Current Market Analysis

Yesterday was an enormous day in the market, from both a technical and a psychological perspective. The Dow Jones Industrial Average closed the session at 10,015.86, above the 10,000 barrier for the first time since the crash last fall. Even more importantly is the fact that the Transportation average also closed at a new high, thereby confirming, for the first time since September 15, a Dow Theory bullish trend. The Industrials have risen by about 53% since the March low. That's quite a rally!

I wish I could tell you that the Bear Market is over, the recession is over, that we are headed for a "V" shaped recovery and that we're headed back to Dow 14,000 again. The problem is that I simply don't believe it. The recession is almost two years old right now. Unemployment is still rising. The federal deficit is still growing. Our trading partners are growing increasingly disenchanted with the losses their taking on their dollar holdings. And while the economy appears to be improving, as I'll talk about below, we still have a long way to go before any intelligent person can declare that we are in anything resembling a robust recovery.

With all of that being said, I wrote in August that "I think the summer rally could extend the stock market gains all the way into the fall as the short-term trends remain very bullish." Well, that's clearly the case right now. And I'm not going to "fight the tape" right now and the current trend remains bullish.

Before we get to the charts, please remember not to confuse a short-term, or "cyclical" trend with a long-term, or "secular" trend. I believe, until proven otherwise, that this is a cyclical bull market, and will stay that way until it doesn't. At that point, we'll have to re-evaluate everything.

So what do the charts tell us now, after the latest Dow Theory confirmation? Well, it shows good times. Seriously, the inverted Head and Shoulders remains intact, as does the rising trendline (the blue line). Other than natural mild corrections along the way, there is little here to suggest anything other than further short-term gains. The one thing that concerns me a bit is that the market has rising in the face of dwindling volume. That means that the "big money" may be sitting on the sidelines waiting for the market to turn lower.

After waiting a month, the Transportation average yesterday finally confirmed the new highs attained by the Industrial average. Similarly, the Head and Shoulders here also remains bullish. I'm not sure where the next resistance level will come in; perhaps around 4,500 or so.

Since May, the yield on the 10-year treasury has traded between 3% and 4%. Right now, we're about at the midpoint. As I suggested last letter, watch for yields to remain in the 3% - 4% range for the remainder of the year before heading inevitably higher sometime beginning in 2010.

