Werlinich Asset Management, LLC

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September 23, 2013

Will the Government Kill the Party?

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

The Dow Jones Industrial Average currently stands at 15,451, up 441 points, or 2.9%, from when I wrote to you last month, which leaves the average up a remarkable 17.9% from the 2012 year-end closing price of 13,104. Even more impressive is that we're only two days removed from a Dow Theory bullish confirmation whereby the Industrial and Transportation averages concurrently hit new all time highs. That's a far cry from the roughly 6% decline we suffered through during a dismal August. The market quickly surged as concerns of a U.S. military intervention in Syria abated. The recent announcement by Ben Bernanke that the Fed would not yet begin to taper their QE program added a rocket booster to the momentum, driving the market even higher. Unfortunately, the subsequent two days saw the market trade lower, leaving the near term momentum unclear. 

For the next eight days, the market will be all about the fight in Congress over the looming budget fight. Once again, like Groundhog Day, Americans face a government shutdown because the Republicans and Democrats cannot put the good of the country ahead of their limited partisan self interest. I'll talk about this more later in the the "What I'm Thinking" section. Suffice it to say, if an accord is not reached before October 1, and the government is forced to shut down, it could be devastating for the stock market.

Last month I asked, "So what should we make of this latest pullback? Is it simply a normal, and healthy, correction in an ongoing bull market or does it presage a greater danger on the horizon? My feeling is that it's the former, and that by Labor Day the markets will have turned around and headed north." That was a fortunate prediction as it was exactly what happened. 

Below is the chart of the Dow Jones Industrial Average. If you had the discipline to ignore the monthly volatility and simply do nothing, you would have enjoyed a roughly 1,000 point increase over the last five and a half months. The current price is above both the 50- and 200-day moving averages. RSI has just dipped below overbought status and MACD may have peaked. All of this suggests we may see a little more selling pressure in the near term. Longer term, it's all up to Congress.

After reaching a new high along with the Industrial average last week, the Transportation Average moved even higher before closing down on Friday. The chart below paints a very bullish picture as the current price is well above both moving averages. It appears that only the government could mess this up.

The Dow Jones Utility Average has been on a roller coaster of late. Rising interest rates have clearly hurt utility stocks. The peak around May 1 clearly overlaps the bottom in interest rates (see the next chart). I've drawn two support levels: blue line around 475 and red line around 465. Near term, now that "taper" is off the table, utilities could benefit. Should these supports hold, and if interest rates stabilize, we could have a buying opportunity. 

As you can see, the yield on the 10-year Treasury bumped against major resistance at 3% early this month before moving a bit lower recently. Rates haven't been that high since August 2011. It's possible that rates could fall further now that the Fed has delayed the taper. Should that happen, bond investors should take advantage of the opportunity to lighten up because rates are certainly headed higher in the coming months.

Last Month's Results

After a great July, the market swooned a bit in August with broad losses across the board. Even so, all the major domestic averages retained their solid gains for the year. With a decent final four months, even the struggling EAFE could eke out a 10% or better gain for the year, which would be a great result considering all the problems in Europe. It should come as no surprise to anyone that the bond market continues to struggle. Given that the Fed has punted on tapering, at least for now, I'd expect rates to level off for a while, minimizing losses in the short run. Longer term I think bond investors will continue to suffer.

