Werlinich Asset Management, LLC

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October 23, 2012

Trouble Ahead?

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

Current Market Analysis

As the market opened for trading today, the Dow Jones Industrial Average stood at 13,346, down about 247 points, or 1.8%, from when I wrote to you last month. In the first hour the market immediately sold off another 1.8%, sending the DJIA to its lowest levels since August. It may be that my calls for a year-end rally were premature. As corporate revenues and earnings slow more than expected, it appears that Q4 could be a tough one for the market, demonstrating that the stock market cannot be manipulated by the Federal Reserve and its monetary manipulations. As I said last month, "I think [QE3] is a complete waste of time, energy and money, but I don't make the policy." Right now, at least in the short run, things are looking grim.

The DJIA had an amazing four month run through the end of September, hitting new four year highs and getting to within shouting distance of its all time high. Unfortunately, as we'll see below, the transportation average failed to confirm that advance, unable to concurrently reach new highs. This suggested danger ahead. It's possible that we're now seeing the problems that the transportation average was forecasting. At the close of trading yesterday the DJIA had dropped just below the 50-day moving average but remained above the rising trend line and the 200-day average. If we close today at current levels, we'll fall below the trend line but remain above 31,000. Last month I suggested that "I wouldn't mind a small pullback to provide a breather before the market tries to surmount the next levels." I guess I should be careful what I ask for.

The transportation average not only refused to reach a new high along with the industrial average, but as you can see below, over the last seven months has made increasingly lower highs (see the red line). This is very worrisome. Should the DJTA fall below support at 5,000 it would be very bearish.

The rally in the Dow Jones Utility Average seems to be regaining some strength. The price has been rising over the past two months and is currently above the rising trend line and both moving averages. As I've said before, utilities benefit from low interest rates so this sector should be solid for the next few years. While I am a bit concerned about the declining volume (see the red line), I reiterate that I'd use any weakness to buy a stake for investors seeking conservative, high-yielding income opportunities.

Interest rates have moved 0.40% higher over the past two months, thwarting the efforts of the Fed to keep rates as low as possible. The rate is currently bumping against resistance around 1.9%. You'll notice that this is the third time the yield has archived this level since August. We'll see if again the rate turns south or maybe moves back over 2% if there is a real sell off in equities.

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, including the reinvestment of dividends. The third quarter finished with strong gains posted across the board in September. Interestingly, the rally was led this time by value stocks after growth had powered the way most of the year. Technology in particular began to lag, which harbors a warning for diminished returns in the fourth quarter. The year-to-date return on the bond index (Barclays Aggregate) continues to lag dramatically behind equities. I've said all year, and I'm certain to be proved correct that it's going to be difficult to make much money in bonds this year when bond yields began the year so low; there simply isn't much further they could drop. The EAFE returned its best gains of the year in the quarter, defying fears of a collapse in the ECU. We'll see what happens in the final quarter as the news from Spain grows increasingly more ominous.

