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Werlinich Asset Management, LLC
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greg@waminvest.com
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January 11, 2016


Tough Times Ahead for 2016

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

Current Market Analysis

[Please read the News and Notes section for an important announcement about the future of this newsletter.]

Last week was the worst opening week of a year in the history of the stock market. The S&P 500 dropped 6.0%. The Dow Jones Industrial Average fell 6.2% and has entered "correction" mode as it is now down more than 10% from the last peak. Even worse, the Nasdaq Composite swooned 7.3% and the Russell 200 plunged 7.9%. The Russell index is now down 19.3% from the peak, which is perilously close to bear market territory. As of the close of business Friday, the Dow Jones Industrial Average stood at 16,346, which is down 919 points, or 5.3%, from when I wrote to you last month. No matter how you slice it, things don't look good, and the bad start foreshadows tough times ahead for the full year. I do think that the majority of this sell off can be attributed to the losses in China rather than anything specific about our domestic economy or stock market. Therefore, I think that this too shall pass.

Looking at the chart of the #DJIA you can see that a key support level above 17,000 was violated by the sell off last week. The next crucial support is the green line just below 15,750. That is the bottom from the August correction. Technically, it's important that the index holds above 16,000. 

The weakness in Transportation Index really did presage the troubles that would eventually envelope the rest of the stock market. I should have listened to that more closely. I kept expecting things to get better, but they never did. After trading in a tight range for five months, late last year through the first quarter of this year, the index basically headed inexorably lower, breaking through one support level after another. Most recently it fell right through support around 7,500 before hitting a key level around 7,000. We must all pay more attention to the transports. When this begins to move higher, I think that will signal a real turnaround. 


The Dow Jones Utility Average has spent most of the past year churning in a range between 610 and 540. The current price of the index is just above both moving averages and an interim support level of 570. Assuming that the Fed makes good on its intent to raise rates this year, the index could come under more pressure. Although I don't think the Fed will move as aggressively as expected (see my predictions below) I do think this will be a year to be underweight utilities. 


For the past eight months the yield on the 10-year treasury bond has remained between 2.0% and 2.5%. Interestingly, after all of the ups and downs, the yield was essentially unchanged for the year. Looking ahead, I expect the yield to stay relatively stable at least for the next six months.


Last Month's Results

Late selling in December brought the year to a painful close, setting the stage for the drubbing we're dealing with right now. While the S&P showed a very modest full year gain, the truth is that the greatest gains were concentrated in very few stocks, like Alphabet, Netflix, Facebook and Amazon.com. The vast bulk of the rest of the stocks in the index went nowhere, or more likely, experienced significant declines. Government bonds were essentially flat for the year. Junk bonds lost 4.5%, but even that was better than the 7.5% drop in small-cap value stocks. Overall, growth trumped value in 2015. I think that may be reversed in 2016.  

