Werlinich Asset Management, LLC

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September 15, 2015

Don't Fear The Correction: It's Normal and Healthy

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

Current Market Analysis

As of the close of business today, the Dow Jones Industrial Average stands at 16,599, which is 878 points, or 5.0%, lower than when I wrote to you last month. The stock market, as defined by the #DJIA, is now down 6.9% for the year (after finishing last year at 17,823). That's the bad news. The good news is that we've already recovered 6% since August 25, when the #DJIA hit the bottom of the "correction" by closing at 15,666. A correction is defined as a drop of 10% or more from the high. So was that the bottom, and are we headed straight back up from here? Honestly, I don't know. I do believe, as I've said many times, that I think the market will finish the year in the black, so if that wasn't the bottom, I don't think we're far from it. That assumes that we don't get more bad news out of China or that the Federal Reserve doesn't have a massive brain fart and drastically tighten their short term lending rates. 

Let's be clear about something: corrections are a normal and healthy part of the stock market. They may not be much fun to go through, but go through them we must. The stock market, like the economy and most every other force in nature, goes up and down; through good times and bad. We've enjoyed six years of a bull market since the last bear market ended in early 2009. That's a long time to go without suffering through a decline of 10% of more; so we were overdue. If we've seen the worst of it we got off easy.

Last month I wrote that I wasn't afraid of "sell in May and go away", and that I was recommending that my readers simply sit tight and hold your positions, as I was doing for my clients. I went on to say that "there are no big storm clouds on the immediate horizon and there are no better options out there for your money." Well, that didn't turn out so well as the correction started almost immediately after publication of the August issue. That being said, if you did just sit tight, or if you had the courage to do some strategic buying, you'll likely end up being very happy a year or two from now. 

The chart of the #DJIA shows the gradual decline, which began in early June, picked up steam in July, before culminating in a blow-off plunge in late August. Since then, the index has moved higher and is now just above the interim resistance line at 16,500. If it can successfully move north of that, the next resistance line comes in around 17,100. If there is another decline, it's important that the index remain above the August low. 

The action in Transportation Index is similar to the Industrial index in that it followed a long slow decline with a major sell off, and has subsequently recovered somewhat. It too has rebounded above interim support (around 8.000). The next resistance level is around 8,700 (green dotted line). As I said last month, I think the railroad sub-sector of this group is poised for a big recovery.

The Dow Jones Utility Average, a supposed safe haven for investors, was not spared the pain of the recent correction. Indeed, from the peak in early February, the utility sector has almost entered bear market territory (down 20% or more) as it is down almost 18% for the year as investors have fled the sector in advance of a rate hike that never materialized. As such, this sector represents an intriguing buying opportunity for long-term investors. The key will be to remain above support around 525 and take a shot at resistance around 570. If a rate hike is already "baked in", then we might actually see a rally before the end of the year. 

We can see what happened to bond yields during the recent panic. Investors fled stocks and flocked to bonds, knocking the yield on the 10-year treasury down to 1.9%. It has since risen back to around 2.25%, which is right in the heart of the upper half of the trading range you see below. I don't expect the range to change much in the next few months, regardless of what the Fed does, or does not do, on Thursday.

Last Month's Results

Last month was simply brutal; there's simply no other way to describe it. There were big losses across all of the major averages. When I somewhat flippantly asked last month "who wants to bet that [the market will] be down in August?" I had no idea how (unfortunately) right I would be. The good news is that if the pattern of alternating gains and losses holds, we should have a profitable September. It's all about the Fed right now and what interest rate policy decision they will make after their meeting next week. My guess is that they will do nothing. 

