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

Nothing goes up in a straight line forever, not even a broad market rally. After peaking recently at 12,361, the DOW Industrials has fallen about 200 points to its present level. I think as long as it holds above 12,000, which is the lower end of the channel, and coincidentally its 50-day moving average, the bullish trend will likely remain in force. As I write this shortly after the opening, the Dow, and most of the stocks that I follow, are up strongly in an early rally. We'll see if this holds. I'm still concerned that the market might be in a classic "blow-off" phase, having rallied so strongly over the past five months. But until this rally is reversed, there is no reason to "fight the tape."

As I mentioned last month, 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 still not the case. The Transports remain about 245 points below the May high. As the Transports move the goods that power the economy, the fact that they have not hit new highs along with the Industrials is a bit worrisome. I'll be keeping an eye on this disparity.

And what is the bond market telling us? It's telling me that there are problems. While the Fed Funds rate remains 5.25%, the yield on the 10-year Treasury has fallen to about 4.50%. That is a very large spread between short and long rates. At the same time Fed Chairman Bernanke tells us that the Fed is poised to tighten rates to stave off further inflationary risks that the bond market just doesn't see. Real estate is deflating, earnings at Wal-Mart are deflating and the value of the dollar is deflating (more on that later) while our debts are inflating. That does not seem to be an inflationary environment. I think that the only inflationary force in the US right now is the increase in the money supply (more coming up on that too).

While I continue to be a bit mystified as to the reasons behind the astonishing bullishness in the market right now, I also see no reason for things to change dramatically between now and the end of the year. I would though remain very vigilant for any "shock" that might upset the delicate balancing act that is our stock market. It probably wouldn't take much to knock the broad market off its lofty perch.

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. Following a run of good months in the third quarter, October may have been the best month of the year for the broad averages. After ten months, the Dow and the S&P are both up by double-digits, and even the NASDAQ is up a respectable amount, even though value continues to trump growth as an investment theme. Assuming that nothing horrible happens in the final two months of the year, investors will have much to cheer about as they ring in the new year.

What I'm Doing Now

Good riddance to bad rubbish. After a lousy third quarter, WAM rebounded strongly in October. As I wrote last month, I felt that the summer doldrums for my portfolios was nothing more than a natural correction and cooling off period after almost four years of outsized returns. In fact, it wouldn't surprise me to have further corrections to some of my positions. That being said, I fully expect that on average, over the next few years, my core sectors will continue to substantially outperform the broad markets. All it takes is some patience and conviction, both of which I have.

A few weeks ago I was forced to liquidate a key position in the energy sector. While I remain quite bullish on the industry, a very negative company-specific event occurred that changed the investment thesis. As a result, I sold that position and I'm now looking to replace that stock with another one in the same sector.

Statistics To Watch

• The most recent four-week average for initial jobless claims, for the week ended November 18, rose to 317,000, which is only fractionally higher than the average for the year of 311,400.
• According to the Department of Labor, non-farm payroll employment rose only 92,000 in October, after large upward revisions in September and August to 148,000 and 230,000, respectively. The Labor Department is famous for their revisions so who knows what the October number really was. Average hourly wages increased to $16.91 from $16.84. The average workweek inched up to 33.9 hours. The number of people holding multiple jobs increased to 7.87 million from 7.79 million.
• The number of unemployed workers fell to 6.7 million in October. The seasonally adjusted number of people, who for economic or business reasons could only find part-time work, rose to 4.3 million and the number of marginally attached workers rose to 1.5 million. My adjusted Comprehensive Labor Index™ rose to 8.59% while the official unemployment rate reported by the government dropped to a new low of 4.4%.
• The Conference Board reported that it's index of Leading Economic Indicators increased 0.2% in October after a revised 0.4% gain in September. Declining housing permits was the biggest negative contributor.
• The University of Michigan Consumer Confidence Index surged to 93.6 in October from 85.4 last month.
• According to the CBO, the government posted a budget deficit of $49 billion in October, which was similar to the same period last year. An interesting note from the 2006 deficit is that net interest on the public debt grew almost 24% from 2005 and Medicare outlays grew another 16.5%.
• According to the Census Bureau, the U.S. trade deficit in September fell to $64.3 billion from $69.0 billion in August as imports fell, likely due to the cheaper dollar making imports more expensive.  
• The Labor Department reported that on a seasonally adjusted basis, the CPI for urban consumers fell 0.5% again in October while the "core" CPI, which excludes food and energy, was up only 0.1%. Again, the reduced value of CPI can be almost entirely attributed to falling energy prices.
• The Federal Reserve reported that for only the second time this year, the amount of outstanding consumer credit fell on a month-over-month basis, as it dropped in September from the record high of $2.367 billion in August to $2.366 billion. I'm confident that this number will rise going forward as consumers spend during the holiday season.
• According to the Census Bureau, retail trade and food service sales fell 0.2% in October after falling 0.4% in September. This continues the trend of slowing retail sales going back to May. On a year over year basis, retail sales were still up 4.5% vs. 2005.
• The Census Bureau reported that privately owned housing starts in October plunged 14.6% from revised lower September levels, and 27.4% from the same period last year, to a seasonally adjusted annual rate of 1.49 million units. Similarly, building permits were down 6.3% from September and 28% from last year and new construction was also lower.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in October fell 3.2% from revised lower September levels, and was down 25.4% from the same period last year, to a projected 1.004 million units. The estimate of new homes for sale, at 558,000, represents 7.0 months of supply at the current rate of sales. The median sale price unexpectedly surged to $248,500, the highest number since April.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in October rose 0.5%, but was 11.52% lower than the same period last year, to a projected 6.24 million units. The estimate of homes for sale, at 3.85 million, represents a staggering 7.4 months of supply at the current rate of sales. The median price of homes sold held steady at $221,000.
• In their latest US Foreclosure Market Report, RealtyTrac reported that 115,568 properties nationwide entered some stage of foreclosure during October, a 3.0% increase from September and a 42% increase 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 51.2 in October. This marked the 41st 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 "preliminary estimate" of the annualized rate of GDP growth for the third quarter of 2006 was 2.2%, which is higher than the "advance estimate" of 1.6%. This follows GDP growth of 2.6% in the second quarter. As always, the final 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 $15 billion in September, or 0.2% of personal disposable income, as compared with a revised negative $49 billion in August. Americans have spent more than they earn every month this year, although the trend is getting smaller. It is therefore no surprise to see foreclosures up and retail sales down.
• The Fed increased M-2 by 0.9% in October, or a 10.8% annualized rate. The supply of M-2 has increased by 5.9% in the last three months and 4.8% in the last twelve months as the Fed attempts to stave off the possibility of deflation. Falling real estate, energy and commodity prices, and falling bond yields suggest that deflation is a possibility. So don't let anyone try to fool you; the Federal Reserve is creating the very inflation that they are supposed to be fighting because they know inflation is much better than deflation in this debt-ridden society.

