Nov ’12 Newsletter

Current Market Analysis

As the market finished trading for the week, the Dow Jones Industrial Average stood at 12,588, down about 758 points, or 5.7%, from when I wrote to you last month, and down 7.5% from the October 5 closing high of 13,610. The latest decline started the day after the election. It was the classic story of buy the rumor and sell the news. Plus, now that the election is finally behind us, we can focus on the looming fiscal cliff, the threat of escalating fighting the the Middle East and the lethargic domestic economy. Given all that, it’s not surprising that the stock market has dropped. The $64 trillion question (that’s inflation for you) is whether this is a simple correction or the beginning of a larger Bear Market.

After hitting a new four year high on October 5 the market has tumbled badly, on increasing trading volume, as you can see below. It appears that we’re now seeing the problems forecasted by the poor action in the transportation average over the past few months. The DJIA has plunged below both moving averages and two supports after carving a clear head and shoulders pattern. It’s now sitting right near another support level (red line). If it falls further, the next support would be around 12,035 (light blue line). If that doesn’t hold, we’ve got real trouble. The one silver lining is that RSI is oversold, suggesting we could be in for a bounce.

The transportation average looks terrible. It is well below both moving averages and sitting right at a big support level. The next important support comes in around 4,500. The fact that the transportation sector is doing so poorly is a very ominous indicator for our economy.

I have to admit, the sudden drop in the Dow Jones Utility Average took me by surprise. The price had been gaining strength over the past two months before this decline. What’s especially dangerous is that the 50-day moving average is poised to fall below the 200-day. That’s bearish. The good news is that RSI is now quite oversold, suggesting that we could be near a bottom. I’m sticking with my long-held position that I’d use any weakness to buy a stake for investors seeking conservative, high-yielding income opportunities.

Interest rates have been trading between 1.4% – 1.9% over the past six months. You can see that resistance was firm three times while support held twice. Should equities experience a prolonged decline, yields could again test the 1.4% support level as investors would flee stocks and seek the safety of treasuries.

As always, I provide the following chart to show the raw results for the preceding month, the quarter-to-date and the year-to-date. After a very strong third quarter, the market turned south in October (and got even worse so far in November). Riskier growth and technology stocks, led by a big declines in tech bellweathers like Apple and Goggle, were particularly hard hit. I warned last month that lags in technology harbored a warning for diminished returns in the fourth quarter. This is not a good omen. While the return on Treasury bonds continues to lag, investors continue to pour money into high yield bonds. These type of annual returns, along with the ever diminishing yields, suggest the easy money has already been made and trouble could be ahead for “junk bonds”. Finally, the EAFE added to the its earlier gains and delivered positive results in an otherwise dismal month. What does that mean?