Name of Index





S&P 500




Large-cap stocks

Dow Jones Industrial Average




Large-cap stocks

NASDAQ Composite




Large-cap tech stocks

Russell 1000 Growth




Large-cap growth stocks

Russell 1000 Value




Large-cap value stocks

Russell 2000 Growth




Small-cap growth stocks

Russell 2000 Value




Small-cap value stocks





Europe, Australia, Far East

Barclays Aggregate




US government bonds

Barclays High Yield




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 September 5 was 275,750, down slightly from the prior week, and about the same as the prior month's figure. The four-week average of 275,750 was roughly 10,000 more than the tally from a month ago. About 2.26 million people continue to collect unemployment insurance, about 100,000 less than last month.
  • The non-farm payroll employment report in August basically was underwhelming as the establishment survey reported that only 173,000 jobs were added in the month, while revisions managed to add 44,000 jobs to the June and July totals. The household survey reported that the unemployment rate fell to 5.1% (which is the Fed's target) while the labor force participation rate remained at a low 62.6 for the third straight month. Average hourly wages for blue collar workers increased to $21.07 while the average work week held stubbornly at 33.7. 
  • Only 8.0 million workers were still being counted as unemployed. 2.2 million people remained unemployed longer than 27 weeks, the same as last month. The seasonally adjusted number of people who could only find part-time work fell to 6.4 million while the number of marginally attached workers dipped to 1.8 million. The number of people holding multiple jobs decreased to 6.9 million. All of this helped the comprehensive U-6 "underemployment" remain at a very low 10.4%. This is not the picture of a robust economy; it's more like a muddling economy. 
  • The Congressional Budget Office (CBO) estimated that on a net present value basis, the Treasury reported a budget deficit of $62 billion in August, leaving the eleven-month deficit at $524 billion, about $61 billion less than the shortfall recorded in the same period last year. After an expected surplus in September, the year-end deficit is expected to be about $426 billion. 
  • The National Association of Homebuilders/Wells Fargo Confidence Index rose one point to 61 in August. "Today’s report is consistent with our forecast for a gradual strengthening of the single-family housing sector in 2015," said NAHB Chief Economist David Crowe. "Job and economic gains should keep the market moving forward at a modest pace throughout the rest of the year."
  • The Census Bureau reported that privately owned housing starts were essentially flat in July after rising 12.3% in June, remaining at an adjusted annual rate of 1,206,000 units, which was 10.1% higher than a year ago. New building permits fell 16.3% from the prior month but remained 7.5% higher than the year before. The general trend in starts and permits is displaying some modest gains but no strong momentum.
  • The Census Bureau reported that on a seasonally adjusted annualized basis 507,000 new homes were sold in July, up 5.4% from June (revised), and up 25.8% from a year ago. The tally, though, remains well below the high set in February. The estimate of the number of homes for sale rose to 218,000, representing only 5.2 months of inventory at the current rate of sales. The median sales price was $285,900, leaving it just below the 12-month moving average price of $289,717.
  • The National Association of Realtors reported that on a seasonally adjusted annualized basis, 5.59 million existing homes were sold in July, an increase of 110,000, or 2.0%, from June, and 10.3% higher than a year ago. The estimate of homes for sale is 2.24 million, which represents only 4.8 months of inventory at the current rate of sales. The average selling price was $234,000, near the highest level since July 2007 and well above the rising 12-month average of $214,817. It appears the pickup in the housing market that I had been expecting may be starting.
  • According to the Institute for Supply Management (ISM), economic activity in the manufacturing sector dipped to 51.1 in August, which barely continued growth for the 25th straight month. The ISM index of non-manufacturing activity dipped to 59.0, near the highest level since I started tracking this in 2008, which signaled growth in the service sector for 67 consecutive months. It's clear the reason wages aren't moving is all of the job gains are in the lower-paying service side of the economy. 
  • The Conference Board reported that its index of Leading Economic Indicators (LEI) decreased 0.2% in July, following a gain of 0.6% in May and June. "The U.S. LEI fell slightly in July, after four months of strong gains. Despite a sharp drop in housing permits, the U.S. LEI is still pointing to moderate economic growth through the remainder of the year," said Ataman Ozyildirim, Economist at The Conference Board.
  • According to the "second" estimate by the Bureau of Economic Analysis, GDP increased at an annual rate of 3.7% in Q2 2015, up from the initial estimate of 2.3%. This was far better than the decrease of 0.2% in Q1, and close to the 2.2% increase in Q4 2014. Still, it remains well below the 5.0% and 4.6% growth rates in Q3 and Q2 2014, respectively. While I'm not sure this is the strong growth that people are hoping for, it's a start.
  • According to the BLS, the seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) increased only 0.1% in July, and only 0.2% for the past 12 months. If you strip out food and energy, CPI rose the same 0.1%. It is clear to me, if not to the Fed, that economic growth is stagnant at best.
  • After falling in July, the Conference Board's Consumer Confidence Index rebounded in August to 101.5, near the highest level of the year. I have to admit I was very surprised by this, considering the carnage in the market in August. I'm sure this reading will fall again in September. "Consumer confidence rebounded in August, following a sharp decline in July," said Lynn Franco, Director of Economic Indicators at The Conference Board. "Consumers’ assessment of current conditions was considerably more upbeat, primarily due to a more favorable appraisal of the labor market. The uncertainty expressed last month about the short-term outlook has dissipated and consumers are once again feeling optimistic about the near future. Income expectations, however, were little improved."

