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

October 22, 2008

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

Current Market Analysis

I'm back after taking a one-month break from writing this newsletter. During that hiatus, I got married, then had the misfortune of being on my honeymoon during one of the worst weeks in the history of the stock market as it suffered through what may end up being the worst of the credit crisis. And to rub salt in the wound, while watching the financial tsunami, Shaena and I were caught in an earthquake that measured 6.1 on the Richter Scale. Fortunately, we were not too close to the epicenter and escaped completely unscathed. What a week!!

As I write this there are clear signs that the "credit crisis" is beginning to abate. LIBOR rates are falling and commercial paper markets are getting better. There is no longer a hysterical edge in the voices of market commentators. Indeed, more and more commentary suggests that things are getting better and that the worst of the credit crisis is likely behind us now. This is not to say that the credit markets are functioning perfectly right now, which they're not; I just believe that things are getting better, and will likely continue to improve in the coming weeks and months. That's the good news. The bad news is that the economy is in lousy shape, and will likely get worse before it gets better.

I'll touch on the economy in much greater detail later in this letter, so let's now turn our attention to the stock market itself, and see what it's telling us. I'm going to show a few more charts than usual this month in order to put things into a little better perspective.

I don't want to spend too much time discussing what you already know - that the stock market has been historically bad, that all kinds of record bad things have happened and that trillions of dollars in wealth have been lost. Beginning September 15, and continuing through October 10, the stock market was in virtual free fall. Since then, stocks have been gyrating wildly. The VIX, or Volatility Index, has soared to unprecedented heights, almost double previous high levels. Investors large and small have fled the scene, selling anything and everything in a classic panic. In August I asked "Has the low been made?" I answered by saying "I don't know." I went on to say that there were two important numbers to keep your eye on: 10,962 and 10,750. The former was the low set by the Dow Jones Industrial Average on July 15. The latter was roughly the midpoint of the low set in July 2006 and the high set in October 2007. I speculated that "should the Dow break below both of these support levels, the resulting crash could get very ugly". Well, the crash was not only ugly, but it was fast, dragging the down down almost 2,000 points in less than two horrible weeks. So again we're left to ask, "has the low been made?" Again I don't know, but I'll keep a close watch.

I'm now going to show three charts of the Dow: a daily, a weekly and a monthly to give you three different perspectives. First is a daily chart of the Industrial Average so far this year. We clearly see the first drop below the March low, then the recent plunge taking the Industrials below the July and September lows. The new closing low is 8,452, although we did hit an intra-day low of 7,882. So 8,452 is our next line of defense.

Next is a weekly chart of the Industrials. Here we can clearly see how the panic selling over the past two weeks smashed through the 10,750 support level. You can also see that the market is quite oversold.

Finally, we'll look at the monthly chart. Here you can see how the Industrials dropped 41% from a wildly overbought situation in 1987, 31% after the tech bubble burst early this decade, and now sits about 35% below the high set a year ago, after briefly falling a dizzying 44% to the intra-day low. Importantly, it looks like the next major support level would be the October 2002 low of about 7,200. Don't even ask what support level follows that one.

After being one of the last bulwarks of the stock market, the Transportation average finally capitulated to the panic selling and crashed below the January low, thereby confirming, according to Dow Theory, a Bear Market. Obviously, this isn't good. The only silver lining is that the average appears oversold and due for a bounce up.

Not surprisingly, the S&P 500 plunged with the rest of the market after trading in a fairly narrow range for the first nine months of the year. It also fell well below 1,165, which was the midpoint of its low in 2002 to its high in 2007.

The following monthly chart of the S&P offers some perspective. It isn't a pretty chart. You can see how close the average fell to a big support level. It will be very important to remain above 775. There is really no clear support below that, so it could be a VERY precipitous fall from there.

Amazingly, the bond market has remained within its year-long trading range of between 3.3% and 4.3%. Without looking at the chart, you might think that bond market has been rather tame. As you can see by the wild gyrations, bond yields have traded wildly within that range as investors have alternately fled to safety or back to equities.

I've never shown this chart before, but it gives a good indication of what's going on in the credit market. This is a chart of 1-month T-bills. Amazingly, during the worst of the panic selling, investors were willing to buy T-bills that paid virtually no return. I would like to see yields on 1-month T-bills yielding around 1.5%. This would give me some confidence that investors see the crisis as being over.

Last Month's Results

As always, I provide the following chart to show the raw results for the preceding month, the quarter-to-date and the year-to-date. There isn't much to say about the market action in September except that it was pretty awful across the board, with foreign and growth stocks leading the way down. And the bad news is that unless there is a pretty strong final week rally, October will be even worse.

