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

WOW. Like last month, I was completely wrong again this month about the direction of the market. Not only did the Dow confound my prediction of a correction and blast right past the former high closing price of 11,723, but it continued to surge ahead and crest the next "magic" number of 12,000. While I can take some comfort in knowing that the so-called "experts" are wrong most of the time, being wrong is never fun. That being said, all things being equal, I'd rather be wrong (and long) when the market goes up than when it goes down. So let's take a look at some key charts and see what they tell us about the market today.

As I said last month (when I was obviously prematurely), the market appears to be very very overbought right now and is in a screaming uptrend. I would expect it to take a little breather sometime soon, but as it has been said, "the market can remain irrational longer than you can remain solvent". I think that this is another example of the "irrational exuberance" that Allan Greenspan spoke of more than a decade ago. So the question becomes how much longer this irrationality can last. The answer is that I have absolutely no idea. But I do believe that it must, and will, end at some point. I'm still concerned that we are in the midst of a "blow-off" after which the broad market will turn sharply lower. As always though, only time will tell for sure what's going to happen.

In classic Dow Theory, for a bull market to be confirmed, the Dow Industrials and the Dow Transports should be hitting new highs at the same time. As you can see from the chart below, that is not the case right now. Although the Transports are rising, they are still about 200 points off from the May high. Like the Industrials, the Transports appear oversold right now and are due for a correction. I would think the strong earnings coming out of the airline and railroad stocks will keep this index moving up for the time being. What will eventually derail this index are the forecasts of future economic slowdowns. But for now, it appears we have clear skies ahead.

And what is the bond market telling us? I think the picture is a bit muddled here. Yields began to drop sharply in July after the Federal Reserve stopped raising rates. From a high of about 5.25%, the yield on the 10-year Treasury plunged to about 4.50%. And while bond prices (which move inverse to yields) have fallen a bit since then, it's still unclear where yields are headed right now. It seems fairly clear to me that the bond market does not see much inflation on the immediate horizon, and is therefore keeping rates low.

Buttressing my argument about the lack of concern about inflation is that the spread between the 10-year Treasury and the TIPS has fallen to 2.23%, which is its lowest point of the year. I realize that I'm beginning to sound like a broken record, but 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, September was another good month, after a solid August and so-so July. The net result - a very good quarter for most of the broad averages with value stocks continuing to lead the way. If we could have a "worst six months" (May to October) like this every year, this period would have to be renamed. As October is almost in the books already, and will end up being another good month, it looks like 2006 will end up being better than most people, including me, expected.

What I'm Doing Now

The third quarter was a poor one for WAM and its clients. After almost four years of stellar returns, we took it on the chin over the summer as our portfolios substantially underperformed the broad market averages. This led to quite a bit of soul-searching on my part. Was it finally time to abandon my core sectors and devise a new strategy? Was I now fundamentally wrong about the direction of the market? Or was this simply a natural correction for sectors that had outperformed since 2002? Remember, nothing ever goes up in a straight line; the market always corrects.

I decided to sit tight, strong in my belief that that the premise of my investment strategy was sound. And while I allowed some extra cash to build up, I did use that temporary weakness to add to some existing positions and buy an initial stake in a leading consumer products company. I've said before, but it's worth repeating, 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 October 23, fell to 306,250, one of the lower levels since March.
• According to the Department of Labor, non-farm payroll employment was essentially flat in September as it rose only 51,000 from an upwardly adjusted August. That was the worst monthly showing since Hurricane Katrina. The Labor Department also said that in the twelve months through March, about 800,000 more payroll jobs had been created than originally reported. Average hourly wages in September increased to $16.84 from $16.79. The average workweek remained steady at 33.8 hours. The number of people holding multiple jobs increased to 7.79 million from 7.49 million. So was the report good or bad? I wish I knew. For me the takeaway is that, once again, the government numbers can't really be trusted.
• The number of unemployed workers fell to 6.9 million in September. The seasonally adjusted number of people, who for economic or business reasons could only find part-time work, remained steady at 4.1 million. The number of marginally attached workers fell to 1.3 million. My adjusted Comprehensive Labor Index™ was down to 8.46% while the official unemployment rate reported by the government remained steady at 4.6%.
• The Conference Board reported that it's index of Leading Economic Indicators, increased 0.1% in September after falling in July and August and for five of the last eight months. Weakness in non-defense durable goods and housing have been the biggest negative contributor.
• The University of Michigan Consumer Confidence Index rose to 85.4 in September.
• According to the CBO, the government posted a budget surplus of $54 billion in September, which brought the estimated full-year deficit down to $252 billion, or $68 billion less than for fiscal 2005. This deficit represents only about 1.9% of the estimated GDP of the country.
• According to the Census Bureau, the U.S. trade deficit in August rose to $69.9 billion, the highest deficit ever recorded. By itself, China represents $19.6 billion, or 28%, of the deficit.
• The Labor Department reported that on a seasonally adjusted basis, the CPI for urban consumers fell 0.5% in September while the "core" CPI, which excludes food and energy, was again up 0.2%. The reduced value of CPI can be almost entirely attributed to the fall in energy prices.
• The Federal Reserve reported that the amount of outstanding consumer credit grew by 2% in August and has reached a new all-time high of $2.351 billion.
• According to the Census Bureau, retail trade and food service sales fell 0.4% in September after a 0.2% increase in August. This continues the trend of slowing retail sales going back to May. On a year over year basis, retail sales were still up 5.5% vs. 2005.
• The Census Bureau reported that privately owned housing starts rose 5.9% in September, but was down 17.9% from the same period last year, to a seasonally adjusted annual rate of 1.77 million. Ominously, building permits were down 6.3% from August and 27.7% from last year and new construction seems to be grinding to a halt.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes rose 5.3% in September, but was down 14.2% from the same period last year, to a projected 1.075 million units. The estimate of new homes for sale, at 557,000, represents 6.4 months of supply at the current rate of sales. The median sale price plunged to $217,200, a multi-year low. It appears that the only reason sales increased in the period was that sellers dramatically lowered their asking price to move their homes.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes fell 1.9% in September, and was 14.2% lower than the same period last year, to a projected 6.18 million units. The estimate of homes for sale, at 3.75 million, represents a staggering 7.3 months of supply at the current rate of sales. The median price of homes sold fell to $220,000.
• According to economy.com, 2.33% of mortgages were delinquent in the third quarter, the highest level since 2003.
• In their latest US Foreclosure Market Report, RealtyTrac reported that 112,210 properties nationwide entered some stage of foreclosure during September, a 2.5% decrease from August but over 63% from a year ago. This trend is likely to continue until rates begin to fall again.
• According to the Mortgage Bankers Association in their weekly mortgage applications survey, for the week ended October 20, loan application volume increased 0.5% from the prior week but declined 13% from the same period a year ago.
• The Institute for Supply Management (ISM) index of manufacturing activity declined to 52.9 in September. This marked the 40th 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 the rate of growth continues to slow.
• The Bureau of Economic Analysis announced that the "advance estimate" of the annualized rate of GDP growth for the third quarter of 2006 was 1.6%. This follows GDP growth of 2.6% in the second quarter. As always, this estimate is likely to be substantially different in future revisions. And remember, GDP growth in the first quarter was a much higher 5.6%.
• Also according to the BEA, personal savings was estimated to be negative $40.5 billion in August, as compared with a revised negative $70.1 billion in July. The August figure means that Americans are saving a negative 0.5% of personal disposable income (or spending more than they are making). This number continues to be negative every month this year. It is no surprise to see foreclosures up and retail sales down.
• The Fed increased M-2 by 0.2% in September. The supply of M-2 has increased by 3.6% in the last three months and 4.4% 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.