Trends To Watch

The price of the dollar index remains range bound as it trades between resistance around 100 and support around 93.5. The current price has fallen below interim support/resistance at 97.5. Should the dollar weaken a bit further it would be a real boon to the natural resource sector, including oil, that has suffered greatly this year in the face of such a strong dollar.

This has been a tough year to be long oil or energy related stocks. From a strong dollar to weak demand to over-production; virtually everything that could negatively impact the price of oil has done just that. The correction added further fuel to the fire, sending the price of West Texas Crude below support at $42.50 to as low as $37.50. It has since recovered somewhat and is currently back in the mid-$40s. It will be hard to make a bull case for the price of oil until the global economy shows signs of sustained growth, and until either supply falls to meet demand or demand rises to meet supply. Until that happens, I expect the price of oil to languish.

The price of gold continues with wither. Last month it tested support around $1,100 before bouncing higher during the stock market correction. As that panic has subsided, so has the price of the shiny metal. I honestly can't see any reason to be a buyer right now. 

I wonder if the officials at the Fed every look at this chart. This is not the picture of a healthy and growing economy. Dr. Copper is telling us that things are not well. The price of copper, which is used in so many industrial applications, is down to a low not seen since the financial crisis ended. That's not good. 

The Nasdaq Composite is in the midst of a rapid snap back from the panic sell off last month. I took advantage of some of those artificially low prices to buy a few leading tech stocks; I hope you did as well. I expect to see the index break above interim resistance at 4,900 before moving higher through the rest of the year. But things won't get really cooking until #AAPL starts moving higher again.  

The correction ruined this otherwise beautiful chart as the financial sector ETF got pounded for a few days, including a one day nightmare. I hope you didn't sell that day at a ridiculously low price. This setup seems like a great time to pick up some leading bank or insurance stocks so I'd be a buyer. 

The housing index has quickly recovered, moving right back to a key support/resistance level at 238. If it can move higher over the next week or so it would be very bullish. 

The index for developed international markets doesn't look good at all. It has been trading around the correction low, and major support, for the past three weeks. Should the Fed increase rates, I would expect to see this index fall further. If they hold off, watch for a quick and powerful rally. On its own merits, I would stay away from this sector.  

I'll repeat what I said last month: suffice it to say that I would stay out of the Chinese stock market. I don't trust their accounting and there is simply way to much overt government manipulation of their markets. This is for speculators only; investors beware. In the next few months, as this triangle formation grows tighter, pressure will build to force a major move one way or another. I don't want to place a bet on the direction. 

