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Werlinich Asset Management, LLC
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greg@waminvest.com
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January 16, 2017


2017 Fearless Forecasts

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

eWell, this is it. For some it's the beginning of Armageddon; for others, it's the time to begin Making American Great Again. Regardless of where you fall on the political spectrum, and what you think about our President Elect, the stark reality is that Donald Trump will be sworn is as the 45th President of the United States on Friday this week. 

This is where I stand on #Trump. I'm horrified by almost everything he says and almost everything he purports to believe in. I fear for the rights of women, people of color, the LGBTQ community and everyone who isn't a straight, white man. I worry that the President-in-Tweet could lead us into global economic conflict with our friends and our enemies. I'm very concerned that he will roll back all of the regulations that have been put in place to protect this planet and the ability for future generations to live here. And I fear that he simply is not psychologically fit to be President. Yet on the other hand, I applaud the ideas that he has put forth to to cut individual and corporate taxes, reduce burdensome (and expensive) regulations, implement a massive infrastructure spending plan, streamline (or even shrink) the federal government, rebuild and reinvest in the military. Time will tell if he can implement any of these proposals. And if he is successful, will they create short-term gains (above-trend economic growth) in return for long-term pain (increased federal deficits, recessions or war). And perhaps more importantly, how will the daily lives of our diverse citizenry be affected by the Presidency of a vain, ego maniacal, argumentative, unstable, thin-skinned bully who has shown little patience for anyone who opposes anything he says or does, or whose beliefs differ from his in any way? Be careful what you wish for American; you're about to get it. 

Now that my personal editorial is out of the way, I'd like to focus on the economy, and by extension, the stock market. And later in this newsletter you'll find my Fearless Forecasts for 2017, and my review of my 2016 predictions. You'll find that the aforementioned prognostications were remarkably prescient. I'll be especially lucky if this year's forecasts are nearly as accurate.

The post-election #TrumpRally has been nothing short of remarkable. In the 46 trading days since November 7, the day before the election, the Dow Jones Industrial Average has gained a stunning 1,626.13 points, or 8.9%. And most of those gains happened in the first three weeks. In many cases, returns like that would be a good year. At the same time, the S&P 500, Nasdaq Composite, Dow Jones Transportation Average and Russell 2000 indices have all hit record levels. One concern that I raised last month, is that this rally simply "borrowed" gains we might otherwise reaped this year. If that is, in fact, true, it might be tougher road to hoe this year. 

So let's review some charts and see what they tell us. Looking at the chart of the #DJIA, we see the powerful surge from the #TrumpRally, beginning in early November and running through mid-December. Since then, the index has vacillated in a tight range between 19,850 and 20,000. This consolidation has allowed some of the froth and the euphoria to work off. Still, 20,000 has been a tough nut to crack. My guess is that we'll see #Dow20k sometime in January.

After taking two years to establish the new record high in November, the Dow Jones Transportation Average dropped about 5% in just two or three weeks. It's recovered a bit since then, but is still faring relatively worse than its industrial sibling. I think the next rally is coming during the first quarter, during which time I believe the index will make a new high.

Interestingly, the Dow Jones Utility Average strengthened a bit last past month, perhaps riding the coattails of the broad market rally, before consolidating over the past few weeks right on a support/resistance line. The Federal Reserve will play a significant role in determining the fate of this sector going forward.  

So what are we to make of the market for US Treasury bonds? After a secular decline in yield that spanned decades, creating tremendous profits for bond holders, we witnessed a very quick "melt-up" in yield causing most observers to call the end of the bull market in bonds and the beginning of a new bear cycle. And then, in the face of all the naysayers, what happened? Bond yields dropped. Last month I posited that" I don't think we'll surpass 3% in the next few months, but it wouldn't surprise me if we see that level in the second half of next year." I still like that prediction. 

Last Month's Results

If you were in a coma for 2016, and you just woke up to see how your portfolio did, you would be very pleasantly surprised. As to the other things that happened last year, well, you may want to go back to sleep. Still, the broad domestic equity markets did surprisingly well, posting double-digit returns. On the other hand, if you had been invested in bonds or the overseas markets, you'd be pretty disappointed today. And if you attempted to "trade" the volatility during the year, you probably didn't enjoy the same gains as investors who followed a simple "buy and hold" strategy. So we head into 2017 with lots of questions, plenty of trepidation, but also a healthy dose of cautious optimism. 