Name of Index

Dec

QTD

YTD

Description

S&P 500

-1.6

7.0

1.4

Large-cap stocks

Dow Jones Industrial Average

-1.5

7.7

0.2

Large-cap stocks

NASDAQ Composite

-1.9

8.7

7.0

Large-cap tech stocks

Russell 1000 Growth

-1.5

7.3

5.7

Large-cap growth stocks

Russell 1000 Value

-2.2

5.6

-3.8

Large-cap value stocks

Russell 2000 Growth

-4.8

4.3

-1.4

Small-cap growth stocks

Russell 2000 Value

-5.3

2.9

-7.5

Small-cap value stocks

MSCI EAFE

-1.3

4.7

-0.4

Europe, Australia, Far East

Barclays Aggregate

-0.3

-0.6

0.5

US government bonds

Barclays High Yield

-2.5

-2.1

-4.5

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 January 2 was 277,000, 10,000 less than the prior week, and about 5,000 less than the prior month's figure. The four-week average of 275,750 was 5,000 higher than the tally from a month ago. The tally of jobless claims has held relatively stable for most of the year. About 2.23 million people continue to collect unemployment insurance, about 100,000 less than last month.
  • After solid, if unspectacular results in November, the non-farm payroll employment report in December blew away expectations as 292,000 jobs were gained in the month, while revisions added back 50,000 jobs to the October and November totals. The household survey reported that the unemployment rate held steady for a third straight month at 5.0% while the labor force participation rate ticked up for the second month to 62.6. Average hourly wages for blue collar workers inched up to a new high of $21.22 while the average work week again remained at 33.7 hours.
  • 7.9 million workers were still being counted as unemployed and 2.0 million people still remained unemployed longer than 27 weeks. The seasonally adjusted number of people who could only find part-time work rose to 6.2 million while the number of marginally attached workers rose to 1.8 million. The number of people holding multiple jobs jumped to 7.86 million. All of this conspired to leave the comprehensive U-6 "underemployment" rate at 9.9%. This relatively good report was lost in a sea of bad news about China. And the concern is that the news will get worse in the coming months.
  • The Congressional Budget Office (CBO) estimated that on a net present value basis, the Treasury reported a budget deficit of $11 billion in December, about $13 billion less than the small surplus recorded in the same period last year. This leaves the three month deficit at $212 billion, $36 billion more than last year.
  • The National Association of Homebuilders/Wells Fargo Confidence Index fell one point to 61 in December, the second drop in a row. "For the past seven months, builder confidence levels have averaged in the low 60s, which is in line with a gradual, consistent recovery," said NAHB Chief Economist David Crowe. "With job creation, economic growth and growing household formations, we anticipate the housing market to continue to pick up traction as we head into 2016."
  • The Census Bureau reported that privately owned housing starts were 10.5% higher in November, recovering from a 12% drop in October, rising to an adjusted annual rate of 1,173,000 units, which was 16.5% higher than a year ago. New building permits rose 11.0% from the prior month and were 91.5% higher than the year before. This all bodes well for the future of the housing market.
  • The Census Bureau reported that on a seasonally adjusted annualized basis 490,000 new homes were sold in November, up 4.3% from October, and 9.1% from a year ago. The estimate of the number of homes for sale was 232,000, representing 5.7 months of inventory at the current rate of sales. The median sales price was $305,000, up almost $20,000 from last month, leaving it above the 12-month moving average price of $295,758. There's nothing wrong with those numbers.
  • The National Association of Realtors reported that on a seasonally adjusted annualized basis, only 4.76 million existing homes were sold in November, a whopping decline of 560,000, or 10.5%, from October. It was also the smallest number of the year, and 3.8% lower than a year ago. The estimate of homes for sale is 2.11 million, which represents 5.1 months of inventory at the current rate of sales. The average selling price was $220,300, off the high levels recorded in June and slightly above the rising 12-month average of $218,658. This is a markedly different picture than the one in new home sales.
  • According to the Institute for Supply Management (ISM), economic activity in the manufacturing sector contracted in December for the second straight month, falling to 48.2. This marked six consecutive monthly drops. The ISM index of non-manufacturing activity also slowed, falling to 55.3, which still signaled growth in the service sector for 71 consecutive months. None of this suggests anything but a very sluggish economy and is the strongest reason for why wage growth is stagnant.
  • The Conference Board reported that its index of Leading Economic Indicators (LEI) increased 0.4% in November, following a solid increase of 0.6% in October. "The U.S. LEI registered another increase in November, with building permits, the interest rate spread, and stock prices driving the improvement," said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. "Although the six-month growth rate of the LEI has moderated, the economic outlook for the final quarter of the year and into the new year remains positive."
  • According to the "third" estimate by the Bureau of Economic Analysis, GDP increased at an annual rate of 2.0% in Q3 2015, down slightly from 2.1% in the second estimate, but down sharply from the 3.9% rate reported in Q2. This was still better than the decrease of 0.2% in Q1, but below the 2.2% increase in Q4 2014. And it remains well below the 5.0% and 4.6% growth rates in Q3 and Q2 2014, respectively. This is not robust growth by any measure, but it's better than the rest of the developed world. And I expect that it will remain near this level for much of 2016.
  • According to the BLS, the seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) remained unchanged in November, after increasing 0.2% last month. If you strip out food and energy, CPI rose 0.2%. Since February the CPI has moved in a tight range between -0.2% and 0.2%. This is another example of the lack of inflation in our economy. 
  • The Conference Board's Consumer Confidence Index increased to 96.5 in December. "Consumer confidence improved in December, following a moderate decrease in November," said Lynn Franco, Director of Economic Indicators at The Conference Board. "As 2015 draws to a close, consumers’ assessment of the current state of the economy remains positive, particularly their assessment of the job market. Looking ahead to 2016, consumers are expecting little change in both business conditions and the labor market. Expectations regarding their financial outlook are mixed, but the optimists continue to outweigh the pessimists." I bet that optimism has faded quickly in January.