Last Month's Results

• According to the Department of Labor, the most recent figure for seasonally-adjusted initial jobless claims for the week ended October 3 was 521,000. The four-week average has declined to 539,750. The seasonally adjusted number of continuing claims for unemployment is just over 6.0 million. That's a lot of people collecting unemployment insurance. And it doesn't account for all the people who have fallen off the rolls but still can't find a job. 7.6 million people have lost their jobs since this recession began in December 2007.
• Non-farm payroll employment was disappointing in September, falling by 263,000 versus a revised 201,000 in August. Average hourly wages inched up to $18.67, while the average work week fell to 33.0 hours, so real wages actually fell a bit.
• The number of workers reported in September as unemployed rose to 15.1 million, increasing the unemployment rate to 9.8%. The seasonally adjusted number of people who could only find part-time work rose to 9.2 million and the number of marginally attached workers held at 2.2 million. The number of people holding multiple jobs fell to 7.06 million. My Comprehensive Labor Index™, which is much more representative of the real unemployment situation, increased to 20.23%. Unfortunately, my prediction that my CLI™ would exceed 20% before the end of the year has come true. The question now is just how high this will get.
• The Congressional Budget Office (CBO) estimates that on a net present value basis, the Treasury reported a federal budget deficit of $1.4 trillion for fiscal 2009. This is $950 billion more than 2008. The deficit for 2009 represents 9.9% of GDP, as opposed to 3.2% in 2008. It was simply a horrible confluence of significantly higher government outlays for things like TARP payments, support for Fannie Mae and Freddie Mac, higher entitlement costs and military spending, plus decreased tax revenues. There isn't much hope that 2010 will be significantly better.
• The Census Bureau reported that the U.S. trade deficit of $30.7 billion in August June was down slightly from $31.9 billion in July. About 66% of this deficit is with China.
• The Census Bureau reported that privately owned housing starts rose 1.5% in August following a flat month in July, but was still down 29.6% from a year ago, to a seasonally adjusted annual rate of 598,000 units. New building permits were up 2.7% from last month but were still down 32% from last year. It appears that the picture for housing starts may be improving just a bit.
• The National Association of Homebuilders/Wells Fargo Confidence Index rose in September from 18 to 19; it's highest level since May 2008.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in August rose 0.7 from the prior month, but were still down 3.4% from the same period last year, to 429,000 units. The good news is that new home sales have increased five months in a row. The estimate of homes for sale is down to 262,000, which represents smaller 7.3 months at the current rate of sales. The number of new homes for sale have decreased in each of the last 13 months, which is also good news. The median sales price fell to $195,200, which was below the 12-month moving average price of $214,625. The falling average sales price suggests that the majority of new home sales continue to be from distressed or foreclosed properties.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in August fell 2.7%, breaking a streak of four consecutive month over month increases. Sales are actually up 3.4% from a year ago, to a projected 5.1 million units. The estimate of homes for sale, at 3.62 million, is the smallest figure since January and represents 8.5 months of supply at the current rate of sales. The median sales price fell to $177,700, which is still slightly higher than the 12-month average of $176,583.
• 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, increased for the fourth straight month, 155.85 in July. While this is certainly an improvement, there is a long way to go to return to better levels.
• According to RealtyTrac, the number of foreclosures in August decreased nominally from July to 358,471, but remained 18% higher than a year ago. Nevada, Florida and California reported the highest foreclosure rates in the country while California, Florida and Michigan had the highest actual number of foreclosures.
• According to real estate research firm Reis, Inc., the national vacancy rate hit a 23-year high despite being propped up by landlords willing to take lower rent to keep tenants. The U.S. apartment vacancy rate rose to 7.8 percent in the third quarter, its highest since 1986, according to the report released on Tuesday. Vacancies have been rising since the third quarter of 2007, according to Reis.
• The Institute for Supply Management (ISM) index of manufacturing activity was 52.6 in September, continuing the general uptrend in place so far this year. This marked the second month in a row in which the manufacturing sector showed signs of growth. The ISM index of non-manufacturing activity was a slightly lower 50.9, but was over 50 for the first time in more than a year.
• The Federal Reserve reported that capacity utilization in the industrial sector increased 0.8% to 69.6% in August after a small increase in July. Capacity utilization still remains 11.3% below the average level of the period from 1972 through 2008.
• The Conference Board reported that it's index of Leading Economic Indicators rose by 0.6% in August, following 0.9% and 0.8% in July and June, respectively. After peaking in July 2007, the LEI fell for 20 months in a row. This is now the fifth monthly increase in a row. Most of the components of the index gained sharply, suggesting that the recession may have bottomed out.
• According to the Bureau of Economic Analysis, the "final" estimate of GDP growth in the second quarter was -0.7%, slightly better than the "advance" and "preliminary" estimates, which both showed a decline of 1.0% from the first quarter. In the first quarter, real GDP declined by 6.4%. This offers more anecdotal evidence that the worst of the recession is now behind us.
• The Federal Reserve reported that in August the amount of outstanding consumer credit fell by an annualized rate of 5.8% from the prior month, to $2,462 billion. That means that consumer credit has declined in eleven of the last twelve months, and is at it's lowest level since July 2007. That's good for consumers, bad for the economy.
• According to the Census Bureau, retail trade and food service sales increased 2.7% in August, but remained 5.3% below the levels from the year before. The Cash for Clunkers program probably had a big part in the overall growth of retail sales. So we'll see if this growth can hold now that Cash for Clunkers is over.
• The Federal Reserve reported in that in August the supply of M-2 actually decreased by 0.6% from the prior month and 2.3% during the prior three months. The supply of M-1, on the other hand, rose by 13.2% during the last three months. It seems clear that the overall rate of monetary expansion appears to be slowing somewhat.
• The Conference Board Consumer Confidence Index fell in September, after a large increase in August, to 53.1 from 54.5. The decrease was largely due to a very pessimistic view of the labor market and general business conditions.
• According to the BEA, disposable personal income continues to fall, which caused the personal savings rate to fall from a high of 6.4% in May to 4.6% in June, then 4.0% in July and 3.0% in August. It's hard to save money if you don't have a job.
• According to the FDIC, 98 banks have failed so far this year, and have either been closed or merged into healthier banks. It is likely there will be hundreds of more failures before the recession is fully behind us.