Name of Index

Dec

QTD

YTD

Description

S&P 500

2.0

3.8

12.0

Large-cap stocks

Dow Jones Industrial Average

3.4

8.7

16.5

Large-cap stocks

NASDAQ Composite

1.2

1.7

8.9

Large-cap tech stocks

Russell 1000 Growth

1.2

1.0

7.1

Large-cap growth stocks

Russell 1000 Value

2.5

6.7

17.3

Large-cap value stocks

Russell 2000 Growth

1.4

3.6

11.3

Small-cap growth stocks

Russell 2000 Value

4.1

14.1

31.7

Small-cap value stocks

MSCI EAFE

3.4

-0.7

1.5

Europe, Australia, Far East

Barclays Aggregate

0.1

-3.0

2.6

US government bonds

Barclays High Yield

1.8

1.8

17.1

High-yield corporate bonds

* Returns 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 7 was 247,000, an increase from the prior week, and about the same as the prior month's figure. The four-week average of 256,500 was an increase of 7,000 from the prior month. Importantly, the moving average at the end of the year was about 17,000 less than it was at the beginning of the year. 
  • The non-farm payroll employment report in December was slightly below expectations, as only 156,000 jobs were gained in the month, while 19,000 net jobs were added in the prior two months. The household survey reported that the unemployment rate ticked up to 4.7%. The labor force participation rate inched up to 62.7, as the number of unemployed fell again. Average hourly wages for blue collar workers rose to a new high of $21.80 while the average work week has remained stuck at 33.6 hours for ten of the last eleven months.
  • 7.5 million workers were counted as unemployed, and 1.8 million people remained unemployed longer than 27 weeks. The seasonally adjusted number of people who could only find part-time work dipped to 5.6 million while the number of marginally attached workers rose to 1.7 million. The number of people holding multiple jobs dropped to 7.68 million. All of this resulted in the U-6 "underemployment" rate falling to 9.2%, the lowest level since the end of 2007.
  • The Congressional Budget Office (CBO) estimated that on a net present value basis, the nation's budget deficit was $26 billion in December, and $207 billion for the first three months of fiscal 2017, $8 billion less than the same period last year.
  • The Census Bureau reported that privately owned housing starts dropped 18.7% in November to 1,090,000, which was down 6.9% from a year ago. It was also the second lowest total of the year. 
  • The Census Bureau reported that on a seasonally adjusted annualized basis 592,000 new homes were sold in November, up 5.2% from October, and up 16.5% from a year ago. The estimate of the number of homes for sale was 250,000, representing 5.1 months of inventory at the current rate of sales. The median sales price was $305,400, just below the 12-month moving average price of $306,417.
  • The National Association of Realtors reported that 5.61 million existing homes were sold in November, the highest level of the year, up 0.7% from the prior month, and 15.4% from a year ago. The estimate of the number of homes for sale was 1.85 million, representing only 4.0 months of inventory at the current rate of sales. The median price was $234,900, up 6.8% from last year, and about $3,600 above the rising 12-month moving average price. 
  • According to the Institute for Supply Management (ISM), economic activity in the manufacturing sector expanded in December for the fourth month in a row, rising from 53.2 to 54.7. The ISM index of non-manufacturing activity held steady at 57.2, which signaled growth in the service sector for 83 consecutive months.
  • The Conference Board reported that its index of Leading Economic Indicators (LEI) was unchanged in November, following a gain of 0.1% in October. "The U.S. Leading Economic Index continued on an upward trend through 2016, although at a moderate pace of growth," said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. "The underlying trends in the LEI suggest that the economy will continue expanding into the first half of 2017, but it’s unlikely to considerably accelerate."
  • According to the "third" estimate by the Bureau of Economic Analysis, GDP increased at an annual rate of 3.5% in Q3 2016, up from 2.9% in the advance estimate. This compares very favorably with 1.4% in Q2, 0.8% in Q1 and 1.4% in Q4 2015. It easily surpassed the 2.0% achieved in Q3 2015. This report will help give the Fed courage to implement the next 0.25% rate increase sometime in the first quarter.
  • According to the BLS, the seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) increased 0.2% in November, after an 0.4% increase in October. Over the last twelve months, the index rose 1.7%. It would seem that the inflation remains below the 2.0% target set by the Fed.
  • The Conference Board's Consumer Confidence Index increased to 113.7 in December from 109.4 (revised) in November. "Consumer Confidence improved further in December, due solely to increasing Expectations which hit a 13-year high (Dec. 2003, 107.4)," said Lynn Franco, Director of Economic Indicators at The Conference Board. "The post-election surge in optimism for the economy, jobs and income prospects, as well as for stock prices which reached a 13-year high, was most pronounced among older consumers. Consumers’ assessment of current conditions, which declined, still suggests that economic growth continued through the final months of 2016. Looking ahead to 2017, consumers’ continued optimism will depend on whether or not their expectations are realized."