Trends To Watch

After surging last year to a multi-year high, what will become of the dollar index this year? Three times last year the index failed to pierce resistance around 100 and five times support held around 93.25. The answer to this question will go a long way towards determining the fate of commodity pricing and the profits of multi-national corporations. I think we'll see the greenback remain in a tighter range in the high 90's.

The decline in the price of West Texas Crude has been a catastrophe for energy investors and for people working in, or serving, the oil industry. As you can see below, things haven't been this bad in the energy sector since the depths of the financial crisis. Bankruptcies are on the rise, layoffs are multiplying and dividends are being slashed. And as much as it pains me to say it, until we hear about production being slashed around the globe, things are not likely to improve any time soon. In fact, we could quickly see prices under $30. 

It shouldn't surprise anyone that the price of gold is finally moving higher, thanks entirely to the rout in stocks last week. While this will certainly please the gold bugs, I don't think the gains will be ultimately sustainable. As a result, I still wouldn't be a buyer. Until the price can break, and remain, above the falling red trend line, I don't think we'll see joy for gold investors.

There simply isn't anything to say about how horrible this chart is. As I said all last year, the desultory picture shown here is a neon sign trumpeting major troubles in our economy. The strong dollar continues to hurt the price of copper, as does the slowing rate of economic growth in China. I'm afraid there is little to warrant any optimism in the near future for the price of copper. I wonder if the Fed is looking at this chart. 

After the tremendous gains enjoyed by the Nasdaq Composite over the past few years, it's not surprising that during a correction the tech-heaving index would take losses larger than the broader market. Indeed last week's plunge wiped out a the entire gains from 2015. But I wouldn't despair; look for the index to rebound fairly quickly as I don't think investors are ready to dump growth stocks just yet. It would help matters if Apple would regain some of its lost luster.

The financial sector continues to trade in a fairly tight range and I don't expect this pattern to change in the next few months. But by the end of the year I do think this sector will break through resistance and record a new high. 

The chart of the housing index does not paint a pretty picture. After achieving a new record high in August the index moved lower throughout the remainder of last year before plunging in December and early January. The price fell right through two interim support levels and is perilously close to major support around 202. Clearly this sector is very concerned about the ramifications of further interest rate hikes by the Fed. So if those increases do not come to pass, we could see a relief rally. 

The index for developed international markets looks very sickly. Twice in the past two months the price has tested support just below 57. If it holds below this level, things could get ugly. I find little reason to invest in the developed foreign world as there just is little to no growth to be had. 

I'm going to repeat what I wrote last month as there is little else to say. I don't trust anything about the stock markets in China. I'd leave that country to the real professionals with boots on the ground over there. For the rest of us, it's probably best to stay away.

After rallying hard in October and November after forming a double bottom in late August and September, the NYSE Bullish sentiment index turned right around and headed back down for a third attempt to pierce resistance at 30. So if history is any guide at all, and if this index truly works as a contra-indicator, one should expect a rally shortly. 

The price of the volatility index, the VIX, has crept back into the "fear" zone above 25. Like the bullish sentiment index above, this suggests that a rally should be forthcoming as this index is also considered a contra-indicator. 

Fearless Forecasts - Looking Back and Gazing Ahead

Each year in the January newsletter I make a number of predictions about the stock market, the domestic economy and a few key trends. At the same time, I use this opportunity to review the accuracy, or lack thereof, of my Fearless Forecasts from the prior year. So first, let's see how my prognostications from last year panned out. The forecasts are in black and what really happened is in red.