Trends To Watch

Last month I said that the daily chart of the S&P 500 looked great for the bulls. Well one month later it looks even better. The upward move has broken above the trading channel to a new high. The S&P is trading well over its moving averages and while it appears a bit oversold, the positive momentum could take it even higher in the near term.

I want to give you an interesting perspective on the overall market and I think this graph does a great job. This is a weekly graph of the Wilshire 5000 for the entirely of this decade. The two obvious trends are very clear. What I found interesting is that almost ever time the MACD rose above +100 there was a significant decline, and almost every time the MACD fell below -100 there was a strong rally. Well, the MACD is right around +100 right now; so beware.

The price of West Texas crude continues to be one of the key factors in the market as far as I'm concerned. The price clearly broke below support and the moving averages during the third quarter. The bounce in price that I was anticipating last month hasn't happened yet, but it is clearly in consolidation right now. My long-time readers know that I am a bull on the price of oil. I'm still convinced that oil prices, over time, will go much higher. The question before us today is how long it will take to resume the upward march. For now, we wait and watch.

Like oil, the price of gold appears to be consolidating right now. After plunging almost $300 per ounce, it rallied strongly, then gradually sold off again, falling to $563 at the end of September. From there the price has rallied to meet its 50- and 200-day moving averages at about $600 today. I have 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 partially "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 (which represents 19 physical commodities) because it dovetails very nicely with the movements in oil and gold. All three showed severe corrections below trendlines and moving averages and all three have rallied somewhat and are now consolidating. Like Jim Rogers, I'm a long-term commodities bull right now. There is nearly enough worldwide production capacity to meet growing demand. There will certainly be bumps in the road, but this bull market is not nearly over yet.

The dollar continues its six month consolidation around $85.50. If the dollar can't rally with the market surging and during this "Goldilocks" economy, there is no reason to think that the dollar will retain its strength much longer. Without the benefit of Federal Reserve rate hikes, I think it's likely that the dollar will begin to slide again due to the coming economic weakness.

Last month I described the rally in the housing sectors as either a "Dead Cat Bounce" or a "Suckers Rally". Well, the rally appears to have some legs. Given the deteriorating housing market, I'm still leaning towards a "Suckers Rally", but some smart people are buying these stocks. Let's give it another month to see if the rally continues. My money says that without a rate cut by the Fed, the rally fizzles.

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 last week. 6-month t-bills yields 5.15% (down from 5.08% last month), 2-year Treasuries yield a lower 4.76%, 10-year Treasuries yield 4.68% and the 30-year Treasury yields 4.79%. 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.

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 Wallst.net. 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.

Autumn is in full swing in the Hudson Valley of New York. The days are growing shorter and the nights are getting colder. I hope you all are preparing for Halloween tomorrow night. Thanksgiving is right around the corner, then before we know it, Hanukkah, Christmas and New Years will be upon us. I hope each of you has had a great 2006 and is getting ready for an even better 2007. If I can be of any help with your investment planning before the end of the year, 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.

Copyright© 2006, Werlinich Asset Management, LLC and www.waminvest.com. All Rights Reserved.