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

Statistics To Watch

  • According to the Department of Labor, the most recent four-week average for seasonally-adjusted initial jobless claims, for the week ended October 11, was 483,250, easily the highest figure of the year. The four-week average from a year ago was a much lower 321,750. These figures continue to be poor no matter how you look at it.
  • Non-farm payroll employment fell by 159,000 in September, after dropping 73,000 in August. Jobs have been lost every month this year. And I assure you, the actual number of jobs lost are much more than the 600,000 reported by the government. Average hourly wages grew a bit to $18.17, but the average workweek fell slightly to 33.6 hours. Real inflation-adjusted wages are stagnating.
  • The number of workers reported in October as unemployed rose to 9.5 million, bringing the unemployment rate to 6.1%. We started the year with 7.7 million people out of work and an unemployment rate of 5.0%. The seasonally adjusted number of people who could only find part-time work rose to 6.1 million and the number of marginally attached workers remained at 1.6 million. The number of people holding multiple jobs increased to 7.72 million. My Comprehensive Labor Index™ rose to 12.53%, the highest level since the end of 2005. My CLI™ is much closer to the true unemployment number in this country.
  • According to the CBO, the government posted a budget surplus of $45 billion in September, which was $68 billion less than a year ago. CBO estimates that the federal budget deficit was about $438 billion in fiscal year 2008, $276 billion more than the shortfall recorded in 2007. Relative to the size of the economy, the 2008 deficit was equal to 3.1 percent of gross domestic product, compared with a deficit of 1.2 percent in 2007 and an average deficit of 2.6 percent over the 2002-2006 period. It is anticipated that the deficit will be at least $1 trillion in 2009, but could easily be as large as $2 trillion. And that is not a mis-print. This cannot be good for the future of the dollar.
  • According to the Census Bureau, the U.S. trade deficit in August was $59.1 billion, down slightly from $61.3 billion in July. The strengthening dollar will hurt exports, but the weakening economy will hurt imports, so I'm not sure what's going to happen to the trade deficit going forward.
  • The Census Bureau reported that privately owned housing starts dropped 6.3% in September, following an 8.1% decline in August, and was down 31.1% from a year ago, to a seasonally adjusted annual rate of 817,000 units. New building permits were also down 8.3% from last month and 38.4% from last year. These are simply terrible numbers.
  • In September, the National Association of Homebuilders/Wells Fargo Confidence Index fell to a record low of 14, down from 17 the month before. below the previous record low of 18 set last month. This index was created in 1985. This incredibly low confidence number belies the one month increase in housing starts and new permits.
  • The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in August plunged 11.5% from the prior month and 34.5% from the same period last year, to a projected 408 million units. That is by far the lowest figure in the four plus years I've been tracking new home sales. The estimate of homes for sale is now 408,000, which represents a whopping 10.9 months of supply at the current rate of sales. The median sales price fell to $221,900 and is below a steadily falling 12-month moving average price of $234,567.
  • The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in August fell 2.2% from the prior month, and were down 10.7% from the same period last year, to a projected 4.91 million units. The estimate of homes for sale, at 4.255 million, represents 10.4 months of supply at the current rate of sales. The median sales price fell to $203,100, which remains below the steadily falling 12-month average of $205,558.
  • The S&P/Case-Shiller Home Price Index, which uses a three-month moving average to track the value of home prices across the US, has fallen to 178.46, it's lowest point since May 2004. This represents a 21.1% drop from the high set in June 2006.
  • According to RealtyTrac, foreclosures increased by 11.7% in August to 303,879, and were 27% higher than a year ago. According to the company, "In August the total number of U.S. properties that received foreclosure filings as well as the national foreclosure rate were both the highest we’ve seen in any month since we began issuing our report in January 2005." Nevada, California and Arizona, respectively, continued to report the highest foreclosure rates in the country.
  • The Institute for Supply Management (ISM) index of manufacturing activity plunged to 43.5 in September, following a weak 49.9 in August. The ISM index of non-manufacturing activity was a better 50.2, suggesting that the service sector, not surprisingly, is doing better than manufacturing.
  • The Conference Board reported that in September it's index of Leading Economic Indicators rose 0.3%, the first increase in five months. This was likely a false rise, derived mostly from a mammoth increase in the money supply. The six-month rate of decline is -1.3% as the economy remains weak, and the outlook is no better.
  • According to the Bureau of Economic Analysis, the "final" estimate of GDP growth in the second quarter was 2.8%, down from the "preliminary estimate" of 3.3%, but better than the "advance estimate" of 1.9%. GDP growth in the first quarter was 0.9%. I can't explain how the government measures GDP growth, but I don't believe for a minute that we experienced any growth in Q2. If GDP were calculated today in the same way as twenty years ago, GDP growth would clearly be negative. I'm convinced we've been in a recession since the fourth quarter of last year and that it continues today.
  • The Federal Reserve reported that in August the amount of outstanding consumer credit decreased by 0.3% from the prior month, to $2,577 billion. This is the first time I have ever seem the amount of outstanding consumer credit go down from one month to the next. I have been waiting for years for this to happen. If this is the beginning of a meaningful trend, it is very negative for the retail sector, and the economy as a whole, and further signifies that we are indeed in a recession.
  • According to the Census Bureau, retail trade and food service sales fell 1.2% in September, following a 0.4% drop in August, June and was 1.0% worse than a year ago. These poor retail numbers are no surprise.
  • The Fed is again ramping up the supply of money. The amount of M-2 has increased by 6.9% in the last three months. But the headline here is that they've increased the supply of M-1 (which is basically the sum of currency, traveler's checks and demand accounts at banks - the narrowest definition of money) by a staggering 19.5%. The Fed is desperately trying to re-liquefy this economy. As Richard Russell has said many times, it's "inflate or die".
  • Amazingly, consumer confidence turned up in September as evidenced by the Conference Board Consumer Confidence Index rising from 58.5 in August to 59.8. I would expect this to be a brief rise in confidence and consumer turn increasingly gloomy in the face of a souring economy. 

