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Indecisive But Still Bullish

(May 24, 2004)

Dear Readers:

In studying the stock market, broad economic trends, and writing these commentaries, I have always kept this quote from Sir Winston Churchill firmly in my mind:

"The farther backward you can look, the farther forward you are likely to see."

Not only does studying history allow me to avoid the mistakes of the past, it also prepares me for change - change in economic trends, stock market trends, and demographic trends.  I attended a lecture given by Jim Rogers late last year, and I remember being most impressed about his knowledge of history and the application of what he had learned to the markets today.  In this particular instance, he talked about the current high boy-to-girl ratio in Southeast Asia, and how it may affect economic trends in the next ten years.  He stated that this same scenario happened in Western Europe approximately a thousand years ago - the result being that women held a historically high number of positions of power soon thereafter.  He predicted that the same scenario will unfold in Southeast Asia in the next ten years.  My personal belief is that people and whole societies who continue to hold on to their chauvinistic views in the near future will be left behind - both socially and economically.  Frankly, nothing will surprise me anymore.

Anyway, onto the markets.  Ask anyone who have followed the markets recently and he or she will probably express his/her frustrations at the recent inactivity of the markets.  Forgive the cliché but watching the action of the stock market over the last few days has been similar to watching paint dry.  The market is still stuck in a narrow trading range and has not been able to break out convincingly in either direction.

Prior to the action of the last few trading days, the market has been oversold for days, as exemplified by indicators such as the McClellan Oscillator, stochastics, and the high number of new lows on the NYSE.  My current guess is that the market should break out to the upside within the next couple of weeks, although a lower low in the next few trading days is probably not out of the question.  That being said, the author believes there is strong support at the level of 9,500 on the Dow Jones Industrials (which represents the 50% retracement level from its all-time high in January 2000 and its recent low in October 2002) - any decline from hereon should be halted at that level.  (I will address the Lowry's Intermediate Sell Signal which I outlined in our last commentary at the end of this commentary.)

So why the bullish stance?  I will soon tell you, but please remember that in the stock market, there is no perfect scenario.  There is also no perfect indicator.  Moreover, some of these indicators are not scientific at all, and interpreting these indicators actually requires a bit of art, so to speak.  From a classic Dow Theory point of view, one bullish indicator that has stuck in my mind for the last few weeks has been the persistent refusal of the Dow Jones Transports to confirm the Dow Jones Industrials on the downside - despite crude prices making nominal all-time highs.  My guess is that if the market is to rally from here, traders would cite this indicator and state: "It was so obvious!"  Unfortunately, things are obvious only in hindsight:


Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to May 21, 2004)

In the author's humble opinion, the persistent refusal of the Dow Jones Transports to confirm on the downside (again, despite $40 crude prices) should not be taken lightly.  Readers should remember that a great number of the biggest rallies and declines in the history of the U.S. stock market has been preceded by a downside or an upside non-confirmation in one of these indices.

As I have also mentioned before, the McClellan Oscillator for the NYSE Composite has been below the zero line since early April but has now turned positive after being oversold for weeks.  More significantly, the Summation Index looks to be in the process of turning up.  My guess is that the Summation Index will not hit any significant resistance until it is close to the zero line.


NYSE Composite Index

The action of the McClellan Oscillator for the NASDAQ is similar:

Now, I don't consider the Put/Call ratio to be a primary indicator but it is interesting to note that no significant bottom in the last two years has not been accompanied by a very high put/call ratio number (calculated by using a 21-day simple moving average of the equity put/call ratio).  The current ratio of 0.766 is a very high number, comparable to the put/call ratios seen during July 2002 and March 2003.  Therefore, I would characterize the put/call ratio indicator as bullish.


Average put/call ratio since 01/02/01

All in all, the technicals (or at least the technicals that I look at) so far look to be on the bullish side, although volume on both the NYSE and on the NASDAQ has been very low.  Like I have said before, there is no perfect scenario when it comes to the stock market.  We will just have to take what the market throws at us.  Anyway, so much for the technicals.  Let's discuss other indicators that may be closer to home for some of our readers.  One persistent topic that never goes out of fashion is the issue of insider selling.  Insider selling or buying data is updated at the end of every week (one of the few things that are constantly updated) - the chart below shows the insider sell-to-buy ratio vs. the S&P 500 as of May 22, 2004.


Insider Sell-to-Buy Ratio vs. Month-End Close of S&P 500 (December 2002 to May 2004)

As one can see, insider selling has been abating since February to March earlier this year.  Decreasing insider selling and increasing insider buying during a stock market decline is usually a bullish sign.  Unless insider selling increases dramatically this upcoming week, insider selling should even be lower than what it was back in May of last year.  What makes it doubly bullish is the fact that May is the month after the reporting of earnings - when insider selling should normally be the most intense (insiders are prohibited to sell any stocks immediately leading into or right after the reporting of earnings - and thus they usually sell a lot of equity holdings once this prohibition period is over). 