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

Barclays Aggregate




US government bonds

Barclays High Yield




High-yield corporate bonds

* Return numbers include the reinvestment of dividends

Statistics To Watch

  • According to the Department of Labor, the figure for seasonally-adjusted initial jobless claims for the week ended October 13 was 388,000, an increase of 6,000 from a month ago and 46,000 higher than the prior week's revised figure. The four-week average of 365,500 is about 10,000 lower than the prior month's tally. After falling the past few weeks, initial claims spiked in the recent report. About 3.25 million people continue to collect unemployment insurance, similar to the prior month.
  • Non-farm payroll employment in September was a mixed bag, as the establishment survey reported that only 114,000 low-paying jobs were added in the month while the household survey suggested that the unemployment rate dropped below the magic 8% line to 7.8%. New monthly job growth has averaged 146,000 this year, as opposed to 153,000 in 2011.
  • Revisions to prior months added back 86,000 jobs, which suggests that the September number may be revised higher in the future. The total number of workers counted as unemployed dropped to 12.1, which helped get the unemployment rate down to 7.8%. The labor force participation rate ticked up to 63.6%. The more comprehensive U-6 "underemployment" rate held steady at 14.7%.
  • A slightly lower 4.8 million people continued to be unemployed longer than 27 weeks. The seasonally adjusted number of people who could only find part-time work jumped to 8.6 million and the number of marginally attached workers inched down to 2.5 million. The number of people holding multiple jobs rose to 6.8 million. The average hourly wages for blue collar workers increased slightly to $19.81 while the average work week remained at 33.7 hours. On balance, this was a mediocre report with a wonderful headline number.
  • The Congressional Budget Office (CBO) estimated that on a net present value basis, the Treasury reported a federal budget surplus of $75 billion in September and deficit of $1.091 trillion for fiscal 2012, which was about $200 billion less than fiscal 2011. The deficit was 7.0% of GDP this year, down from 8.7% in 2011 and 9.0% in 2010, but still higher than any year between 1947 and 2008.
  • The Census Bureau reported that the U.S. trade deficit of goods and services was $44.2 billion in August, slightly more than in July. Still the trade deficit continues to be fairly stable this year.
  • The Census Bureau reported that privately owned housing starts surged 15% in September, building on a 4.1% gain in August. Housing starts are now a whopping 34.8% higher than a year ago, to a seasonally adjusted annual rate of 872,000 units. New building permits were up 11.6% from the prior month and 45.1% higher than the year before. This is a strong sign that the recovery is continuing.
  • The National Association of Homebuilders/Wells Fargo Confidence Index gained 1 point in October to 41. That marks the sixth straight monthly increase in builder confidence, and its slowly creeping up towards a healthy figure of 50. This metric too shows a strengthening recovery in housing.
  • The Census Bureau reported that on a seasonally adjusted annualized basis, the 373,000 new homes sold in August was roughly the same amount as in July, but were 27.7% higher than a year ago. The estimate of homes for sale was 141,000, which represents a paltry 4.5 months at the current rate of sales. The median sales price jumped in the month to $256,900, which is the highest monthly figure since March 2007, and well above the rising 12-month moving average price of $230,925. The new home sale market remains very tight; and will remain that way until banks relax their lending standards a bit and more new inventory comes to market.
  • The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes were 1.7% lower in September, after rising 8.1% in August, to 4.75 million units, but remained 11% higher than a year ago. The estimate of 2.32 million homes for sale means there's only an estimated 5.9 months supply on the market. The median sales price fell a smidge to $183,900, which is well above the rising 12-month average of $171,742. As with new homes, the existing home market is getting tighter and tighter, which suggests that prices will start rising soon.
  • The S&P/Case-Shiller Home Price 10-city index, which uses a three-month moving average to track the value of home prices across the US, rose for the fourth straight month in July, posting a solid 1.5% increase. There's little question that the trend of increases will continue through the rest of the year.
  • The Institute for Supply Management (ISM) index of manufacturing activity was 51.5 in September, ending the string of three straight months of contraction in the manufacturing sector. I have to admit I'm surprised by this turnaround given the uncertainty facing big business between the election, potential tax increases, deflation in Europe and unrest in the Middle East. This anxiety makes companies reluctant to hire because they simply cannot quantify the return on that investment. The service sector, on the other hand, shows no sign of slowing down. The ISM index of non-manufacturing activity was 55.1, up from August, which marked growth in the service sector for 33 consecutive months.
  • The Conference Board reported that it's index of Leading Economic Indicators increased by 0.6% in September after a decrease of 0.4% in August. Says Ataman Ozyildirim, economist at The Conference Board: "The U.S. LEI increased in September, more than offsetting the decline in August. The LEI has been signaling an economy that is fluctuating around a slow growth trend. The six-month growth rate has slowed substantially, but still remains in growth territory due to positive contributions from the housing and financial components."
  • According to the Bureau of Economic Analysis, the "third" estimate of GDP growth for Q2 2012 was 1.3%, down from 1.7% in the "second" estimate, and down further from 2.0% in Q1 and 3% in Q4 2011. Indeed, we're back to the 1.3% from Q2 and heading towards the 0.4% of Q1 of last year. This hardly seems like an economic recovery. And I truly believe that no amount of QE is going to make things any better. It's going to take time and pain like all true recoveries.
  • The Federal Reserve reported that in August the amount of outstanding consumer credit was $2.73 trillion, up from the prior month and growing at an 8% annualized rate. This is a return to growth after falling slightly the prior month. We're still waiting to see a real contraction resulting from the stagnant labor market and zero real wage growth.
  • According to the Census Bureau, retail trade and food service sales increased 1.1% in September, following a 1.2% increase in August, leaving them 5.4% higher than a year ago. These numbers are telling us that either the economy is better than we're led to believe, or that consumers are simply delusional. The big winners were electronics and appliance stores and gas stations. Most other sectors saw modest gains.
  • The Federal Reserve reported that in September the six month rate of growth in the supply of M-2 (a broader view of money) was 6.4%, up slightly from August. The supply of M-1 (a narrower definition of money), on the other hand, rose a much faster 13.9%. How much longer can the Fed continue to increase the supply of money? And when will the banks release their death grip on these funds and actually put the money to work in the economy? Where's the Congressional hearing about that?
  • The Conference Board's Consumer Confidence Index surged to 70.3 in September, after falling in August, bringing the index back to the highest level since February. Says Lynn Franco, Director of The Conference Board Consumer Research Center: The Consumer Confidence Index rebounded in September and is back to levels seen earlier this year (71.6 in February 2012). Consumers were more positive in their assessment of current conditions, in particular the job market, and considerably more optimistic about the short-term outlook for business conditions, employment and their financial situation. Despite continuing economic uncertainty, consumers are slightly more optimistic than they have been in several months."
  • According to the FDIC, 3 banks failed in August, bringing the total number of bank failures so far this year to 43, which is 31 better than this time last year. It's clear that there will be far fewer bank failures this year than the 92 banks that failed in 2011, which was a big improvement over the record 160 banks that were either closed or merged into healthier banks in 2010, and 140 in 2009. By comparison, only 26 failed in 2008 and a negligible 3 in 2007. I wonder if we'll return to the 2007 levels any time soon.