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 14 was 309,000, an increase of 15,000 from the prior week's revised figure. The four-week average of 314,750 is about 15,000 lower than the tally from a month ago. The four week average has decreased by 59,000 since the beginning of the year. According to the seasonal average, about 2.8 million people continue to collect unemployment insurance, which is almost 200,000 lower than the prior month. Overall, this picture continues to improve, but too slowly.
  • The non-farm payroll employment report in August was the second monthly disappointment in a row. The establishment survey reported that a modest 169,000 jobs were added in the month, while the figures for June and July were both revised lower, subtracting 74,000 jobs, after subtracting 26,000 in the prior month's revisions. The household survey reported that the unemployment rate fell to 7.3%. The 11.3 million workers counted as unemployed were fewer than last month while the labor force participation rate dipped lower to 63.2%. More and more people continue to leave the work force.
  • The more comprehensive U-6 "underemployment" rate fell from 14.0% to 13.7%. But 4.3 million people continued to be unemployed longer than 27 weeks (up from the prior month), the seasonally adjusted number of people who could only find part-time work fell to 7.9 million and the number of marginally attached workers fell to 2.3 million. Those numbers don't provide much comfort. The number of people holding multiple jobs fell to 6.8 million. The average hourly wages for blue collar workers perked up to $20.20 while the average work week remained steady at 33.6 hours. Overall, the picture continues to be muddled at best and continues to bedevil the Federal Reserve.
  • The Congressional Budget Office (CBO) estimated that on a net present value basis, the Treasury reported a federal budget deficit of $146 billion in August, about $45 billion better than the same period last year. That leaves a deficit of about $750 billion for the first eleven months of fiscal 2013, almost $411 billion less than the record figure reported for the same period of fiscal 2012.
  • The Census Bureau reported that the U.S. trade deficit of goods and services was $39.1 billion in July, a small increase from the prior month, but still among the smallest monthly deficits since October 2009. It's not completely improbably that the deficit could fall below $25 billion within a year.
  • The National Association of Homebuilders/Wells Fargo Confidence Index remained steady in September at a revised level of 58. While builder confidence remains at an eight year high, there are reports of some hesitancy on the part of home buyers due to the sharp rise in interest rates, requiring builders to pause and survey the changing environment.
  • The Census Bureau reported that privately owned housing starts increased 0.9% in August to a seasonally adjusted annual rate of 891,000 units, leaving them 19.0% higher than a year ago. New building permits fell 3.8% from the prior month but remained 11.0% higher than the year before. This is showing the affects of rising interest rates.
  • The Census Bureau reported that on a seasonally adjusted annualized basis, only 394,000 new homes were sold in July, a huge 13.4% decrease from a revised lower June report, and only 6.8% higher than a year ago. The estimate of number of homes for sale inched up to 171,000, which represents 5.2 months of inventory at the current rate of sales, up from 4.3 last month. The median sales price has fallen for three straight months and is down to $257,200, which is straight on the 12-month moving average price of $257,500. These poor results are directly attributable to rising interest rates and they're not helping the case for Fed tapering.
  • The National Association of Realtors reported that on a seasonally adjusted annualized basis, 5.48 million existing homes were sold in August, an increase of 1.7% over July and 18.9% higher than a year ago. The estimate of homes for sale held steady at about 2.2 million, which represents 4.9 months of inventory at the current rate of sales. The median sales price remained around $212,100, slightly higher than the rising 12-month average of $205,067. The picture in existing homes seems to slightly better than in new homes.
  • According to the Institute for Supply Management (ISM), economic activity in the manufacturing sector expanded in August for the third straight month as the index increased to 55.7, the highest reading of the year. In addition, the ISM index of non-manufacturing activity was 58.6, which marked growth in the service sector for 44 consecutive months.
  • The Conference Board reported that it's index of Leading Economic Indicators increased 0.7% in August, following an 0.5% increase in July. Says Ataman Ozyildirim, economist at The Conference Board: "After a brief pause, the U.S. LEI rose sharply in July and August, resuming its upward trend. If the LEIís six-month growth rate, which has nearly doubled, continues in the coming months, economic growth should gradually strengthen through the end of the year." Says Ken Goldstein, economist at The Conference Board, tempered that optimism by saying: "One unknown is how resilient confidence will remain, both consumer and business, given the mixed signals from the housing and labor markets. Perhaps the bigger question is a satisfactory resolution to federal budget squabbles."
  • According to the Bureau of Economic Analysis, the "second" estimate of GDP growth for Q2 2013 was an improved 2.5%, up from the first estimate of 1.7%. Both figures are an improvement over the meager 1.1% growth (revised downward) generated in Q1 and the anemic 0.4% growth in Q4 2012. For comparison, growth was 3.1% in Q3, 1.3% in Q2 and 2.0% in Q1. These tepid numbers were part of the reason the Fed decided not to taper at their September meeting.
  • The Federal Reserve reported that in July the amount of total outstanding consumer credit grew at a 4.5% annualized rate, to around $2.85 trillion. This is the highest number I've noted since I first started reporting this statistic in 2007. What's troubling is that this increase in consumer credit is barely registering in the retail sector. So where is the money going?
  • The Conference Board's Consumer Confidence Index rose to 81.5 in August after a dip in July. Says Lynn Franco, Director of The Conference Board Consumer Research Center "Consumer Confidence increased slightly in August, a result of improving short-term expectations. Consumers were moderately more upbeat about business, job and earning prospects. In fact, income expectations, which had declined sharply earlier this year with the payroll tax hike, have rebounded to their highest level in two and a half years." A surging stock market in September will likely result in improved confidence next month.
  • According to the FDIC, four banks failed in August, leaving the total for the year at 20, versus 40 through the same period last year. My target of 25 bank closings for the year looks like it might be a little too low, but we'll see.