Trends To Watch

Interestingly, after a big drop in the relative value of the dollar in the first five months of last year, followed by an enormous rally over the next seven months, the price of the dollar index today is basically where it was a year ago. Still, this is basically the highest level for the index in about 13 years. And as I've said many times, a strong dollar is good to a point, but it does have a deleterious effect on the earnings of large, multi-national corporations with lots of sales outside of the U.S., as it makes their products relatively expensive versus other, cheaper currencies. It also puts pressure on commodity prices. So we will continue to watch this chart closely.

The price of West Texas Crude managed to break through resistance around $52 last month, but as you can see, the price is hovering right around that support/resistance line. And these higher prices are driving big gains in the stock prices of companies throughout the energy sector. Should the price remain in the $50s, or even move up to $60, we could expect to see businesses in the oil patches start hiring again as they attempt to bring production back online. 

I have to admit that the volatility in the price of gold is vexing me. I've been very bearish for the last few years, which is been both smart and stupid, depending on the particular moment in time. But looking at the bigger picture, as an investor, not a trader, I think I've made the correct call to remain on the sidelines. In December the price of gold cratered right through resistance just below $1,200 per ounce, but the price has recovered and is currently right at that support level, and right at the 50-day moving average. So we'll see what comes next. 

The good times continue to roll for the tech sector, as evidenced by the chart below, showing the tremendous gains in the Nasdaq Composite. The price of this index continues to move higher, defying all the critics who have too quickly lamented the end for FANG stocks (Facebook, Amazon, Netflix and Google) and their high flying brethren. Investors must continue to block out the noise and focus on the growth and the earnings potential of these stocks. As long as they continue to innovate, grow market share and generate massive cash flows, their stocks should continue to appreciate. If, on the other hand, President Tweet starts a trade war with Asia, then all bets are off.

After surging the record levels in December, the financial sector seems to be taking a well needed breather. This sector, which has been a clear beneficiary of the Trump victory, has profited from the hope that he, and the Republican Congress, will repeal Dodd-Frank, and perhaps other regulations, thereby releasing banks from some of their regulatory shackles. In addition, higher interest rates means higher lending margins, which will goose earnings. Once again, patient investors, like myself, have been rewarded. 

The housing index looks to be taking a bit of a breather as well right now as it digests the December rate increase and the expectation of future hikes. Looking ahead, I would expect the index to remain in the trading range outlined between the dotted green and the solid red for the first quarter, after which the next rate increase could send the index lower. 

I've been a bear on the developed international markets for more than a year, and looking ahead, given all the pronouncements by Trump of treaties (like NAFTA, TPP and Iran) being ripped up, possible trade wars, Brexit, and the possible dissolution of the Euro Zone, I would continue to stay away from this sector. 

The NYSE Bullish sentiment index has managed to remain in a narrow range for the last ten months, as three times it has failed to pierce resistance around 71.Sentiment has remained high for the past month, yet RSI is waning. We'll see if this optimism holds through the inauguration and into the rest of the first quarter.  

Finally, the price of the VIX remains at absurdly low levels, suggesting way too much complacency among investors, and that makes me nervous. We're due to have something happen. Perhaps Trump will tweet something stupid that will piss off a key trading partner, or an important industry. That won't happen, right? 


