Current Market Analysis

Is the market getting better or worse? Is the economy getting better or worse? Are things going to get better or will they get worse? If you have the answers, please email me and let me know. Seriously, ask 100 different people and you may get 100 different answers. We are either in a Bear Market or a Bull Market; either the economy is vibrant or slowing or in recession; and we're either just fine or headed to hell in a hand basket. As it relates to investing, the correct answer can lead to riches and the wrong one to steep losses. But as I have said over and over, the worst thing you can do it panic. Make sure you have an intelligent plan, then follow that plan until you have to come up with a new plan. Simple. Ha.

The good news is that things are a little better than when I wrote to you three weeks ago. As I write this around mid-day, the Dow Jones Industrials are about 250 points higher than where they were three weeks ago. After bottoming out at 12,743 on November 26, the Industrials quickly soared to 13,727 on December 10 on hopes for a big rate cut by the Federal Reserve. When the Fed only cut rates by 0.25% instead of the hoped for 0.50% the market quickly and powerfully turned down. The multi-trillion dollar question then becomes "where does the market go from here"?

The feeble efforts by the Fed notwithstanding, the credit and housing crises continue unabated and the economy is clearly slowing, no matter what anyone tries to tell you otherwise. The biggest problem facing the country right now, outside of the various wars that we are fighting, is not inflation or recession but stagflation. Don't let the Fed fool you; they will gladly trade inflation for stagflation (concurrent negative growth and inflation) or recession. More rate cuts are coming. The fear is that their actions will be too little too late. So while I often speculate about what is going on, let's take a look at some charts and see what the market says.

The daily chart of the Dow Jones Industrial Average shown below is a little busy, but I wanted to show a few things. First, you can see the violation made last month of the August low, albeit a very brief violation, and the subsequent recovery. That's good. Next, you can see that we're still well above the low of 11,939 set last March. That's good too. Finally, you can see by the three short blue lines, what could be a major "head and shoulders" pattern being formed. Were this pattern to continue, it is possible that the right shoulder could continue down to test that old March low. That would be very bad. A rise above 13,780 could clearly break the pattern. That would be very good and could suggest that the market could test the high of 14,198 set in October. This picture will get a lot clearer in the next few weeks.

The next chart I have again borrowed from Richard Russell, and it is a bit ominous. This shows the Industrials for the past twenty years. What I've shown in red is that there have been two times, 1986-1987 and 1995-1999, during which the market was significantly overbought according to relative strength. Each time resulted in MAJOR bear market correction. It appears that 2006-2007 may have formed a similar, if not quite as dramatic, overbought situation. The good news is that the basic trend-line of the market, the blue line, remains intact. Maybe we'll be able to work off that overbought situation without a major bear market. Again, time will tell.

The picture for the daily chart of the Transportation average is similar to the Industrials. After consolidating above a support level of 4,700 from August through early November, the Transports plunged below the closing low of 4,672 set on August 16. Like the Industrials, the Transports rallied hard to rise back above support, but has now fallen back. The green line shows the next major support level. Let's hope that those lows are not tested.

Last month, in order to give you some perspective, I showed you a graph of the action on the 10-year Treasury for the past 17 years. Only the period from late 2002 through early 2004 brought lower yields than what we have today. When looking at the shorter-term chart below you'll notice that when the equity markets rallied in early December, the bond market sold off, increasing yields as investors raced back to stocks. Just as quickly, investors have moved back to bonds as the stock market turned down. Bottom line, I think yields have further to fall over the next few months.