Trends To Watch

The dollar index has fallen steeply over the past two and a half months. Indeed, after once again failing to pierce resistance at 85 in July, it has fallen close to support at 79. The weakness in the dollar has fueled price increases in base metals, and other commodities like petroleum. While the dollar could weaken a bit more thanks to the continuation of QE, it's unlikely to fall much further. In fact, it's likely the greenback is ripe for a rebound before the end of the year. 

Gold looks like it may again test the floor set this summer. Prices are dropping as the economy shows no evidence of inflation and investors prefer to move into riskier assets. Even the weaker dollar isn't helping to add luster to the yellow metal. Frankly, it does appear that the decade long bull market may finally be over. 

The price of West Texas crude continues to hold steady within the upper end of its trading range. Resistance at $110 looks very solid. The current price is flirting with the 50-day moving average and RSI has moved into the mildly oversold range. I said last month that "I think the index could hold between $100 and $110 for a while before making a move in one direction or the other." So far, so good, but seasonal factors, whereby prices ease heading into winter, could send prices lower in the next few months. 

The bull market in the financial sector continues as the ETF climbs steadily higher. Note how the price remains above both moving averages and refuses to drop below the rising trendline (in blue). There's not much more to say other than buy on weakness. 

The housing sector is simply a puzzle. Rising interest rates are clearly hurting the sector, although rates remain historically low. The index fell over 20% in just three months and formed a "death cross" (where the 200-day moving average moves higher than the 50-day average), which is very bearish. Yet support held around 165 and the index subsequently bounced quickly higher, gaining 16% in the first three weeks of the month. So where is housing headed? If rates stabilize and the Fed holds off on tapering, I think the sector moves higher. 

The index for the developed international markets moved through resistance around 63.5 and reached another new high last week. While the current price is well above both moving averages, RSI has reached an overbought level. This could lead to a bit of profit taking. Still, this is a very bullish chart. 

The Chinese stock market is teasing us again. Is this a real recovery or another head fake? The Shanghai index gained a stellar 22% in only two and a half months before backing off a bit last week. Will the interim resistance (green dotted line) hold, or will the rally peter out and lead the index back toward support? It's bullish that the 50-day moving average has turned up and the 200-day average has flattened out after a long decline. A stronger China would be a boon for the world's economy. 

The NYSE Bullish sentiment index is in solidly bullish territory right now. It's been ten months and counting since the index last fell below 60. I'm very comfortable with sentiment in the mid-70s. Should it approach 80, or should RSI move into overbought territory, watch for a correction. 

Right now about 75% of stocks traded on the New York Stock Exchange are currently trading above their 50-day moving average. While this is the higher end of the trading range, it is not dangerously so. Like the bullish sentiment, I'm comfortable with this area. 

Finally, the VIX, or the "fear index", has recently moved out of "normal" zone and back into "complacent"  territory. This is a bit worrisome as it suggests investors are too comfortable in the current economic and political situation. This could portend some upcoming trouble. 