* 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 November 10 was 439,000, an increase of 51,000 from a month ago and 78,000 higher than the prior week’s revised figure. The four-week average of 383,750 is about 18,000 higher than the prior month’s tally. After falling the past few weeks, initial claims spiked in the recent report. About 3.33 million people continue to collect unemployment insurance, up from the prior month. While some of this can be attributed to Hurricane Sandy, the increases are ominous.
• Non-farm payroll employment in October showed some improvement, but remained a mixed bag. The establishment survey reported that 171,000 jobs were added in the month while the household survey said that the unemployment rate inched up to 7.9%. In this instance, the increase wasn’t bad news as it meant that more people were re-entering the work force. If they cannot find jobs soon, then the unemployment rate will likely move back above 8% in the next few months.
• Revisions to prior August and September added 88,000 jobs, on top of the 86,000 that were added in the September report for July and August. The trend is very good, suggesting next month will see even more jobs added retroactively. The total number of workers counted as unemployed rose to 12.3, which helped move the unemployment rate up to 7.9%. The labor force participation rate ticked up to 63.8%. The more comprehensive U-6 “underemployment” rate dipped to 14.6%.
• 5.0 million people continued to be unemployed longer than 27 weeks. The seasonally adjusted number of people who could only find part-time work fell to 8.3 million and the number of marginally attached workers inched down to 2.4 million. The number of people holding multiple jobs remained at 7.0 million. The average hourly wages for blue collar workers fell slightly to $19.79 while the average work week fell to 33.6 hours. While the headline number of jobs added looked good, the fact that people are working less hours, for less money, is very disturbing.
• The Congressional Budget Office (CBO) estimated that on a net present value basis, the Treasury reported a federal budget deficit of $115 billion in October, about $15 billion more than the first month of fiscal 2012. After four consecutive years of deficits greater than $1 trillion, let’s see if our elected officials are able to enact any kind of meaningful debt reduction plan this coming year.
• The Census Bureau reported that the U.S. trade deficit of goods and services was $41.5 billion in September, down from $43.8 in August. The trade gap was $52.5 billion in January, so real progress has been made.
• The Census Bureau reported that privately owned housing starts surged 15% in September, building on a 4.1% gain in August. Housing starts are now a whopping 34.8% higher than a year ago, to a seasonally adjusted annual rate of 872,000 units. New building permits were up 11.6% from the prior month and 45.1% higher than the year before. This is a strong sign that the recovery is continuing.
• The National Association of Homebuilders/Wells Fargo Confidence Index gained 1 point in October to 41. That marks the sixth straight monthly increase in builder confidence, and its slowly creeping up towards a healthy figure of 50. This metric too shows a strengthening recovery in housing.
• The Census Bureau reported that on a seasonally adjusted annualized basis, 389,000 new homes were sold in September. That’s 5.7% higher than last month, and 27.1% better than a year ago. In fact, it’s the highest level since April 2010. The estimate of homes for sale was 145,000, which represents only 4.5 months at the current rate of sales. The median sales price dipped this month to $242,400, after a big increase in August. That remains solidly above the rising 12-month moving average price of $233,067. The new home sale market remains very tight, which augurs well for future price increases.
• The National Association of Realtors reported that on a seasonally adjusted annualized basis, sales of existing homes were 1.7% lower in September, after rising 8.1% in August, to 4.75 million units, but remained 11% higher than a year ago. The estimate of 2.32 million homes for sale means there’s only an estimated 5.9 months supply on the market. The median sales price fell a smidge to $183,900, which is well above the rising 12-month average of $171,742. As with new homes, the existing home market is getting tighter and tighter, which suggests that prices will start rising soon.
• The S&P/Case-Shiller Home Price 10-city index, which uses a three-month moving average to track the value of home prices across the US, rose for the fifth straight month in August, posting a decent 0.9% increase. There’s little question that the trend of increases will continue through the rest of the year.
• The Institute for Supply Management (ISM) index of manufacturing activity was 51.7 in October, marking two months of tepid expansion in the manufacturing sector. The service sector, on the other hand, shows no sign of slowing down. The ISM index of non-manufacturing activity was 54.2, down a bit from September, but still marking growth in the service sector for 34 consecutive months.
• The Conference Board reported that it’s index of Leading Economic Indicators increased by 0.6% in September after a decrease of 0.4% in August. Says Ataman Ozyildirim, economist at The Conference Board: “The U.S. LEI increased in September, more than offsetting the decline in August. The LEI has been signaling an economy that is fluctuating around a slow growth trend. The six-month growth rate has slowed substantially, but still remains in growth territory due to positive contributions from the housing and financial components.”
• According to the Bureau of Economic Analysis, the “advance” estimate of GDP growth for Q3 2012 was 2.0%, a decent improvement from the 1.3% growth in the second quarter and matches the growth from Q1. Unfortunately, it’s a ways away from the 3% recorded in Q4 2011. We are all still waiting for the economic recovery we’ve been promised. I’ll say it again: no amount of QE is going to make things any better. What we need is a clear and simple tax policy, a resolution to the fiscal cliff and the government getting out of the way of business.
• The Federal Reserve reported that in September the amount of outstanding consumer credit was $2.74 trillion, up from the prior month and growing at an 5% annualized rate. A second month of growth in consumer credit can only be helpful to retail sales, which would in fact help the economy.
• According to the Census Bureau, retail trade and food service sales increased 1.1% in September, following a 1.2% increase in August, leaving them 5.4% higher than a year ago. These numbers are telling us that either the economy is better than we’re led to believe, or that consumers are simply delusional. The big winners were electronics and appliance stores and gas stations. Most other sectors saw modest gains.
• The Federal Reserve reported that in October the six month rate of growth in the supply of M-2 (a broader view of money) was 6.4%, up slightly from September. The supply of M-1 (a narrower definition of money), on the other hand, rose a much faster 14.2%. I’m getting bored with reporting this increase month after month.
• The Conference Board’s Consumer Confidence Index increased again in October, rising to 72.2. Says Lynn Franco, Director of The Conference Board Consumer Research Center: “The Consumer Confidence Index increased again in October and is now at its highest level this year. Consumers were considerably more positive in their assessment of current conditions, with improvements in the job market as the major driver. Consumers were modestly more upbeat about their financial situation and the short-term economic outlook, and appear to be in better spirits approaching the holiday season.”

