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How Hot is Hot?

(December 19, 2003)

My partner will be on vacation in Toronto starting this weekend, and since he's the technical guy that handles everything from developing economic models to web mastering, we would not be updating our website until he comes back - sometime the first week of January.  Today I will write an abbreviated commentary, since everyone is in vacation mode and there have been no surprises in the market during the last two weeks.

How hot is hot?  This question was first asked by Robert Rhea, the famous Dow Theorist who traded the markets back in the first 30 years or so of the 20th century.  He avoided the crash of 1929, and bought the market within a few days of the 1932 bottom.  This question was first asked by him in regards to the bull market of the 1920s - towards the end of 1928, it was obvious that the speculation in the stock market was reaching an euphoric stage, and that a top and the subsequent crash was pretty close by.  Valuations were outrageous and public participation was rampant.  But just how hot is hot?  How can we determine when we should exit?  Or even short?  Alan Greenspan stated as early as 1994 that there was a bubble in the stock market, and only when he got tired of calling it a bubble, did the bubble finally burst.  Bernard Baruch and Joseph Kennedy exited the markets in late 1928 or the summer of 1929, and Jesse Livermore already started planting short positions in the same summer (Livermore noted that breadth was getting worse even as the stock market was making new highs and shorted the weak industries and maintained long positions in the strong industries).

Bears have been so used to the "straight line" decline from 2000 to late 2002 that they now have a trouble in seeing just how far this rally can go.  Sure, valuations are still ridiculous and the employment situation has not been getting significantly better.  But we have had a vicious non-stop bear market for three straight years - why can't we give the bulls a break for a while?

I know of several people who actually capitulated and sold all their mutual funds and stocks in the July and October 2002 bottoms - something that I really have not witnessed in past declines during the last few years.  It is now obvious that we have had a pretty big swing and there are still no signs of a top.  Optimism is building, however, but the obvious question is: how hot is hot?  Bill Miller quoted Sir John Templeton last week, stating: "Bull markets are born on pessimism, they grow on skepticism, mature on optimism, and die on euphoria."  (Never mind that Bill Miller misquoted Templeton - Templeton is a big-picture guy and does not even come close to thinking that this secular bear market is over.  What Bill Miller is talking about is probably just a bull swing within the secular bear market we are currently in.)  He stated that we are still in the skepticism stage, and I think he may have a point.

Optimism is building, however.  The IPOs and secondary offerings are all coming back, and equity inflows continue to roar into the market.  CTRP had a double the first day (on an intraday basis), something which we have not seen in an IPO since November 2000.  Margin debt during October on the NYSE had its first significant increase for the longest time.  The VIX is at a very low level of 16 (very low relative to the post 1998 period).  But all around me, I still see traces of skepticism in the latest rise of the stock market, and if you tell them that the market may probably go back to 8,000, they are still not calling you an idiot -- yet.

Sentiment-wise, I still do not see signs of a top, and neither do I see it in the breadth figures, even though the NASDAQ may be somewhat lagging here.  (Volume was actually okay yesterday and breadth was impressive, by the way, with the A/D line on the NYSE making a new high.)

The big news yesterday was the yield of the long bond declining below 5% yet again - the housing boom continues to march on.  Any fears of an adverse impact on the stock market caused by higher interest rates have also been alleviated.  But consider this:

Monthly Chart of the Commodity Research Bureau Index vs. the 30-Year Treasury Yeild(January 1956 to August 2003)

This is a chart that I posted a couple of months ago comparing the CRB index to the yield of the 30-year Treasuries.  At the time, I stated that if the 30-year Treasury yield moves above 6%, then the downtrend is probably over.  Since the yield declined below 5% yesterday, we are still safe for now - but note the relationship between the CRB index and the yield of the 30-year Treasuries (please see the September 28, 2003 commentary).  Something has to give here.  Either the CRB index will have to break down or yields will have to move up.  That being said, the CRB index may actually have a breakout failure here - any failure to break out above 260 in the next couple of months may actually have some pretty bearish consequences on the index.  Conversely, if the CRB index can break out above 260 and convincingly stay above 260 for the next couple of months, then yields would most probably move back up.

More cautious investors should also consider this:

Since March, hedge funds have piled in about $200 billion into the market -- with some of them now fully long or even leveraged on the long side.

Since March, pension funds have put in about $100 billion -- with most not planning to make any significant contributions next year.  The ones with a 1/1 plan year (most of them have a 1/1 plan year) would make regular quarterly contributions if they are not highly funded, and their first contribution would be 1/15 and then nothing afterwards until 4/15.

Since March, individuals have piled in about $130 billion into mutual funds, with an unknowable amount into stocks.  At the same time margin debt has gone up about $27 billion on the NYSE (and even more on the NASD) from March to the end of October.

IPOs and secondary offerings should be more prevalent next year with insider selling continuing its current brisk pace.  From then on, the individuals may be the sole supporters of the stock market - unless insider buying comes back or if foreigners start buying our stocks again.  Ultimately, this may depend on the performance of US$ going forward.

Should I Short?

Shorting is an inherently difficult business.  When a short-seller tries to make some money on the short side in the general market, he or she usually will need very good reasons for it.  Do I see a good reason right now?  Probably not.  I don't think I can say with confidence this move is nearly over until I have seen more speculation or euphoria in this market.  I believe this up trend will only die in exhaustion.  So just how hot is hot?  I believe once the last person gets on the bus (the ones who got out of the market in July 2002 or October 2002) then there will be no one left to support the market.  A lot of this evidence will probably be anecdotal.  Let me know if you know anyone who got out at that time last year and watch him or her like a hawk.  Once that person buys stocks again, then we will start shorting them all.

Or in the words of 'Sell'em' Ben Smith: "Sell'em all!  They are all going to zero!" (spoken in the days of the 1929 crash).

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