Trends To Watch

For the past two months the dollar index has traded in a very tight range between 79 and 80. Interestingly, the index is sitting right at the midpoint (dotted line) between the trading range established over the past year and a half. The future direction of the dollar could help determine the fate of the stock market. There is strong support for the dollar between 78 and 79. Should the index slip below that it could be a boon for equities.

After spending much of the year writing about the declining wedge patterns for gold, silver and copper and suggesting that a big bullish was forthcoming, I was proven right in September with big rallies in all three commodities. Now, those rallies seem to be petering out. Look at the action of gold.After approaching $1,800/oz, I told you last month that "RSI is very overbought, so I wouldn't be surprised to see a bit of profit-taking, but looking ahead, this is extremely bullish." Well, the price has backed off so much that RSI is now approaching oversold levels. The current price is right around the 50-day moving average. Interim support should come in around $1,700/oz (green dotted line), at which point I'd probably be a buyer again.

If you listened to my suggesting to buy gold before the big breakout, you were amply rewarded. Now, like gold, silver has moved from wildly overbought to oversold in only a month. The trading pattern seen below is very clear. The current momentum is bearish but longer term I still think the investment thesis is bullish. Our next buying opportunity may be coming up shortly.

And lastly we see that copper also had moved dramatically higher in September before consolidating in October. Interestingly, the current price has converged right at both the 50- and 200 day moving averages. I think the first key support will be around $3.50 (green dotted line). The next support would be around $3.20.

After briefly teasing $100/barrel, the price of West Texas crude has dropped over the past month. I think this is a reflection of the dismal state of the global economy and the assumption of lower consumption going forward. Also, the spread between WTIC and Brent Crude as widened again to $21. Given today's economic climate, the political and social unrest in the Middle East, and the constant threat of conflict, I'm surprised that the price spread is so wide. Looking ahead, I still believe the "normal" trading range for WTIC will be between $80 and $100.

The financial index has continued to move higher and it's again bumping against resistance at $16.25. The financial sector could be facing some head winds looking ahead because of an unintended consequence of QE. Specifically, banks are seeing their net interest margin, which is the difference between their borrowing and lending cost, get squeezed. This could crimp bank earnings. So I'm going to maintain my stubborn position of avoiding bank stocks.