  1. I think the broad markets will again finish higher in 2015, although not without some greater pain, and with less of a gain. I think the best case scenario puts the Dow Jones Industrial Average up 8%, but could be as little as 5-6%. Let's say the year-end price will be around 18,750. Like last year, I think the S&P 500, with a greater emphasis on tech and growth, will do a little better, finishing up as much as 10%, for a closing price of 2,200. I expect a tough year getting to those gains. We should have four or five declines of more than 5%, with one or two of those being more than 10%. But as last year, buy and hold will be the way to go. Although I was clearly correct about the pain we would endure, and that the S&P 500 would outpace the Dow Jones Industrial Average, I was still too optimistic about the final results for the market. The Dow fell 2.2% to finish at 17,425, while the S&P dipped 0.7% (both before the effects of reinvested dividends). We survived the two months between mid-August and early October when the market ranged between down 5% and down 10%. 
  2. I expect that 2015 will be a difficult year for foreign markets. Look for the developed world, as represented by the MSCI EAFE index to be in negative territory for the year. I also anticipate that the recent gains in the Shanghai index will be reversed next year. And at least one member of the European Union, if not two, will default on a loan. This proved partly prescient as the EAFE finished down 3.5% for the year after slumping most of the second half. The gains on the Shanghai index were indeed reversed, in a spectacular plunge over the summer in which the index fell 45% before reversing to finish the year 9% higher than it started. 
  3. This is the year the experts believe the Fed will begin to raise rates, and the consensus is sometime this summer. I think the Fed will hold off raising rates longer than anticipated, and once they begin, will raise less than expected. I believe they won't raise before Q4 at the earliest, and if they do raise, they won't increase by more than 25 basis points during 2015. The yield on the 10-year Treasury will remain likely hit a high of 2.25% and could go as low as 1.5%. I was dead on here as the Fed held off until December before hiking rates 25 basis points. The yield on the 10-year Treasury hit a high of 2.50% and a low of 1.65%. 
  4. The dollar index will continue to move higher in 2015. In fact, I think we could see a gain of about 10%, bringing the index close to 100 for the first time since 2003, and closer to parity with the falling Euro. This prediction was also spot on as the dollar index rose almost exactly 10%, and did briefly surpass 100 before closing at around 99. 
  5. What happens to the price of West Texas Crude this year will be one of the biggest stories of 2015. The price has already plunged 50% and it will likely fall further before hitting bottom. I think it could go as low as $40, or even briefly to a quick panic sell off of $35. At that point, the energy sector will be the buy of the year, or of multiple years. It's hard to pick a possible high price, but I'll say $75. This prediction was unfortunately correct as oil was indeed an enormous story as the price of "black gold" fell to a low of $34.75 in December after peaking at just over $60 in June. 
  6. It's tough to make a call on gold for this year. A stronger dollar and lack of inflation should hurt the price. But heavy buying by Russia, China and India, among others, will help prop up the price. In addition, expected stock market turmoil should increase interest in gold. So I'll leave the median price around $1,250 with a low of $1,100 and a high of $1,350. I got this mostly right as the misery in gold continued for the third year as the price peaked around $1,300 in January before falling to a low of $1,045 in December. The median price was around $1,170. 
  7. I expect the rally in the housing sector to peter out in 2015. I think the rate of growth in new homes will slow considerably, to less than 5% at best, or a drop of 5% at worst. Existing homes will do a little better because they cost less. The HGX will likely be flat for the year, with the first half performing better than the second. I was partly right here. After peaking in February, the number of new homes sold in November was slightly low than the tally from last December and the average sales price was roughly flat. The number of existing homes sold was down 6%, whereas the average sales price was 5.8% higher. The housing index (HGX) peaked in August before falling, although it still finished almost 5% higher for the year.
  8. I think the average rate of GDP growth over the next four quarters will be between 2.75% and 3.00%. Falling oil prices will curb growth in the energy sector and a strong dollar will hurt exports. Concerns about global deflation will also limit GDP growth overall. I was a little too optimistic about the rate of GDP growth last year. The average for the past four quarters was a modest 2.0%. Falling energy prices really put a crimp in things, as did the soaring dollar. 
  9. The headline unemployment rate in 2015 could fall as low as 5.4%, and will likely be no higher than 6%. The U-6 measure for unemployment will likely range from 11% - 12%. The labor participation rate is unlikely to move appreciably. Wage growth will continue to be weaker than needed. I was right in the tenor of this prediction but I was a bit off on the numbers. The labor force participation rate barely budged, and wage growth was stagnant for most of the year. After peaking at 5.7%, the unemployment rate fell to 5% and the U-6 hit a low of 9.8%.  