Trends To Watch

Not surprisingly, the chart of the S&P 500 looks very much like the chart of the Dow Industrials. Most importantly, it shares the same parabolic rise over the past five months. And while the recent correction has cured the immediate oversold situation, I think investors should expect some form of further correction, or cooling off period.

I want to again show you the "Big Picture" of the market by looking at the weekly chart of the Wilshire 5000 covering the past six years. The first thing to notice is that the index is only about 5% below its all time high of 14,991, set in early 2000. From a technical standpoint, you should note the almost every time the RSI hits or passes 70, there is a correction and if it gets down to 30 there is always a rally. Similarly, when the MACD rises above +100 the index usually declines, whereas moves below -100 presages a rally. Well, the RSI is now at 70 and the the MACD is right around +100 right now; so beware.

The "relatively" low price of West Texas crude continues to provide support to the overall market. Virtually nothing has changed in the chart since last month as the consolidation continues. My long-time readers know that I am a bull on the price of oil. I remain convinced that oil prices, over time, will go much higher. The question is when prices will resume their upward march. For now, we wait and watch.

While oil continues to consolidate in a tight range, the price of gold appears, at least temporarily, to have broken out of its consolidation and moved strongly upward. The price of gold is now trading above its 50- and 200-day moving averages and is poised to move over $650 per ounce. With RSI close to 70, I would expect some short-term price decline before further gains. Eventually, a move past $676, the July high, would be significant. As I have written over and over, 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.

Permit me to show you two charts on the movement of the dollar. The first is the daily action for the past two years. Clearly, the dollar has plunged below support and is now very oversold, and therefore due a rally. More importantly though is the downward trend and the violation of that support level. I wrote last month that "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." At least for now, that appears to be the case.

The second chart, to me, is much more ominous. It shows the monthly price action of the dollar since 1983. With the exception of the three years encompassing 2000 to 2003, the dollar has, for the last twenty years, traded between 80 and 100. I believe it would be a very bad thing If the dollar falls below 80. Low interest rates and a significantly devalued dollar would create a powerful reason for foreign investors to rethink their investments in this country. If that were to happen, rates would have to move up in order to continue to attract that investment, and that could destroy the delicate balance that now underpins our stock market.

Well, the "Suckers Rally" in the housing market continues. I suppose if this goes on much longer I'll have to admit that I am the Sucker. Some contrarian investors have made good money on this rally over the past few months. While low interest rates can't hurt, nearly every statistic out there screams to me that we haven't seen the worst yet in this sector, so I'm going to sit this move out. 

Finally, let's look at the ever-steepening inverted yield curve below. The Fed Funds lending rate is still 5.25%. 6-month t-bills yields 5.12% (down from 5.15% last month), 2-year Treasuries yield a lower 4.67%, 10-year Treasuries yield 4.50% and the 30-year Treasury yields 4.60%. 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

It's hard to believe that in two days it will be December. It has been the warmest November in memory here in New York. In fact, the weatherman says it may be 65 tomorrow. It does make you wonder about the whole global warming issue. If it's almost December, that means that Hanukkah, Christmas and New Years are almost upon us. So enjoy the upcoming holiday parties. 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.