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 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. I clearly got this wrong, although I was dead on with my best case scenario for the first ten months. After Trump's victory, and the ensuing rally, the market finished much higher than I anticipated. But the gain on the DJIA did, in fact, surpass the result on the S&P 500, as predicted.
  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%. I was certainly correct that the domestic market would far outpace the results in the developed foreign markets, as the EAFE finished down 0.7% for the year. And the Shanghai index lost 12.3%, very close to my predicted 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%. I was close here as the Fed only had one rate hike of 25 basis points, in December. I did not anticipate how low the yield on the 10-year Treasury would go, as it well to an historically low level of 1.3%, before finishing the year around 2.5%, after peaking at 2.6%.
  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. This prediction was pretty spot on as the dollar index spent most of the year between 94 and 100, but it peaked at almost 104. 
  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. This prediction was spot on, as the price of oil hit bottom in February at $26, then spent nine months between $38 and $50, before cresting at $55 in late December.
  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. Once again, I was pretty accurate with this prediction as the price of gold rose about 9% last year. I missed on the high as rose up to $1,375, and the median price was closer to $1,275. 
  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. I missed this one. Housing was much more robust than I anticipated as interest rates stayed much lower than I expected. The HGX rose about 35% from the trough in February to the peak in July. The next five months traded in a tighter range. was partly right here. 
  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. I nailed this as the average rate of GDP growth over the last four quarters was just over 1.75%, for all of the reasons I gave in my prediction. 
  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. I was remarkably close here as the headline unemployment rate finished the year at 4.7% while the U-6 ended at 9.2%. The labor force participation rate finished exactly where it started. Wages rose 2.2% 
  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. Like many people, I could not have predicted the Trump victory. And to be honest, I'm still in shock. I'm hoping for the best but preparing for the worst. 
All in all, my forecasts were remarkably prescient, notwithstanding the big miss on the election. 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. I have to admit that the uncertainty surrounding the Trump presidency adds multiple layers of difficulty to my predictions this year. That being said, here goes nothing:
  1. I expect both good and bad times for the broad markets in 2017. I think we'll certainly have at least one, possibly two, downturns of between 5% and 10%. That being said, I think we'll finish the year in the black, with the Dow Jones Industrial Average up 6-8%. So much depends on the Fed, the economy and President Tweet and the Republicans. I also think the S&P 500 will do a little better than the DJIA this year as tech stocks outperform the rest of the market.
  2. As I've been saying, correctly, for a few years now, I would continue to avoid the developed foreign markets of Europe. Honestly, I have no opinion about the market of the developing world as that is not a focus of mine.
  3. Like last year, it is generally expected that the Fed will raise rates four times this year for a full 1% rate increase. I believe that the Fed will be a bit more restrained, and only raise rates twice. As a result, I expect the yield on the 10-year Treasury to trade in a range between 3.25% and 2.25%.
  4. The dollar index should remain in a relatively narrow trading range in 2017. Stronger monetary policy should limit the downside to about 97 with a upside potential as high as 104. I think the average for year will be right about 100-101.
  5. This should be a stronger year overall for the price of West Texas Crude. I expect the price will remain above $50 for the majority of the year, with a possible low of $40 and a brief spurt to as high as $60.
  6. It's hard to forecast the price of gold, but I am not optimistic. While I do expect one or two spurts higher during stock market turbulence, I think the price will finish the year below $1,200 per ounce.
  7. The housing sector could take a bit of a hit this year. Millennials seem unwilling to start buying homes, preferring to rent. This, and rising rates, will stunt demand. So like last year, I see the maximum upside at 5%, but the possible downside as great as 10%.
  8. I think we will have a more robust GDP growth rate in the next four months than we had in the prior year. As such, I think the average over the next four quarters will be between 2.50% and 2.75%. 
  9. The headline unemployment rate in 2017 is unlikely to fall much further simply because it cannot go much lower. The key change will be a tick up in the labor force participation rate as more people get jobs. I see the primary unemployment rates remaining between 4.7% -  5.0%, while the U-6 rate falls to around 9.0%. Wage growth will continue to move higher, at an annual rate of around 3.0%.  
  10. Finally, I do believe Trump and the Republican Congress will enact sweeping tax reform. If Trump builds a wall, the American people, not Mexico, will pay for it. At least two of his Cabinet nominees will fail to be approved by Congress. He will appoint to the Supreme Court a very polarizing jurist that gets the Left out in the streets in protest. You will hear from the Democrats the need to start over with "grassroots" organizing to take back the House in two years.


What I'm Thinking and Doing

The latest #TrumpEffect on the market is the pharmaceutical sector, which is getting pummeled thanks to President Tweet, who has decried the high price of drugs. And the defense sector still hasn't recovered from his attacks on Lockheed Martin and Boeing. I still hope that someone will shut off his twitter feed once he takes office on Thursday. Never before has the stock market had to worry so much about the daily proclamations of a President, and their effect on individual stocks. 

2016 was a very good year for the clients of Werlinich Asset Management. I cannot disclose individual, or aggregate, returns because my results are neither audited nor based on industry standard calculations. Still, our results were very satisfying and leaves me very optimistic for future gains. As I mentioned last month, I pruned a number of holdings in November and December, further focusing my holdings on my best ideas and freeing up some cash for new ideas. 

I began 2017 with fewer than 90 securities held across all of my portfolios under management. That is likely the lowest total since I started in business almost twenty years ago. Still, my investment philosophy remains unchanged: buy quality stocks, most of which pay a dividend, in the sectors of the market that have the greatest chance to succeed, then hold indefinitely. I also believe very strongly that I should be able to explain, in two sentences of less, why I want to own a particular security. If I can't do that, it's probably too complicated or I simply don't understand it. And if that's the case, I shouldn't own it. 

News and Notes

Winter vacation is over and all the kids have returned to school. Nola is about to begin her last semester at Wesleyan before graduating in May. Lily begins the second half of her freshman year at GW. She is also very excited to begin an internship with Rep. Nita Lowey. Ezra is in final preparations for taking the SATs this weekend and his driver's test in three weeks. I wish him luck on both! Kathiryn and I enjoyed a wonderful Christmas and New Years break and are energized for big things this year.

That's it for this month. I look forward to communicating with you in the months ahead. 

Best regards,


Greg Werlinich
President

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