• According to the FDIC, 4 banks failed in October, bringing the total number of bank failures so far this year to 47, which is 38 less than this time last year. It’s clear that there will be far fewer bank failures this year than the 92 banks that failed in 2011, which was a big improvement over the record 160 banks that were either closed or merged into healthier banks in 2010, and 140 in 2009. By comparison, only 26 failed in 2008 and a negligible 3 in 2007. I wonder if we’ll return to the 2007 levels any time soon.

Trends To Watch

The dollar has been in a strong uptrend since bottoming out last October. A strong trading range has been carved out this year between support at 79 (red dotted line) and resistance at 84. Recently, a stronger greenback has meant bad news for equities and could mean more trouble if it continues to rise.

For the past year the trading range for gold has been between $1,500 – $1,800/oz. Most recently gold tumbled a bit before bouncing off minor support around $1,675 (green dotted line). I think the green line might offer a great entry point for those still waiting to build a position in the shiny metal.

The price of silver has carved out a solid trading range this year between $26.15 – $35.70. After bouncing off resistance in early October there’s been some profit taking recently. Silver still looks bullish to me. We may be at, or nearing, the next buying opportunity I mentioned last month.

The price of copper doesn’t look quite so healthy. The recent drop has dropped the price below the interim support/resistance line at $3.50 (green dotted line). The next line of defense appears to be around $3.20. As the price of copper is often thought to be a proxy for the health of the economy, the price weakness is not a surprise. With RSI so oversold we could be due for a bump.

Similar to the price of copper, the weakness in the price of West Texas crude is likely a reflection of the dismal state of the global economy and the assumption of lower consumption going forward. Giving some support to the price is the geo-political unrest in the Middle East which increasingly appears to be headed towards an escalated level of conflict. Looking ahead, given the risks, I think the more likely direction is higher prices, not lower.

The financial index failed once again to breach resistance at $16.30. The financial sector is facing some head winds due to some unintended consequence of QE. In particular, banks are seeing their net interest margins, which is the difference between their borrowing and lending costs, get squeezed, which negatively impacts earnings. So I’m going to maintain my stubborn position of avoiding bank stocks.

Even with the recent weakness, the housing sector continues to be a winner. Unless the housing data suddenly turns south, it’s hard to be opposed to this trade. In fact, further weakness due to general market conditions could provide a nice buying opportunity.

The index for the developed international markets has failed six times over the past year to pierce resistance around 55.50 The good news is that it also failed to fall below support at 46. This index is going to track news out of the EU and will also likely follow the lead of the US markets.

The chart of the emerging markets continues to be virtually identical to the one for the developed countries. I’ve been waiting for months for this correlation to end and I’ve been wrong all along. I don’t understand why this synchronicity exists and I don’t know how much longer it will continue. It just makes no sense.

The Shanghai index continues to be a horror show. Each time there’s been a hint of recovery it’s been quickly squashed. The index is in danger of dropping below another important support level. If it does that, the next support comes in around 1,700, a level not seen since the financial crisis of 2008. Considering the world is MUCH better off than it was back then, why is the Chinese market doing so badly? What’s going on that we don’t know about? Stay tuned.

Now we come to our three contrarian indicators. First is the NYSE Bullish sentiment index. This chart suggests that the market is no longer too bullish. In fact, we’re beginning to look a bit bearish, especially according to RSI which has just reached oversold territory. Past history suggests we could have a bit farther to fall before the recovery begins.