Last Month's Results

• According to the Department of Labor, the most recent four-week average for initial jobless claims, for the week ended December 15, was 343,000 an increase of almost 11,000 from a month ago.
• Non-farm payroll employment rose by 94,000 in November, following a revised higher gain of 170,000 in October. Almost all of the growth came from the service industry, while the goods producing, construction and manufacturing sectors all lost jobs. Average hourly wages grew a bit to $17.63. The average workweek remained steady at 33.8 hours.
• The number of unemployed workers remained unchanged at 7.2 million. The seasonally adjusted number of people who could only find part-time work rose back to 4.5 million and the number of marginally attached workers remained at 1.4 million. The number of people holding multiple jobs fell to 7.79 million. My Comprehensive Labor Index™ rose to 8.93%, while the unemployment rate reported by the government remained at 4.7%.
• According to the CBO, the government posted a budget deficit of $101 billion in November, which was $28 billion more than a year ago. Much of that difference results from the timing of payments and a different number of business days from a year ago.
• According to the Census Bureau, the U.S. trade deficit in October was $57.8 billion, slightly worse than the revised $57.1 billion in September. Our trade deficit with China keeps growing, and has now reached $25.9 billion.
• The Census Bureau reported that privately owned housing starts fell 3.7% in November, and was down better 24.2% from a year ago, to a seasonally adjusted annual rate of 1.19 million units. New building permits were down 1.5% from last month and down 24.6% from last year, which suggests that the outlook for future housing starts remains bleak and continues to worsen.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in October rose 1.7% from the prior month (the numbers for which had been revised much lower), but were still down 23.5% from the same period last year, to a projected 728 million units. The estimate of homes for sale is now 516,000, which represents 8.5 months of supply at the current rate of sales. The median sales price plunged to $217,800, which is below the ever-shrinking 12-month average of $242,775. And these prices to not include the "incentives", like cash rebates, used by builders to entice people to buy their properties.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in October fell 1.2% from the prior month, and were 20.7% lower than the same period last year, to a projected 4.97 million units. This marked the eight straight month in which fewer homes were sold than the prior month. The estimate of homes for sale, at 4.45 million, represents a staggering 10.8 months of supply at the current rate of sales. The median sales price fell slightly to $207,800, which remains below the 12-month average of $218,625. The housing mess just continues to get worse and worse.
• According to RealtyTrac, foreclosures actually fell 10% in November to 201,950, after a small rise in October. Foreclosure filings were still up 68% from a year ago. In general, the number of foreclosure filings has dropped over the past three months, potentially signaling better times ahead.
• The Institute for Supply Management (ISM) index of manufacturing activity was 50.8 in November, down slightly from 50.9 in October, marking the fifth straight month in which the index has decreased. There can really be no argument that the economy is slowing.
• The Conference Board reported that it's index of Leading Economic Indicators "decreased sharply for the second consecutive month in November", and has been down four of the past six months.The leading index fell 1.2 percent (a decline of 2.3 percent annualized) from May to November, the largest six-month decrease in the index in six years. Not good.
• The Bureau of Economic Analysis announced that the "final estimate" of GDP growth for the third quarter of 2007 was 4.9%, consistent with the "preliminary estimate" of 4.9% and up considerably from the "advance estimate" 3.9%. The increase in real GDP in the third quarter is misleading. There was a huge increase in exports thanks to a weak dollar and a large increase in government spending, especially on defense. Bet on GDP falling in the fourth quarter.
• The Federal Reserve reported that the amount of outstanding consumer credit increased by 0.2% from the prior month in October, to $2,490 billion. The consumer continues to be the driving force keeping the economy going.
• According to the Census Bureau, retail trade and food service sales rose 1.2% in November from the prior month and were up 6.3% from a year ago. This was the best monthly showing since May. Maybe the holiday season won't be so bad after all.
• The Fed increased M-2 by 0.4% in November. The supply of M-2 has increased by 4.7% in the last three months and 6.2% in the last twelve months. According to John Williams on his website "Shadow Government Statistics" (www.shadowstats.com), the increase in M-3, which the Fed no longer publishes, is approaching 16%!

One of the most important trends in the market continues to be the action in the financial sector. The mortgage/credit crisis appears to be one of the principal reasons for the economic malaise in this country and the attendant damage to the stock market. Below is a graph of the Financial Spyders Index, which represents 93 financial stocks, the top ten of which represent 47% of the index. The financial sector accounts for almost 18% of the S&P 500. Last month I said that while "this sector is somewhat oversold, and could be due for a bounce, I believe there is further to fall before we reach a bottom." I'm sticking with that opinion.

The price of West Texas Crude is right in the middle of a year-long up-trending trading channel. Last month I said that "it is just a matter of time before that level ($100 per barrel) is breached, and there is nothing the pundits and talking heads who give all the reasons why it shouldn't be this high can do about it. That being said, there is no reason why we couldn't have a bit of a retracement or consolidation before the next move higher begins." Well, as you can see below, we have retraced and are consolidating as we speak. However long this lasts, I believe the price is heading inexorably higher.

Like oil, the price of gold continues to rise regardless of what the critics say. Last month I said that "when the Fed cuts the rate again . . . the price of gold will likely be closer to $900 than $800." Oh well, can't win them all. But then again, they didn't cut rates as much as expected. Like oil, gold has retraced and is now consolidating. And like oil, I expect the price to continue to rise.

The price of copper is often viewed as a proxy for the economy because of its widespread use in manufacturing. Other than the first three months of the year, copper has been in an extended trading range for almost two years. It appears that this range may be breaking down which would be a harbinger of negative sentiment for the economy, at least in the short-term. I still believe in the long-term health of copper prices due to demand from China and the rest of the rapidly developing world.

For the past few months I've been showing a long-term chart of the decline in price of the dollar. I'd like to switch back to a shorter view. You'll notice that back in early 2006 the 200-day moving average crossed above the 50-day average and the dollar index has gone down ever since. Today we're seeing a bounce in the price of the dollar, but until the 50-day average rises above the 200-day, I won't call this as the bottom. I think the interest rate cuts in our future are likely to return the dollar to its downward path. 

The housing sector has rallied a bit over the past few weeks as the experts claim the bottom is made. I don't believe it. I think we're still a long way from the bottom. Don't try to catch a falling knife. 

Now I'll show you a trend that has gone almost completely unnoticed. Check out the action on the Dow Jones Utility average. Recently it hit a new all time high. How's that for a stealth bull market? You don't read too much about utilities in the Wall Street Journal and CNBC doesn't waste much breath on them either. But good money is quietly being made.

The yield curve continues to steepen. What needs to happen is for the short end of the curve to drop further. Last month I said that "I think that before 2008 is over, the Fed Funds rate will be no higher than 3.5%, as opposed to its current 4.5% level. It might even be as low as 3%." The current Fed Funds rate is now 4.25% and will likely be 4.00% after the next meeting in January as the Fed will fight a recession tooth and nail, inflation and the dollar be damned.

What I'm Thinking and Doing

Personal News and Notes

Greg Werlinich
President

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