Current Market Analysis...Slowly Declining

I suppose that after patting myself on the back for most of the year as many of my predictions for the market have come to pass, I must accept some culpability for when I'm wrong. In my last letter, with the Dow teetering at about 9,750, I remarked that I was dismayed to read that the Big Money investors of Barron's predicted that the Dow Jones would rise an astonishing 1,000 points in the last two months of the year. I thought Barron's was doing a terrible disservice to their readers with such a ridiculous forecast. Well, as I write this, the Dow is 10,625, a mere 100 points below the year-end Big Money prediction of Dow 10,724. Certainly, with four weeks left in the year, a lot could happen in the market, but it appears that their year-end forecast may not be far off. Mea culpa.

That being said, I haven't changed my investment stance or my outlook one bit. My clients and I have enjoyed this rally as much as anyone, yet their fortunes aren't tied to its continued ascent. The Bush re-election notwithstanding, I don't think any of the factors that have led me to my current sector strategy have changed at all; in fact, they may be even more pronounced now. Too many investors fall into the trap of believing that one month's (or even one week's) performance marks a trend. I believe we should be looking not so much to the past, but rather to the future. The past can offer some hints as to future performance, but the truly successful investors will have divined the future trends, and invested accordingly. That is what I try to do for my clients.

As I look at the recent market action, I am struck by how closely tied the fortunes of the broad market are to the price of oil. As the price of oil moves up, the market goes down. Conversely, when oil moves lower, as it has done for the past few days, the market moves strongly higher. This linking seems to be overwhelming the many other factors that should be driving the market one way or the other; factors such as the falling dollar, the growing deficit, rising interest rates and the continued war in Iraq, just to name a few.

From a technical perspective, this rally broke the pattern of the Dow trading at lower highs and lower lows (see the chart below). This is very bullish in the short-term. For this rally to have staying power, it will have to rise above the February high of 10,754. If it doesn't, we'll probably go back to a trading range for a while. The key would be for the Dow to stay above the 10,250 range, which is where the 50 and 200 day moving averages are currently meeting.

On top of everything else hovers the specter of the December 14th meeting of the Federal Reserve. It is widely expected that Mr. Greenspan and Co. will continue their efforts to temper the threat of inflation by increasing their short-term lending rates by another 25 basis points. I think this increase is a virtual certainty. That would bring their lending rate up to 2.25%, on the way to at least a rate of 3% sometime next year.

Finally, we can't forget about the bond market. Here we begin to see some cracks in the dam. Since my last newsletter about five weeks ago, the yield on the benchmark 10-year treasury bond has risen from a remarkably low 3.97% to 4.39% today. This reflects the continued weakness in the dollar, the ever-growing trade and budget deficits, and the concern that our Asian creditors may be slowing the purchase of our debt in the hope of finding better returns for their money. While a rate of 4.39% is hardly cause for concern (it is still, after all, a historically low rate), the upward trend in the yield bears watching, as does the action of the Asian central banks.

What I'm Doing Now...Reducing Pharmaceuticals and Increasing Natural Resources and Defense

I have made few substantive changes to my portfolios. I have though continued to trim my large-cap pharmaceutical holdings due to the growing threat of litigation and the resultant downward pressure on their stock prices. That being said, I believe this is a short-term problem, and I fully expect to increase my allocation again in the future because an aging demographic in this country favors this sector in the long run.

As I was reducing my pharmaceutical allocation, I was increasing my exposure to the natural resource and energy sectors. I firmly believe the long-term macro-economic trends are excellent for these investments.

For the same reasons, I have been adding to my holdings in the defense sector. I'm confident that the US government will continue to spend an ever-increasing amount of money on our national defense and therefore this is one of my core sector holdings.

Current Trend...Same Old Story: Natural Resources Up, Dollar Down

Allow me to plagiarize the following sentence from my last newsletter because it continues to hold true: "Longtime readers of this newsletter may be getting bored of me pounding the table for the energy, commodity and precious metals sectors (which I lump together in an omnibus "natural resources" group), but unless you get bored with making money, you should be paying very close attention." The greatest bull market in the stock market today continues to be in natural resources, notwithstanding the drop in oil prices over the last few days from $50 per barrel to just over $43 today. Natural gas prices have fallen back from their high of around $8 MCF to just under $7, yet they remain at relatively high levels. Gold has shot up to around $450 an ounce and silver has risen to almost $8.00 an ounce. The key to making money on this bull market is not to try to trade the short-term ups and downs, but rather to stake out a position and sit with it until the bull market is over. Personally, I think we are closer to the beginning of this uptrend than the end.

A more difficult trend to profit from, and more worrisome to the long-term health of the domestic economy, is the degradation in the value of the dollar. As you can see in the chart below, the dollar has been in a slow but steady slide since May, and that slide has accelerated over the past month. The theoretical silver lining to this decline is that because it should make imports more expensive and our exports more competitively priced, it should be helping to reduce the trade deficit. That deficit is on pace to exceed $630 billion in 2005. The US requires about $55 billion a month, or $1.8 billion each day to fund the deficit. The unfortunate reality is that, at least so far, the devalued dollar is not helping, as the trade deficit just continues to grow. Other countries would rather reduce their prices in an effort to keep the US consumer buying their products. Eventually though, if the dollar continues to fall, the trade deficit should shrink somewhat.