All in all, my forecasts were pretty on target, and if I had been closer with my prediction for the overall stock market, I would have had an almost spotless record. And remember, I have no formal training in economics. I'm just someone who closely observes what is happening in the world and tries to apply that knowledge to my investment management business. Anyway, last year is history now; it's time to look forward, which means a new set of Fearless Forecasts. So without further ado, here we go:

  1. I believe the broad markets will struggle again in 2016, as evidenced by its horrible start. I think the best case scenario puts the Dow Jones Industrial Average up 4-5%, but it could just as easily fall for the second year in a row, ending down as much as 10%. So much depends on the Fed, the economy, the elections, the weather, China and unexpected events like terror and natural disasters. After finishing last year at 17,425, I see the #DJIA closing the year at around 16,750. If that comes to pass, I think the value weighted average will outpace the tech heavy S&P 500. Watch out for a spike of volatility this year.
  2. I think that 2016 will be worse for the developed foreign markets than for the US, so I would expect their markets to underperform ours by up to 5%. As for the Shanghai index, I anticipate full year losses of at least 10%.
  3. It is anticipated that the Fed will raise rates four times this year for a full 1% rate increase. I believe that a weak global economy, as well as a less than robust domestic economy, will mean no more than two 25 basis point increases will be announced. As a result, the yield on the 10-year Treasury will remain likely range between a high of 2.75% and a low of 1.75%.
  4. The dollar index will probably move in a tighter range in 2016. As such, I expect it to trade between 95 and 101, with the bulk of the time spent between 98 and 100.
  5. I think the price of West Texas Crude will hit bottom in January, falling as low as $25 a barrel in panic selling before staging a modest recovery. I don't believe the real price boom will happen until 2017, limiting the high this year to between $45 and $50 per barrel.
  6. Even though I'm not ready to start buying gold again, I do believe the price of gold will end the year higher than it started, thanks to global unrest. It wouldn't surprise me to see a full year price gain of around 10%. It also wouldn't surprise me to see another year of losses if the world is less turbulent than I expect. I see the median price around $1,100 with a low of $1,000 and a high of $1,200.
  7. I expect the housing sector to hold steady this year. New home sales will suffer more than existing ones thanks to higher interest rates and higher acquisition costs. The sector won't fall much though thanks to more Millennials buying homes for the first time. The HGX will likely trade in a range of up or down 5% for the year.
  8. I think the average rate of GDP growth over the next four quarters will be lower than the Fed would want, ranging only between 1.75% and 2.00%. Falling oil prices will destroy growth in the energy sector and a strong dollar will continue to hurt exports, as will a weak economy in China. This will be a big story during the election debates.
  9. The headline unemployment rate in 2015 in unlikely to fall much further as the labor force participation rate simply refuses to change appreciably. I see the primary unemployment rates going no lower than 4.8 while the U-6 rate bottoms around 9.4%. Wage growth will tick a little higher, but won't grow much more than 2.5%. Most of the jobs created will be in the lower paying service sector. 
  10. Finally, I have to take a stab at the Presidential election. I must admit, I don't have a strong feeling about it just yet, beyond the fact that if someone like Trump or Cruz were to win I would want to flee the country. The truth is that even though I'm a registered Democrat, I'm not enamored with Hillary either. That being said, I predict Hillary will defeat Marco Rubio in a tight election as a fractured Republican party fails to deliver Rubio the votes he needs to beat a unified Democratic party.

