Current Market Analysis

I am finishing this newsletter on Christmas Eve, which means many readers won't around to read it. Therefore, I'm going to try to keep this edition a bit shorter than the last few months. Besides, thematically, there really isn't much new to discuss, other than the Bernie Madoff scandal. All I want to say about that is I will be very interested to read about how exactly he managed to lose upwards of $50 billion, and where it all went. The real tragedy of this story is the money lost by charities, hospitals, colleges and dozens (hundreds?) of individual investors who have been wiped out. This story will play out for months and the misery is likely to be even worse than expected.

Getting back to the stock market, I have a bright spot for you. The market, as represented by the Dow Jones Industrial Average, is only down 60 points, or 0.7% since I wrote to you last month. Considering the carnage of the prior few months, that's very good news. The market bottomed out on November 20 and has risen nicely since then. A further silver lining is that the November low did not fall below the 50% mark of 7,470 or the October 2002 low of 7,286. That is actually very positive from a technical basis. So at least for now, things have calmed down a bit in the market. As long as the market can rise, or even just remain steady, in the face of the deteriorating economy, that is very positive. In addition, new lows on the NYSE have fallen dramatically since hitting 92% of all stocks traded on October 10. That also is positive as we look forward. So now let's look and and see what the charts tell us.

I'm going to start, as always, with charts of the Dow Jones Industrial Average. The daily chart shows the 20% bounce off the November 20 low. Technically, I'd like to see the index rise above the 9,026 level and challenge the 9,000 support level. Failing that, just stay above 8,000.

The weekly chart shows how close the Industrials came to violating a very important support level before bouncing higher. I would like to see the index find support in the mid 8,000's before attempting to move higher.

Like the Industrials, the Transports have recovered a bit from the November 20 low and is attempting to consolidate. Any meaningful advance would need to bring the average above 3,638.

The next chart should scare the heck out of bond investors. I think this is a picture of the latest market bubble. The yield on the 10-year Treasury has fallen to an unbelievably low 2%. The yield on the 30-year bond has fallen to a similarly low level of 2.6%. How can any investor think it's a good idea to lock up money for 30 years for a return of 2.6%? When the "flight to safety" finally ends and investors again return to riskier assets like equities, this bubble will burst and bond investors will likely suffer big losses.

The "flight to safety" mentioned above has reduced the yield on one- and three-month Treasuries to 0%. That isn't a misprint. Investors are willing to buy t-bills knowing they will earn nothing rather than buy equities. That's all you need to know about the state of the stock market right now. But this too will change in the weeks and months ahead.

Last Month's Results

• According to the Department of Labor, the most recent four-week average for seasonally-adjusted initial jobless claims for the week ended December 13, was 543,750, 25,750 higher than only three weeks ago and 200,000 greater than the figure reported a year ago.
• Non-farm payroll employment fell by a staggering 533,000 in November. The September job losses were revised from 284,000 to 403,000 and October was revised from 240,000 to 320,000. This brings the number of jobs lost in the first eleven months, as currently reported, to more than 1.75 million. Average hourly wages grew a bit to $18.30, and the average workweek held dropped to 33.5 hours, so real wages are actually falling.
• The number of workers reported in October as unemployed rose to 10.3 million, bringing the unemployment rate to 6.7%. We started the year with 7.7 million people out of work and an unemployment rate of 5.0%. The seasonally adjusted number of people who could only find part-time work rose to 7.3 million and the number of marginally attached workers grew to 1.9 million. The number of people holding multiple jobs fell to 7.54 million. My Comprehensive Labor Index™ rose to 14.32%, the highest level since the end of 2005. My CLI™ is much closer to the true unemployment number in this country. I wouldn't be surprised to see my CLI™ at around 20% sometime next year.
• Calculating the federal deficit, already a quagmire, has gotten worse due to the Troubled Assets Relief Program (TARP). Now the CBO is reporting the deficit on a cash and adjusted basis. CBO estimates that the Treasury will report a federal budget deficit of $408 billion for the first two months of fiscal year 2009, $253 billion higher than the deficit recorded through November of last year. This estimate includes $191 billion disbursed for the TARP during the first two months of the fiscal year. CBO believes that the equity investments for that program should be recorded on a net present value basis adjusted for market risk, as specified in the Emergency Economic Stabilization Act of 2008, rather than on a cash basis as recorded by the Treasury. Evaluating TARP on a net present value basis, CBO estimates the federal deficit totaled $267 billion through November. If you understand that, please let me know and explain it to me.
• According to the Census Bureau, the U.S. trade deficit in October was $57.2 billion, up slightly from $56.6 billion in September.
• The Census Bureau reported that privately owned housing starts dropped 18.9% in November, following an 6.4% decline in October, and was down 47.0% from a year ago, to a seasonally adjusted annual rate of 625,000 units. New building permits were also down 15.6% from last month and 48.1% from last year. While these are terrible numbers, the declines are needed in order to help clear out excess housing inventory.
• In September, the National Association of Homebuilders/Wells Fargo Confidence Index remained at a record low of 9, the same miserable level as a month earlier. This index was created in 1985. And as I predicted last month, the homebuilders have begun lobbying Congress for a bailout.
• The Census Bureau reported that on a seasonally adjusted annualized basis, sales of new homes in November fell 2.9% from the prior month and 35.3% from the same period last year, to a projected 407,000 units. That is by far the lowest figure in the almost five years I've been tracking new home sales. The estimate of homes for sale is now only 374,000, which represents a whopping 11.5 months of supply at the current rate of sales. The median sales ticked up slightly to $220,400 but remained below the steadily falling 12-month moving average price of $230,283.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes in November fell 8.6% from the prior month, and were down 10.6% from the same period last year, to a projected 4.49 million units. The estimate of homes for sale, at 4.20 million, represents 11.2 months of supply at the current rate of sales. The median sales price fell further to $181,300, which remains below the steadily falling 12-month average of $184,450. It is obvious that prices are falling, and must continue to fall, to move the inventory of existing homes for sale. It's safe to assume that many of these are foreclosed properties.
• 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, fell to 173.25 in September, it's lowest point since April 2004.
• According to RealtyTrac, foreclosures actually decreased by 7.3% in November to 259,085, but remained 28% higher than a year ago. This better news is due in large part to new laws limiting foreclosures and to aggressive loan modification programs. Nevada,  Florida and Arizona, respectively, reported the highest foreclosure rates in the country.
• The Institute for Supply Management (ISM) index of manufacturing activity fell to 36.2 in November. This is the worst level since 1982. Any number below 40 suggests a serious recession. The ISM index of non-manufacturing activity was a puny 37.3. Business continues to suffer.
• The Conference Board reported that in November it's index of Leading Economic Indicators declined 0.4%, marking a decline in seven of the last eight months. It would have been even worse if not for the continued growth in the money supply. The six-month rate of decline is now -2.8% as the economy gets weaker, and the outlook is no better.
• According to the Bureau of Economic Analysis, the "final" estimate of GDP growth in the third quarter was -0.5%, down from the estimate of 2.8% GDP growth in the second quarter and 0.9% in the first quarter. The second quarter "growth" was surely an illusion. The fourth quarter will likely be the worst quarter of the recession.
• The Federal Reserve reported that in September the amount of outstanding consumer credit actually decreased by 0.1% from the prior month, to $2,578 billion. That means we've had a decline in consumer credit for two of the last three months. That's good for consumers, bad for the economy. We'll see if this continues.
• According to the Census Bureau, retail trade and food service sales fell 1.8% in November, following a 2.8% decline in October, and was 7.4% worse than a year ago. This marks the fifth consecutive month in which retail trade and food service sales fell on a month-over-month basis.
• The Fed increased the supply of M-2 by an astonishing 13.9% in the last three months. But the headline here is that they've increased the supply of M-1 (the narrowest definition of money) by a staggering 37.6%. The Fed is desperately trying to resuscitate this economy and avoid the horrors of deflation.
• The Conference Board Consumer Confidence Index rose in November to 44.9 from the all-time low of 38.8 set in October. While that offers a bit of good news, there is still very little current confidence in this economy.