Trends To Watch

We have lots of trends to look at this month. As usual, let's start with the financials. Two months ago I wrote that "I don't think we've seen the worst yet. I think we're going to have a number of banks fail, and more merge out of existence, before the credit crisis runs its course." Well, Bear Stears and Lehman Brothers are gone. AIG, Fannie Mae and Freddie Mac are basically in receivership. Washington Mutual, Wachovia and Merrill Lynch were taken over in last second rescues. Goldman Sachs and Morgan Stanley converted to bank holding companies. And that's just in this country. You can be sure that even with the government's best efforts, other banks will fail. I also said that "I believe that the financials are an important indicator of the health of the stock market and the economy - the canary in the coal mine if you will. That canary is still breathing right now, but I expect it will keel over before too long." The canary is dead.

Housing remains a mess, and like the financials, faked out many observers with false rallies. In August I said that "it will take a rise above at least 155 to convince me that the housing sector has turned the corner. I think this is another in a long line of "false bottoms" for housing." That certainly was the case. And I'm confident that things will get much worse before it gets better. The housing sector remains the epicenter of the entire financial/stock market crisis and has a long way to go before heading up in any meaningful way.

Unfortunately, here is where my crystal ball failed me; in fact, it simply shattered. In August, with the price around $110 per barrel I asked, "So where is the price headed now? In the short run (read: next few months), I don't know. It could go lower still I suppose. In the long run though, I firmly believe that the price of oil is headed inevitably higher." To be honest, I never thought that oil could possibly fall this low. I was surprised, and dismayed, when oil plunged from $110 at the end of September to around $70 today. I've shown below the next two support levels of about $60 then around $50. In this environment, anything can happen in the short-term. Long-term, meaning over the next few years, I'm convinced oil will again move higher.

One would have thought (I certainly did) that the price of gold would have held up well during this crisis and the ensuing panic. And for a little while, it did just that. But I was clearly wrong when I said that "I feel confident that we'll see $1,000 per ounce again before we see $850." That didn't work out so well. But I've also said over and over again that "I don't recommend that you trade gold. It's better to establish a position and simply sit with it. Part of why we own gold is for "portfolio insurance". And part is to protect us against rampant inflation and the debasement of our currency. If I'm wrong about the general upward trend of gold, it will likely mean the stock market is headed much higher, and we would be more than compensated for our "losses" in our gold positions by higher equity prices." So if you own gold, just sit tight. If you don't, consider using this low price as an entry point, even though there is support even lower at $650 an ounce. The biggest reason for the weakness in gold is the surge in the dollar (see below), and I cannot believe that the dollar will remain strong for too long.

The "stealth" bull market in silver is over before anyone even realized it was happening. Like gold, the price of silver is plunging thanks in large part to the strength of the dollar. 

Physician heal thyself! Dr. Copper is very sick. The price of copper has plunged almost 50% in six weeks to a two and a half year low. Forget any talk of inflation; deflation is the name of the game right now. Expect the Fed to continue throwing money out of the helicopter.