What I'm Thinking and Doing

I started Werlinich Asset Management almost 19 years ago, in March of 1997. In that time I've witnessed two historic bear markets, following the collapse of the tech bubble (2000 - 2002) and the housing bubble (2008). Both times stocks came roaring back with massive bull markets. We've also experience numerous periods of modest corrections and subsequent rallies. Each of these actions are part of the normal cycles of a healthy stock market. Last year would appear to have marked the end of the latest and lengthy rally, with most broad averages ending the year flat to slightly down. It would not be the worse thing in the world for 2016 to follow a similar pattern. That would be a far better result than another punishing bear market. Indeed, if the market does trade basically sideways for two years, that would release some of the froth resulting from a six year rally to historic record highs, and allow earnings multiples to fall to more acceptable levels. It would also set up 2017 for solid gains, which is also the typical result of the first year of a new election cycle. 

So if 2016 is likely to result in modest gains or losses, what is the best game plan? I believe it would be to own a diversified basket of blue-chip, dividend paying companies with a reasonable allocation of growth among industry leading companies in today's leading sectors. Some of you may also want to own bonds which is fine, although I still don't like bonds at these yields as I believe the downside outweighs the upside. I still believe today, as I did almost twenty years ago, that being a patient investor, and taking a longer-term view (3-5 years is appropriate) is the best way to create, build and protect your wealth. It sounds trite, but the name of the game is still to buy low and sell high. If you can consistently do that over 20, 30, 40 or 50 years, you'll be just fine.

Now that the Fed finally popped its cherry and raised the short-term lending rate by 25 basis points in December, the common wisdom is that they will raise rates four times in 2016, each time by another 25 bp. I take a contrary view. I think they will hike rates a maximum of twice this year. The economy is simply not strong enough, nor is it growing fast enough, to justify the danger of more rate increases. So look for one increase in each half of the year. I think the Final Four will be Trump, Cruz, Rubio and (in a surprise) Christie. If nothing else, that fight to the finish will be entertaining, and more than a little terrifying. As for the Dems, I think Bernie will eventually accede the crown to Hilary, setting up a very interesting battle between the two parties in the fall, assuming, or course, that the Hairpiece does not run as an independent after being denied the Republican nomination. 

On Friday I took advantage of the week long rout by spending about $250,000 in accumulated cash rounding up existing positions in a few portfolios. All of these investments were made looking out years into the future. I anticipate most, if not all of those purchases will produce solid gains within the next year or so. For the rest of my portfolios, I'm content to sit tight and wait for things to play out. I'm very comfortable with the vast majority of my current holdings and I believe my clients are well positioned for whatever the market will throw at us in 2016. That being said, I remain vigilant to any significant changes in the market that my precipitate action on my part to either stem losses or initiate a new position. 

News and Notes

I published my first newsletter in August of 2003. Since then, I have written a new letter almost every month for the past twelve years. In that time we've enjoyed a two massive bull markets and survived one painful crash. We've experienced Bull and Bear markets and just about everything in between. Hopefully my newsletters have helped you become a better investor and make smarter decisions over the past twelve years, resulting in higher returns. But now, it's time for a change. 

I've given a lot of thought over the past few months to how long it takes me to write my newsletter, what content is most important and most timely, and how many people actively read it each month. I came to the conclusion that it was time to make a change. Therefore, starting immediately, I will publish "News and Views" on a quarterly, rather than a monthly basis. This means that my next issue will be disseminated in April.  In the interim, I will resume blogging. It will be via the blogs that I'll share, in a much more timely fashion, some of what I'm thinking about the market, the economy and the political landscape. I will also continue to tweet virtually every day. So if you are not following my blog, or my twitter feed, please click on the links at the top of the newsletter and do so. I hope that this new schedule will satisfy my loyal readers. Please write to me and let me know what you think. 

As for me and the family, we're all doing well. Nola is home from college and enjoying catching up on her sleep. Lily and Ezra are back in school and heading toward mid-terms. For Lily, the next few months will be all about waiting to hear from colleges. We're all keeping our fingers crossed that she gets into the school of her choice. Kathiryn and I are looking forward to spending some time in warmer weather over the next few months.

So that's it for now. I look forward to communicating with all of you via twitter, my blog and this newsletter throughout the rest of the year. And let's hope that the next 51 weeks are better than this last one.

Best regards,



Greg Werlinich
President


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