what does all of that mean to you? It means that you continue to pay a "consumption tax" due to higher energy prices, and as I said last month, this tax will eventually act as a drag on economic growth because the more we spend on energy, the less we have to spend on other things. On the other hand, low interest rates will continue to stimulate the economy and the housing market by making it less expensive to borrow. If enough foreigners stop buying, or worse still begin to sell treasuries, then rates will begin to rise, whether the Fed or anyone else likes it or not. That won't be good for anyone.

Statistics to Watch...Mixed Bag

• After a modest increase of 144,000 jobs in August, the labor department announced another disappointingly small increase of 96,000 non-farm payroll jobs in September. Average hourly wages increased by $0.01 to reach $15.78. The average workweek remained steady at 33.8 hours.

• The total number of unemployed workers fell from 8.02 million in August to 8.003 in September. The number of part-time workers held firm at around 4.45 million. The number of "marginally attached" workers rose slightly to 1.6 million. Therefore, with a total labor force of 139.5 million, my "underemployment rate" dropped slightly to 10.08%, while the official unemployment rate reported by the government remained at 5.4%.

• The four-week average for initial jobless claims has increased slightly to 347,000.

• The University of Michigan Consumer Confidence Index dropped slightly to 95.9. People continue to be upbeat about the economy.

• According to the Congressional Budget Office (CBO), the federal government recorded a record deficit of $415 billion for the fiscal year ended September, although it was somewhat less than originally forecast. This represents about 3.6% of GDP, which is not out of line with historical figures.

• According to the Census Bureau, the federal trade deficit in August was $54.0 billion, up from $50.1 billion in July.

• 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 0.2% in September after rising 0.1% in August. The "core" CPI, which excludes food and energy, rose 0.3%.

• 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 September after falling 0.1% in August. The "core" PPI was up 0.3%.

• The American Association of Individual Investors' (AAII) bullish sentiment fell from 51.2% for the week ended September 24 to 42.5% for the week ended October 22. Investors are again growing more wary.

• According to a survey of 70 retail chain stores by the Bank of Tokyo-Mitsubishi, same store sales were up 2.4% on a year over year basis in September. While this is not a great number, it does improve on August's poor performance.

• I'll report on the September figures for sales of new single family homes next month. It is likely the Census Bureau will report an increase for the month. Sales of existing home rose 2.4% last month after declining for the prior two months. The effects of low interest rates cannot be emphasized enough.

• The Institute for Supply Management (ISM) index of manufacturing activity fell to 58.5 in September, marking the second straight month that the index fell below 60.0. According to the survey, the ecomony is still growing, but at a slightly slower rate.

So what does all this mean to you? It means that if you have a job, work hard and be thankful for the paycheck. It means that jobs aren't being created fast enough to really fuel the economy, which is still growing, but more slowly than earlier in the year. It means that low interest rate mortgages are still powering a strong housing market. Yet the stock market continues to decline in the face of this solid economic news. That's disturbing. Remember, the stock market is a forecasting instrument. It's looking ahead and it doesn't like whatever it sees. So for now, to borrow a phrase from John Mauldin, we continue to "Muddle Through". Therefore, I continue to be "cautiously pessimistic" for the remainder of this year and into next year.

Personal News and Notes

The days are getting shorter and colder and winter seems almost upon us. All eyes turn to Boston and their quest to finally end the Curse. After disposing of the Yankees in record fashion, it appears that this may indeed be the year be the year that the Red Sox win the World Series for the first time since 1918. We should all be on the lookout for unusually cold weather in Hell.

I'm still waiting for my publisher to deliver my e-book on Sector Rotation Investing that I've written for The Black Book on Personal Finance. Once again, I hope to have it back from the publisher "any day now". As soon as I have it I'll let you know. I'm still hopeful that the completed hardcover will be published and available in bookstores in time for year-end.

Don't forget to vote next week. Whatever your political, social or economic beliefs, it is important that you go to the polls and cast your vote for the candidate that you feel will be the best man to lead us for the next four years.

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