How about some more liquidity analysis?  I have discussed this over and over again but margin debt data was just released a few days ago and I really cannot resist.  Long-time readers of our commentaries should be familiar with the chart below:


Wilshire 5000 vs. Margin Debt (January 1997 to April 2004)

Margin debt numbers for the NASD have not been released yet so I have chosen to use the March data point for April.  Since the NYSE numbers did not change significantly during April, I do not anticipate the NASD numbers to be significantly different either.  Moreover, since the NASD amount make up less than 6% of the total margin debt amount, I believe using last month's margin debt data point for the NASD is a very logical thing to do.

Please note that despite the declines of the stock market in mid March and late April, the total margin debt amounts have continue to hold up.  There has been no forced liquidation thus far.  The professional speculators are still bullish.  If we are to follow the experience of the 1966 to 1974 bear market rallies (which I still believe we will), then margin debt will not decline significantly until there is a definite top in the stock market.  Also, free credit balances in cash and margin accounts have continued to build up, suggesting that there is more "fuel" to sustain a stock market rally.  Therefore, by my interpretation, the margin debt indicator is still suggesting that we are in a cyclical bull market.

Now, I have not discussed the following since November of last year (and neither has anyone else, really) but the money supply (as defined by M-3) has turned back up after being flat for the second half of last year:


Weekly M-3 vs. Dow Jones Industrials (January 1, 1999 to May 10, 2004)

Please note the circled areas above.  These areas coincided with periods during the last five years when the growth of M-3 was either flat or negative.  Please also note the action of the DJIA coinciding or immediately following these areas - they were not pretty, indeed.  The questions to ask are: Are we currently suffering from the effects of flat M-3 growth during the second half of last year?  If so, are we at a bottom here and if not, how much further of a decline will we see?  I have mentioned previously that a DJIA of 9,500 is a very strong support level, but this is merely a guess (although I do consider it as a "good guess") on my part.  Although I do not have answers to these questions, I do know that the growth in M-3 has been accelerating since January, and this "should" translate into a higher stock market (all else being equal) within the next few months.

Now, I want to address the issue of the Lowry's Intermediate Sell Signal that I discussed a couple of weeks ago.  Not every indicator is created equal, and not every intermediate sell signal generated by Lowry's should be treated equally either.  The signal that was triggered on May 10 has historically experienced a significant number of whipsaws, since it is usually triggered late in the game - when the Lowry's Selling Pressure indicator crosses over the Lowry's Buying Power indicator.  Such a signal is generated only when the market is inherently oversold.  These sell signals are usually only useful during the end of a secular or cyclical bull market and I do not think we are near the end of the current cyclical bull market yet.  For example, during the 1966 yo 1974 bear market, seven such Intermediate Sell Signals were triggered.  The first one was triggered on March 14, 1966 - at the end of the great 1949 to 1966 bull market (when the DJIA has already declined to 917, down approximately 8% from its all-time high of 995).  From this level to the bottom before the next buy signal was triggered, the DJIA declined another 5.8%, a relatively small decline in the grand scheme of things.  The next two such Intermediate Sell Signals were triggered on November 1, 1967 and February 24, 1969.  From the trigger date until the bottom before the next buy signal, the DJIA declined 2% and 0.5%, respectively (and it only took seven days, and one day, respectively, to reach those bottoms).  Obviously, that cyclical bull market within the 1966 to 1974 secular bear market was not about to die yet, and neither do I think the current cyclical bull market will die now.  The next signal triggered on November 20, 1969, however, was a legitimate signal, as the DJIA declined 10.5% from the trigger date to the bottom before the next buy signal.  The experience of the final three signals was similar, as the first two were false signals (4.2% and 2.5% declines, respectively).  The second cyclical bull market within the 1966 to 1974 secular bear market did not end until the final signal was triggered on January 16, 1973, with the DJIA at 1,004.  The DJIA proceeded to decline over 11% within the next few months.

To conclude this commentary, I believe the current bullish indicators outnumber the bearish indicators - thus, I am now leaning towards the bullish side.  While the latest Lowry's Intermediate Sell Signal has to be respected, history has shown that this current signal is most likely a whipsaw.  We may get a few more days of downside volatility in the next week or so, but the author believes that the line of least resistance is probably up, with the worst case scenario being a trading range over the next several months.

Signing off,

Henry K. To, CFA

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