What I'm Thinking and Doing

In a surprise move, Chairman Ben Bernanke last week announced that the Federal Reserve would not yet begin to taper the $85 billion bond buying program initiated to stimulate the economy. Bernanke stated that there were still too many weak spots in the economy, like employment and housing, and that the QE program would continue until specific targets are met. As a result, bond yields dropped, the dollar sunk, gold prices shot up (briefly) and equity prices jumped. Party on Garth! While I enjoy a rising market as much as the next investor I do worry about what happens when the Fed finally decides, as it must, to remove the punch bowl. It will be a delicate balancing act to gradually cease those bond purchases without cratering both the bond and equity markets, and by extension, the entire economy. I think Bernanke is counting the days until his retirement. Janet Yellin must be wondering if she really wants the job.

I've already written countless pages in my newsletter, blog and twitter feed, ranting about the gutless and selfish sycophants that pretend to be leaders Congress. I don't want to bore you with the same withering criticisms, many of which I'm sure you share. Suffice it to say that these morons are once again holding Americans hostage as their inability to put aside partisan politics in order to draft a federal budget leaves us a scant seven days shy of a partial government shutdown. I can make an argument that, in certain circumstances, it wouldn't be a bad thing for the government to close for a while. But in this case, it would be a very bad thing for all concerned. I still believe that a deal will be struck before October 1 as all Congressmen are concerned first and foremost with their own re-election and to be blamed for shutting down the government won't help any of them at the ballot box. Still, until the President signs some type of accord, whether it be a full budget, or more likely a short-term fix, the market is likely to trade sideways, waiting to see what happens. 

So where does all of this leave the market? Last month I wrote that "my instincts tell me that this downturn is temporary and that by the end of the year, the market will be higher than it is today." I stand by that prediction. I think if we can get through this latest budget impasse, the market will move higher through the rest of the year as more money leaves cash and the fixed income sector and moves into equities. There are still too many people who haven't participated in this rally as they've been sitting on the sidelines waiting for a correction that hasn't come.

Many homeowners use the transition from Summer to Autumn to prune their trees and shrubs and fertilize their lawn for the upcoming Winter. Similarly, investors must periodically prune their portfolios to reduce deadwood and clear room for future growth. While this isn't an easy process, as it can be very hard to admit your mistakes and take some losses, it must be done, and it can actually be very liberating. I have spent the better part of 2013 doing just that. I've eliminated close to three dozen positions, some held for many years. Probably the most difficult thing I've done is drastically cut my precious metals holdings, a position that I had accumulated over more than a decade. Unfortunately, the prices of gold and silver, and to a far greater extent, the fortunes of the companies that mine the metals, have suffered for more than a year. So I decided to stop the bleeding because times and conditions have changed and I had to change as well. We'll see if I simply called the bottom or if I made the smart, if belated, decision. 

News and Notes

The shorter days and cool nights mean that fall has arrived and it's back to school for all of our kids. Nola is enjoying college, but still trying to adjust to more classwork and less sleep. Lily and Ezra are back in school and back in their regular grooves of babysitting and tennis lessons, respectively. As much as I love summer, it's nice to have a normal routine in the house again. It's also nice to be in that (all too short) period between air conditioners and heaters, when the windows are wide open and the house smells clean and fresh. 

Two weeks ago I worked with a wonderful photographer to take some new professional pictures. It had been more than a decade since I last posed for formal head shots and I figured it was time to update my look. You'll see a few of the pictures adorning this newsletter, my website, my blog and my twitter feed. I hope the next ten years are a bit gentler than the prior decade. 

Finally, we're getting closer to the publication of my interview in the November edition of The Suit Magazine. As soon as the article appears on their website, I'll let my readers know. I hope you enjoy it.

As always, I thank you, my readers, and remind you that this newsletter is for you. I have been writing News and Views for ten 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, or if you know someone that might benefit from my guidance, I'd be pleased to be of service. Simply give me a call or drop me an email.

Best regards,

Greg Werlinich

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