Simply stated, the housing sector continues to be a winner as it has more than doubled over the past year in a virtually nonstop rally. Given the positive data coming out the housing sector, described in detail above, it's hard to be opposed to this trade.

Remarkably, the index for the developed international markets continues to recover. The EAFE index has surged off major support at 46 and is making it's second attempt to pierce resistance around $56 (red dotted line). This situation can change at any moment so it requires are attention.

It continues to amaze me that the chart of the developed international markets is virtually identical to the one for the emerging markets. This should not be the case as the two markets could not be more different in their composition. The former is made up of stodgy, no growth markets while the latter is comprised of fast moving countries with huge future growth potential. I've been writing for months that this correlation would have to end and I've been wrong each time. We'll see if I'm proven right eventually. For now, the chart is bullish and the index approaches resistance at 44 (orange dotted line).

For two years I've been bemoaning the sad state of the Shanghai index. Each time there has been a hint of recovery it's been quickly squashed. So what's happening now? Is it the beginning of something positive or simply another head fake to sucker in more investors? What does this chart tell us about the TRUE state of the Chinese economy? If it's really this bad, we're all in trouble.

Now we come to our three contrarian indicators. First is the NYSE Bullish sentiment index. This chart suggests that the market is still a bit too bullish after the big run up, and that there is more downside potential ahead.

Next we see that about 60% of stocks traded on the New York Stock Exchange are currently trading above their 50-day moving average, down from 85% only a month ago. This hints that the correction is underway but may not be finished yet.

Finally, we look at the VIX, or the "fear index". After being overly complacent as summer drew to a close, we are seeing the beginning of a spike in volatility. Taken together, these three charts suggest to me that in the next few weeks we could have further losses in the market.

What I'm Thinking and Doing

Like much of America I've been thinking a lot about the election, which thankfully will take place in just two more weeks. After almost two years, untold millions of dollars spent and even more promises made, we will finally pick between President Obama and former Governor Romney. I've said all along that I believe Obama will be re-elected in a relatively tight race and I'm sticking with that prediction. I think the important issues have been articulated, even if the positions of the candidates aren't always as clear. While I know who I'm voting for, I don't think either one will be able to address the key problems of the deficit, healthcare, jobs and Medicare without a real partnership with Congress, and I don't see that happening any time soon. That will take courage that neither party possesses. So we will simply continue to limp along, regardless of who wins.

As for the market, I think we're at a dangerous inflection point. The situation in Europe is not getting any better. We are drawing ever closer to the "fiscal cliff" with no resolution in sight. Q3 corporate earnings seem to be coming in weaker than expected. The stocks of some of the big tech companies like Google, (GOOG), Apple (AAPL) and Microsoft (MSFT) are looking awful and growth stocks like Chipotle (CMG) have fallen off dramatically. I'm being extra cautious right now. I'm not looking to buy anything new right now and I might sell a bit into strength to raise some additional cash. I wouldn't mind having some extra money ready for the inevitable sell off.

Professional News and Notes

I've written almost two dozen original articles in my blog and I'm slowly building up a a following, which is extremely gratifying. It seems as though politics has dominated my thoughts recently, but I expect that after the election I'll return to a greater focus on the stock market. So please check it out and share your thoughts by clicking here. As I'm trying to expand its coverage, I would really appreciate it if you could forward the link to some of your friends and colleagues and comment on one or more of the existing blog posts. It would also be helpful if you could suggest topics for future entries. If you "follow" the blog, you'll be notified by email any time I post some new copy.

Between now and the end of the year I expect to make some changes to my website. I'm hoping to "freshen the look" and make it more current and accessible. I'll keep you posted as the new version gets closer to going "live".

As always, I thank you, my readers, and remind you that this newsletter is for you. I have been writing News and Views for almost nine years now. If you'd like to read any prior edition, simply go to my website and click on the link to my newsletter archives. I hope you have learned something about our economy and our stock market, and that you will continue to follow along with me in the future. If you have any thoughts or suggestions on how to make it 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.

Best regards,

Greg Werlinich

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