Next we see that only about 22% of stocks traded on the New York Stock Exchange are currently trading above their 50-day moving average, down from 85% only two months ago. It’s also below 30% threshold that’s provided support in the past. This is very bearish. If we get down to the 12% level, we could set up for a huge rally.

Finally, we look at the VIX, or the “fear index”. I’m surprised that the VIX hasn’t moved higher given how far the broad market has fallen and given the two charts above. This suggests that we may have further to fall. Until there is more “fear” we’re probably not ready for a recovery.

What I’m Thinking and Doing

About the only good news these days is that the election is FINALLY over. In my Fearless Forecast edition back in January I said “I believe President Obama will defeat Mitt Romney in a relatively close election as a divided GOP is unable to coalesce behind Romney. The Tea Party is marginalized and the Senate remains in Republican control. Fiscal austerity, job creation and tax policy are the main debate points.” I’d say I nailed that one right on the head. Now, Obama and the lame duck Congress MUST figure out a way to avoid pushing this country over the “fiscal cliff”. Should every possible tax increase and spending cut go through the 4-5% reduction in GDP would push the United States into a deep recession. But I believe that the self preservation instincts of our politicians won’t allow that to actually happen. Somehow they will figure out how to avoid the cliff. It’s likely that they’ll compromise on some easy tax increase wins and entitlement cuts then push the harder decisions into next year to let the next Congress fight it out. And the sooner they do this the better for the stock market, which hates uncertainty.

At the end of the day, I don’t think the results of the election will change things very much. We still have a left-leaning president with no real mandate and a divided Congress with a weakened Tea Party. That’s a great prescription for more of the same where there’s lots of talk and very little real action. I think the best we can hope for, in the short run, is some modest compromise and lots of procrastination. Looking longer term, I truly hope the President looks to his legacy and makes a real effort to articulate a tax and spending policy that makes sense. If he does, the Republicans will be forced to the table and maybe a plan that can save us from becoming Greece and Spain can be shaped. Or not.

Last month I said that “we’re at a dangerous inflection point” in the market. Between the “fiscal cliff”, weaker than expected Q3 corporate earnings, a domestic economy in a stupor and a heightened conflict in the Middle East the market is teetering between a correction and a Bear Market. As a result, I’m being extra cautious right now. I haven’t bought anything new since September because I’m allowing our cash reserves to build. At some point I think we’ll have a great buying opportunity and I want to be ready.

Professional News and Notes

First of all I’d like to send my thoughts and prayers out to everyone who suffered through the effects of Hurricane Sandy. My family and I were fortunate to only lose power for four days and have no damage to our home or property other than the loss of five trees. Hundreds of thousands of people were not so lucky. Even today there are a few still without power and many without heat or hot water. That doesn’t include the countless people who have lost their homes and businesses. It will be years before the full impact of this storm is absorbed and the people and land recover. I sent some money to my local Red Cross chapter this week. It’s only a very small drop in the bucket but I hope it can help someone in need.

In collaboration with my new web designer, I have just begun work on my new website. It was time to “freshen the look”; make it more current and accessible. I hope to have it up and running before the end of the year.

I’ve now written two dozen original articles in my blog and I’m slowly building up a a following, which is extremely gratifying. I imagine there will be plenty to write about between now and the end of the year. I’d be very interested in hearing what you have to say. So please check it out and share your thoughts by clicking here. As I’m trying to expand its coverage, I would really appreciate it if you could forward the link to some of your friends and colleagues and comment on one or more of the existing blog posts. It would also be helpful if you could let me know what you’d like me to write about, because after all, it’s about your money. If you “follow” the blog, you’ll be notified by email any time I post some new copy.

As always, I thank you, my readers, and remind you that this newsletter is for you. I have been writing News and Views for over nine years now. If you’d like to read any prior edition, simply go to my website and click on the link to my newsletter archives. I hope you have learned something about our economy and our stock market, and that you will continue to follow along with me in the future. If you have any thoughts or suggestions on how to make it better, please let me know. And if you’d like to speak with me about your investment needs, I’d be pleased to be of service. Simply give me a call or drop me an email.

Best regards,

Greg Werlinich
President