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Trend Still Up?

(October 19, 2003)

The major broad market indices all made new highs for the week, including the Dow Industrials, Transports, Nasdaq, S&P 500, the S&P 400 mid caps, and the S&P 600 small caps. That being said, the current market is overbought and looks tired - as evident by the Intel reversal and the weak market on Friday. Moreover, earnings look only okay so far at best. Insider selling is restricted until two weeks after earnings, but it is currently picking up. The insider sell-to-buy ratio was only 12 at the end of last week. Today, it is at 32.50.

One thing that people have not been talking about but which may have broad implications is the domestic money supply. Back in the 1960s and 1970s, it was something that many people paid attention to today it is greatly ignored by all which is fine with me, since once an indicator becomes popular, it usually ceases to work (with the low VIX being the latest case). Below is a quick analysis which I have put together by summarizing the M3 and the subsequent Dow action since January 1, 1999:

Weekly M3 vs. Dow Industrials (January 1, 1999 to October 6, 2003)

The five semicircles on the above chart highlights the periods during the last four years when M3 growth was flat. Please note the action of the Dow Industrials following or during each of those periods in the first four instances - DOWN. Please also note M3 growth in the last four to five weeks. The latest week ending October 6, 2003 was a shocker - a negative growth of M3 of $39 billion! Need we say more?

We spoke about the VIX in the previous paragraph. Note that the VIX has been a very reliable predictor of stock market declines for the last few years, as evident by the second chart shown on our "Investment Strategy". During the last few months, however, the "low VIX" had been cited so many times by the popular financial media that it had ceased to work as a reliable indicator. That being said, once the decline failed to materialize, the financial media stopped talking about it. Therefore, after ignoring the VIX for the last few weeks, we believe the VIX should now be closely watched and that the current low reading of 17.62 (19.19 on the VXO - which is the old VIX) should be respected.

Three weeks ago, we discussed the implications of a rise in yields in 30-year Treasuries. Despite the rise in yields during the past two weeks, this huge downtrend still remains in place. In fact, yields may have peaked in the very short-term as suggested by the following candlestick chart:

30-year Treasuries

The action of last Friday may have been a short-term trend reversal of the yield in the 30-year Treasuries. I would closely watch the action of 30-year Treasuries during the early part of this week. If yields manage to pierce Thursday's lows any time this week, then the probability of a short-term trend reversal of the 30-year Treasury yield would be greatly increased. That being said, I am not the only person out there that claims there is an artificial market in U.S. Treasuries (please read the latest Barron's interview with Rudolph-Riad Younes, manager of the Julius Baer International Equity Fund whose 10-year performance puts him ahead of 91% of all U.S. mutual fund managers).

Conclusion

While breadth and volume remains bullish, the secondary trend is most probably in the midst of turning bearish, as evident by the negative growth in M3, the low VIX, and the McClellan Oscillator turning negative (coupled with an overbought and "tired-looking" market). Insider selling should also pick up once earnings season is over. This is a good time for my readers to start selling their weakest holdings, and re-investing those cash in the market once the "all clear" signal is given or if the market becomes oversold again. A breaching of the 9,500 level on the DJIA (on a closing basis) would most probably lead to a more serious correction ahead.

Gold

Readers interested in the yellow metal may be interested in this article from the Economist:

http://www.economist.com/agenda/displaystory.cfm?story_id=2135349

It is interesting to note that gold has been the purest form of money for the last five thousand years of human history - with the latest boom in the precious metal ending only a mere 23 years ago. Meanwhile, experiments in paper currency which sprouted up in the last 700 years have all ended up in major failure (special examples include the Ming Dynasty in China and John Law's infamous experiment in paper money in France in the 1720s). The author believes the latest experiment in paper currency all over the world would also collapse in time, but when? Only God knows.

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