The price action of the dollar index remains bad and in fact, seems to be getting worse. The index has fallen well below both the 50- and 200-day moving averages and the 50-day average has moved way below the 200-day. In addition, the index has fallen below one support level and is dangerously close to falling below a second. I said last time that "as the budget deficit grows to unprecedented levels and the economy remains weak, I expect the dollar to fall further. The dollar is in big trouble." I see nothing to change that opinion. If the trend follows the head and shoulders pattern that I outlined, the index could certainly head towards the next resistance at around 72.

Where are the gold naysayers now? It's awfully quiet out there in "gold is a barbaric relic" land. It's pretty hard to argue with the reality that gold is now firmly over $1,000 per ounce. That being said, there will certainly be a correction and some profit-taking, but this is not the top; this is just a point along the way in an upward trend to a much higher level.

Just to give you some perspective, and to further debunk the gold naysayers, take a look at the weekly chart of gold over the past 10 years. Try to imagine any other asset class, or any other investment, that has performed as well over the past decade. If you can think of one, please let me know.

The price of West Texas Crude has resumed its inevitable upward march. The price of black gold has moved above strong resistance at around $75. From a technical perspective, there is little in the way of a move back to $100. Two months ago I wrote that "regardless of any short-term movements, I'm convinced that the price of oil is headed inevitably higher. And the rising triangle pattern is bullish also." Well, that bullishness has rewarded investors who were long oil-related securities.

The rising price of copper continues to be a good indicator of growing economic strength. And while I believe much of this increase is due to economic activity in China, it's still a positive. On a purely technical basis, the fact that the 50-day moving average has crossed above the 200-day average, that the metal is making higher highs and higher lows, is very bullish. Until the rising trendline is clearly broken, I would expect prices to continue to increase.

We appear to be at a very interesting juncture for the financial sector. After moving sideways for about three months in the spring, things again turned positive in the summer. Now, the sector appears to be bumping up against a big resistance level. It would be very bullish for the XLF to break clearly above $16.50. I still believe that the fate of the financials is tied to the unemployment rate. If unemployment moves too much higher, housing foreclosures, credit card defaults and loan losses all rise, forcing already sick banks to raise even more capital or simply go under. Watch this situation very closely.

The slightly better results in the housing market over the past few months have been reflected in the price of the housing index. A key resistance level just under $100 was broken to the upside, but it has not been smooth sailing by any means as the sector isn't close to being out of the woods yet. Like the financial sector, housing is clearly linked to the labor markets, interest rates and the overall economy. It wouldn't take much to knock housing back down.

Foreign markets, as represented by the MSCI EAFE index, continue in their basic uptrend. There is nothing in this chart that would suggest any meaningful concerns.

I wanted to show you the chart of China because it's very interesting to see that the Chinese stock market experienced a major selloff in August, from which it hasn't yet fully recovered. As investors, should we be worried about this? As China is the engine that basically drives the world's economy, I think so. This could either be a good buying opportunity or a flashing danger sign.

Another potential danger sign is the poor action of the Baltic Dry Index. Is this simply moving in tandem with the Chinese stock market, or is there a more insidious danger being signaled here? If the index drops below the bottom of the triangle, that would be very bearish.

The NYSE Bullish Percent Index represents the percentage of stocks listed on the NYSE that signal a buy. Contrarians would argue that the extreme levels of exuberance noted in the chart suggest a bearish indicator because there is little room left to the upside. The good news is that even though we have a very high level of bullishness, RSI is basically flat at 50. Until the rising triangle pattern is punctured to the downside, this should remain bullish.

The volatility index, also known as the "investor fear gauge", continues to move lower. Indeed, it has returned to the middle of the normal range. This is very good and suggests a basic optimism for the near-term future of the market.

What I'm Thinking and Doing

Personal News and Notes

Greg Werlinich
President

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