The trends are a little more difficult to discern right now, thankfully, as the downward trends have momentarily been halted. For the current bounce in the financial index to have any long-term meaning, the index must rise above the 16-17 support levels. If the rally simply rolls over and falls below the 8.67 level, this would have been just another dead cat bounce.

Similar to the financials, the current action in the housing index will only be meaningful to me if it can rise to around the 100 level. I have been consistently bearish on housing, and while I remain so, the amazingly low mortgage rates offers a ray of optimism. As the inventory of existing homes drops further, and as builders continue to cut back on new construction, a case can be made for a recovery in a few months driven by those low rates. The argument against housing is the frightening rise in unemployment. Time will tell which of these two forces wins the day.

The price of West Texas Crude continues to fall thanks to worldwide demand destruction. Even massive supply cuts by OPEC can't stem the price erosion. The price of oil has fallen to four-year lows. There is talk that prices could fall to around $30 in the short-term. The current price has effectively killed the alternative energy movement. Nobody is talking about solar, wind or ethanol any longer. Future projects are being mothballed. But mark my words, we are setting up for a massive price increase when demand returns as there won't be enough supply to meet that demand.

Gold seems to once again be moving up, as I have been expecting. I think that the price of gold could again, with some fits and starts of course, head north of $900 per ounce on its way to test that $1,000 level. Remember, I don't recommend that you trade gold. It's better to establish a position and simply sit with it. Part of why we own gold is for "portfolio insurance". And part is to protect us against rampant inflation and the debasement of our currency. If I'm wrong about the general upward trend of gold, it will likely mean the stock market is headed much higher, and we would be more than compensated for our "losses" in our gold positions by higher equity prices. So if you own gold, just sit tight. If you don't, consider buying during times of weakness.

The price of copper, which is often thought of as a proxy for the economy, continues to spiral down. It has now fallen 67% in the past six months and, in the short-term, could drop further still. Longer-term, as the world attempts to fix, or build its infrastructure, the price of copper will inevitably recover.

After surging about 23% over nine months, the greenback swooned about 11.5% as the Fed opened up the fiscal floodgates. Going forward, will the world continue to view the dollar as a safe harbor or will the world grow wary of our nation's growing deficits and what that will mean to our currency? The answer to that question must be viewed in a global context as other nations struggle with similar problems. So where is the dollar headed? Long-term, I think it's headed lower.

Like our domestic averages, foreign markets, as represented by the MSCI EAFE index, have bounced a little over the past month, but continue to be down about 50% for the year.

Finally, in honor of the holidays, my last chart will be some good news. Volatility in the market, as measured by the VIX, sometimes known as the "investor fear gauge", has fallen precipitously. Indeed the VIX has fallen by more than 50% from the high, and is almost back to "normal" levels. This means a much calmer market, which is exactly what we need right now.

What I'm Thinking and Doing

I honestly don't have anything new to say this month. I suggest you re-read my comments from last month as they remain timely. I'll have a lot more to say about the economy and the markets in my January letter. The only thing that's really changed since last month is the Bernie Madoff scandal. The good news for my clients is that we didn't have one dollar invested with Mr. Madoff. The lesson to be learned from this whole situation is that investors large and small really need to know with whom their are placing their trust when they hire a financial advisor.

Personal News and Notes

Greg Werlinich
President

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