On the other hand, the downside of the declining dollar is its potential effect on interest rates. Theoretically, as the value of the dollar goes down, our interest rates would have to rise in order to capture foreign investment. If rates don't go up enough to compensate for the their losses on the dollar, foreign investors will begin to invest their money in other, stronger, currencies. There are already some indications that this may be happening, as Asian and Russian investors have, at least temporarily, reduced the amount of US debt that they've been buying. If that were to continue and accelerate, it would have very negative implications for our economy.

So what does all of that mean to you? As I said last month, it means that you continue to pay a "consumption tax" due to higher energy prices, and that this tax will eventually act as a drag on economic growth because the more we spend on energy, the less we have to spend on other things. Rising interest rates will also act as a drag on the economy and the individual consumer. Although the next interest rate hike by the Fed is baked in to the market right now, they are going to have an increasingly difficult balancing act to manage as they fight the opposing forces of inflation on one side and recession on the other.

Statistics to Watch...Not Too Bad

Job creation over the past four months has been fairly strong, but on average, still not quite strong enough to keep up with population growth. August and September were revised upward to 198,000 and 139,000, respectively. October was revised down to 303,000. The November report came in with a modest 112,000 new jobs created. Average hourly wages have increased slightly to $15.83. The average workweek remained steady at 33.7 hours.
• The total number of unemployed workers has remained steady at just over 8 million since August. Similarly, the number of part-time workers has also held firm at around 4.5 million and the number of "marginally attached" workers is holding at about 1.6 million. My "underemployment rate", not surprisingly, is steady at around 10.1%, while the official unemployment rate reported by the government remains at 5.4%. People holding more than one job grew by 519,000 in October and another 346,000 in November. People with multiple jobs represent 5.4% of the total employment figures. The four-week average for initial jobless claims continues to fall, and is now 335,750. The University of Michigan Consumer Confidence Index rose slightly to 96.7. According to the Congressional Budget Office (CBO), the federal government recorded an estimated deficit of $58 billion in October. It is further estimated that the budget deficit for the 2005 fiscal year could reach $650 billion, or 5.7% of GDP, as opposed to the 2004 deficit of $415 billion or 3.6% of GDP. According to the Census Bureau, the federal trade deficit in September was $51.6 billion, down slightly from $54.0 billion in August. The US is on pace for another record annual trade deficit. The Labor Department reported that the Consumer Price Index, which measures changes in the prices paid by urban consumers for a representative basket of goods and services, rose 0.6% in October, while the "core" CPI, which excludes food and energy, rose 0.2%. The Labor Department also reported that the Producer Price Index (PPI), which measures the average change over time in the selling prices received by domestic producers for their output, jumped 1.7% in October thanks to soaring energy prices. The "core" PPI rose a more modest 0.3%. The American Association of Individual Investors' (AAII) bullish sentiment fluctuated wildly during November, but finished the month at 49.50%, up slightly from October. Last week the bullish sentiment hit 64%. What a difference a week makes. According to a survey of 70 retail chain stores by the Bank of Tokyo-Mitsubishi, same store sales were up 2.0% on a year over year basis in October. Higher numbers were expected until Wal-Mart doused the lofty expectations by announcing a lower than expected sales forecast. The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes were about 1.2 million in October, about the same as in September. The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes were about 6.75 million in October, about the same as in September. Maybe the slightly higher interest rates are beginning to affect the housing market. The Institute for Supply Management (ISM) index of manufacturing activity for November was 57.8, marking the fourth consecutive month that the index fell below 60.0. According to the survey, the economy is still growing, but at a slightly slower rate.
• It was reported that GDP growth in the 3rd quarter was 3.7%, up from 3.2% in the 2nd quarter but still lower than the 4.3% anticipated growth rate.
• It now takes 1.34 US dollars to buy one Euro. This is the lowest exchange rate since the Euro was introduced.

So what does all this mean to you? It means that jobs are being created, albeit too slowly. It means that people are working as much as they can and spending everything they make on inexpensive imported goods. It means people should be very concerned about debt in the face of rising rates. It means the economy is going pretty well, but that health is somewhat fragile. It means that I continue to be "cautiously pessimistic" for the remainder of this year and into next year.

Personal News and Notes

For those of us on the East Coast, winter is basically upon us. The days are short and cold; in fact, some areas north of me have already gotten their first snowfall. For those readers in the Midwest, the ski season has already arrived. My Boston-area readers still probably haven't noticed the cold yet.

I've delivered the final edits of my chapter on Sector Rotation Investing for The Black Book on Personal Finance to my publisher. I should have my completed e-book back next week. Shortly after that, it will be available for purchase through my website. I hope many of you will be kind enough to buy and read it. I believe that you will find the content to be interesting and informative. The completed hardcover will be published and available in bookstores in the spring. If you haven't already done so, don't forget to (whenever possible) match up capital gains and losses to minimize your year-end tax bill. If you have any questions about this process, or the wash-sale rule, consult your tax or financial advisor. If you don't have one, give me a call and I'll help you. It has been a very good year for WAM and its clients. I hope it has been an equally good one for you. If your investment returns haven't lived up to your expectations, or if you'd just like to make a change from the way in which you are currently handling your investments, now is a good time to call me and ask for a simple portfolio review. That could be the best phone call you'll make all year. My next letter to you will be in January. So please allow me to wish you a wonderful holiday season full of joy and friendship and a Happy and Healthy New Year.

As always, I thank you for your interest and consideration, and invite you to write or call me if you have any questions, or if I can be of service to you in any way.

Best regards,

Greg Werlinich
President