Here is another new chart: the Baltic Dry Index. Most directly, the index measures the demand for shipping capacity versus the supply of dry bulk carriers. The index indirectly measures global supply and demand for the commodities shipped aboard dry bulk carriers, such as cement, coal, iron ore and grain. Because dry bulk primarily consists of materials that function as raw material inputs to the production of intermediate or finished goods, the index is also seen as a good indicator of future economic growth and production. As such, it appears that the prospects for future economic growth look dim indeed. I would though expect at least a short-term bump because this index is massively oversold.

I must admit that I have been completely surprised by the almost 15% rise in the dollar index over the past six months. I was convinced that the actions of the government to stimulate the economy and unfreeze the credit markets would have soured all investors on the dollar. What I failed to realize was that as bad as things are here, they are better than much of the rest of the world. And the rest of the world continues to view the dollar as a safe port in a storm. So, for now, the dollar strengthens. Given the fact that the federal budget deficit for fiscal 2009 will exceed $1 trillion, and could be as much as $2 trillion, it's very hard to make a case for the continued rise in the dollar. I think it's just a matter of time before it rolls over again.

If you think our stock market looks bad, allow me to present the rest of the world, as expressed by the MSCI EAFE index, which is down almost 50% over the past twelve months. Do you feel any better? Not if you have overweighted international holdings in your IRA or 401k.

Things are even worse in China. The Shanghai Index, which I use as a proxy for China, broke below the support level from early 2007 and has now fallen a staggering 70% from the peak. The next support level is around 1,500, or about 75% below the peak.

What I'm Thinking and Doing

This has been the most difficult couple of months that I've experienced in my 15+ years in this business. I believe we have been living through a financial crisis, not an economic crisis. That financial crisis caused a classic "run on the bank" panic that decimated the financial sector and took everything else with it. The Dow lost 18% in the week of October 5 - 10. Then a couple of days later, it lost 733 points, or 7.9%, in a single session. At the bottom, the Dow was down 40% for the year. With all of that doom and gloom, let me repeat, this is not an economic crisis. We have a poor economy; we are likely in a recession, but this is not a crisis. The de-leveraging of the financial crisis has been, and continues to be painful, but it isn't the end of the world. Countries all over the world are doing everything in their power to prop up the remaining financial companies and loosen the credit markets. And while the process is far from over, progress is being made. Shortly we'll be able to turn our full attention to the economy and what that means for the stock market.

While the horse is already out of the barn, it's worth repeating that this is not a stock market for anyone who needs their money now, or in the next year or so. Anyone with less than a two or three year time horizon should be in cash or short-term treasuries.For those with a longer horizon, I think we're moving closer to a buying opportunity, although we're not there yet. I believe the recession (yes, we are in a recession, regardless of what the government tells you) is going to last longer than I originally expected. I think the best case scenario is for the market to begin to recover sometime late in the first half of next year as it discounts the worst of the economic woes and looks ahead to the eventual recovery. That being said, I would avoid investing in much of the broad market right now, especially consumer discretionary and anything heavily dependent on global economic growth. It is imperative to have a well-thought out investment strategy, a lot of patience, and the fortitude to stick with your plan. If not, find an advisor to help you. In addition, you should also minimize or eliminate your debt, cut back on discretionary spending and save as much as you can. That is the best advice I can give you.

With very few exceptions, I haven't bought anything in months. What I have done is follow the advice I gave above. I substantially reduced WAM's already modest exposure to economically sensitive companies and raised cash. Now, I'm just sitting and watching. For the most part, I'm going to stick with the rest of what I own, even as they have fallen substantially with the rest of the market, because I believe in the long-term story of my core sectors. I don't mind holding cash while I wait for the best opportunities to put that money to work.

Personal News and Notes

Shaena and I enjoyed a beautiful wedding, witnessed by some of our closest friends and family. It was really a perfect evening. The bride was gorgeous, my daughters lovely and my son incredibly handsome. Even the weather did it's part, allowing us to hold the ceremony outdoors in full view of a magnificent fall sunset. Now that the wedding and honeymoon are over, I get to enjoy simply being Shaena's husband.

There really isn't much else to talk about right now outside of what's happening in the economy and the stock market. Therefore I'll end this letter as I usually do, by thanking you, my readers and reminding you that this newsletter is for you. If you have any thoughts or suggestions on how to make it even better, please let me know. And if you'd like to speak with me about your investment needs, I'd be pleased to be of service. Simply give me a call or drop me an email. I look forward to writing to you again next month.

Best regards,

Greg Werlinich

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