The NYSE Bullish sentiment index crumbled to a new low last month in the wake of the correction. But as you can see, sentiment had been falling steadily for months. I'm not sure when sentiment will turn, and clearly I've been wrong with my recent "buy" signals, but things are setting up for a major rally sometime soon. And when it happens, it should be powerful. 

Look what happened to the VIX during the correction. It spiked from the low teens to over 50 in just a few trading days. It then dropped back to about 20 in just two weeks. Crazy. But it certainly presented a great buying opportunity for those with the cash and the courage to ignore the doomsday announcements and understand that it's best to buy when there's blood in the streets. 

What I'm Thinking and Doing

Clearly, fear won out last month as global stock markets plunged, due in part to concerns about a much smaller than expected rate of economic growth in China and also because of worries that the Fed may raise rates and kill whatever growth may be bubbling here in the U.S. I think the market was simply looking for an excuse to have a long overdue correction and used those reasons to precipitate a swift and powerful sell off. I still believe that the fundamental underpinnings of our economy and stock market are healthy. There is no massive bubble waiting to burst. Corrections are a natural part of the stock market cycle and are to be embraced, because when they're over, the stage is set for the next big gains. 

After the big losses we endured last month, my prediction in January that the Dow Jones Industrial Average could be up 8%, but may only gain 5-6%, could be at risk. I still think that we'll have a fourth quarter rally that will put the market in the black by year-end.

One quick thought on the Fed. I think it's 50/50 as to whether or not they raise their short-term lending rate by 25 basis points. But that's really besides the point. The point is that it really doesn't matter what they do. They should have raised rates a long time ago. Whether their lending rate is 0.25%, 0.50% or 0;75% really doesn't mean that much to the average American or the U.S. economy. In fact, higher rates would probably help large segments of the population that relay on the interest from their savings accounts. Most interest rates in the country are set by the market, not by the Fed. And those rates will likely stay reasonably low for months or years to come. So let's get past this "big" Fed announcement and understand that it simply isn't that important.

Over the summer I increased my cash position from about $700,000 to nearly $3 million as I reduced my allocation to the energy sector, eliminated my holdings in the mining sector, trimmed my REIT holdings and sold a few smaller and underperforming holdings. It was painful to sell some of those stocks, many of which I had owned for over five years; some of which more than ten. But when times and conditions change, you have to be willing and able to change with them. And you can't second guess your decisions. You just have to stand by your convictions and move forward. That being said, after the August 24 "mini flash-crash", I started putting some of that money to work. Although I didn't buy any new stocks, I added to many existing positions. All told, I spent almost $1.2M over the past two weeks buying great companies at substantially reduced prices. I'm very confident that all of those purchases will be very profitable in the months and years to come. 

News and Notes

I can't believe summer is just about over. No more outdoor swim practices. No more white linen clothes. Before we know it we'll be back to jeans and fleece. All three kids had great summers and are now back in school. This is the big year for Lily as she will soon begin sending in her applications for college. Ezra seems to be slipping right back into the routine. I think he's going to have a really good year. Nola is now a junior in college, and working hard on her theater major. It's really nice to see all three of them doing well, getting in a good groove. 

After a busy month of super fun activities in August, Kathiryn and I won't be letting up much this month. By the end of the month, Kat and I will have celebrated both of our birthdays, Kat will have performed three gigs with her two bands, we will have been to a jazz club and a Broadway show in NYC, attended two concerts (Jackson Browne and The Doobie Brothers) and enjoyed another baseball game with the FIRST PLACE  Mets. 

I guess the only good thing about cooler weather coming up is that we get to plan all of our winter travels. We've got three trips booked already for between now and the end of the year. The first will be in early November to San Francisco where we'll have the honor of seeing one of my oldest friends, Sallie Kim, installed as a judge. That should be really incredible.

That's it for now. I look forward to writing to you again in October.

Best regards,

Greg Werlinich

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