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A Bottom Looks Near

(July 26, 2004)

Dear Readers:

In my commentary last week, I promised that I will provide an interim update this week to my readers once the NYSE short interest and margin debt numbers have been updated.  I will now provide such an update, along with additional studies supporting my current bullish thesis.  As I have stated before to my readers, trading or investing in the stock market involves gauging the various probabilities and making a good or wise decision based on what you have gauged and evaluated.  There is no sure thing in the stock market.  There is also no perfect stock market analyst.  However, this market analyst is obsessed with the market, and I have personally spent over ten hours this weekend analyzing tons of historical data, coming up with the different scenarios, and evaluating each of those possible scenarios.  There are times when a stock market analyst should take a stand on what he believes in, and this is one of those times.

Bottom line: I am still bullish, and I will now show you the reasons why.

I am not going to show you the chart of the Dow Industrials vs. the Dow Transports (readers are probably getting tired of it) today - so let's first get started with a discussion about the ARMS Index (or the TRIN).   Last week, I mentioned that Don Hays of has noted in the past "that whenever the 10-day ARMS Index reached a level of 1.50, a bottom is usually close at hand - with most of them coming within the next ten trading days.  Exceptions have been few - recent exceptions were the declines immediately after the events of September 11th and the stock market decline during March to July 2002.  Friday is the seventh day since the 10-day ARMS Index closed at a level above 1.50."   Since last week, I have looked closely at nearly a decade worth of data and I could say that I concur - even during the various times (again, except for the week immediately after the events of September 11th and the March to July 2002 decline) during the 2000 to 2002 bear market, the 10-day ARMS Index has topped a level of 1.50, the market has usually touched bottom - and all within the next 12 trading days (as opposed to ten that Hays mentions).  Friday just happened to be the 12th day since the 10-day ARMS index surpassed a level of 1.50?  Coincidence?  We will see.

In this commentary, I will attempt to take the analysis further - by incorporating a 21 DMA of the ARMS Index as well (the 21-day ARMS Index).  Following is a chart with the 10-day and 21-day ARMS Index vs. the DJIA:

10-day and 21-day ARMS Index vs. the daily closes of DJIA

Please note that the 10-day ARMS reached a super high level of 1.74 on July 15th.  It has since reversed, even as the 21-day ARMS reached a high of 1.48 last Friday.  The 10-day ARMS crossing below the 21-day ARMS is a buy signal, although the signal may some time be early.  The 21-day ARMS Index, however, is a longer-term indicator, and a reversal of the 21-day ARMS Index (combined with the fact that the 10-day ARMS index has decisively crossed below the 21-day ARMS Index) is most probably a legitimate buy signal.  Readers should keep in mind that an ARMS reading of less than 1.3 tomorrow (even a flat to slightly down market will do) would result in a potential reversal of the 21-day ARMS index.  This signal is all the more authoritative given the already historically super high reading of 1.48.

Frequent readers of this site know that I have been making numerous comparisons of the current secular bear market with the 1966 to 1974 secular bear market.  The reason is this: Prior to the current secular bear market, the only other secular bear market which has a high chance of resembling today's secular bear market is the 1966 to 1974 bear market.  In the pre-WWII period, the government and the Federal Reserve did not try to meddle too much with the economy.  Today, they do, and they also did during the 1966 to 1974 period.  I will follow up with historical charts of the 21-day ARMS Index during the cyclical bull markets (approximately the 1967 to 1968 and the 1971 to 1972 periods) of the 1966 to 1974 secular bear market but for now, let's look at something else.  Over the weekend, various analysts pointed to the fact that the 50-day moving average (50 DMA) of the DJIA has crossed below the 200-day moving average (200 DMA) (known as a "Golden Cross" in Japanese Candlesticks technical analysis) and how the implications should be and/or are bearish.  I am not oblivious to this - in fact, I have been watching this.  Moreover, I was the only analyst I know of that informed his readers of such a bearish crossing in the semiconductors group, as represented by the Philadelphia Semiconductor Index (or the SOXX).  Since that commentary on May 10th, the SOXX has fallen by more than 10%.

I am not going to post a recent chart of the DJIA but I will post the charts of the 1967 to 1968 and the 1971 to 1972 cyclical bull markets with the 50 DMA and the 200 DMA superimposed on them:

In the instance of a bearish golden cross (50 DMA crossing below the 200 DMA) during the 1967 to 1968 cyclical bull market, the DJIA had a weak rally before subsequently bottoming at approx. 6.5% below its cross over point. It then subsequently went for a retest of its all-time high before the secular bear took over again.

In the instance of a bearish golden cross (50 DMA crossing below the 200 DMA) during the 1970 to 1972 cyclical bull market, the DJIA again had a weak rally before subsequently bottoming at approx. 11.5% below its cross over point. It then subsequently broke its all-time high (which was unconfirmed by the Dow Transports) before the secular bear took over again.

Please note that in both instances, the crossing of the 50 DMA below the 200 DMA did not mean the end of the cyclical bull markets - cyclical bull markets that were within the huge 1966 to 1974 bear market.  In fact, in both instances, there was a subsequent rally (which gave a chance for bulls to get out) before the market suffered a 6.5% and 11.5% (from the cross over point) correction, respectively.  In both cases, the cyclical bull market did not ultimately top out until months later.  I am currently not even looking for a correction in the magnitude of 6.5%, for the following reasons:

1) There are just too many people today talking about this bearish "golden cross."  There were never this many people talking about the bearish crossings prior to the August to September 2001 and the May to July 2002 declines.  Like I said, I also did not find anyone talking about this bearish crossing ten weeks ago in the SOXX index.  Back then, the bearish crossing was an ominous sign precisely because of this reason.  Now, I am not so sure.

2) It does not take much for the 50 DMA to cross back above the 200 DMA in the DJIA.  If the DJIA goes up 200 points by week's end and maintains that level for a few trading days, then the 50 DMA would have crossed back above the 200 DMA - fully negating this bearish signal.  This is something that bears should consider given the oversold readings we currently have as well as the bullish liquidity indicators which I will mention in a short while.

3) The average of the most serious corrections during the 1967 to 1968, the 1971 to 1972, and the 1975 to 1976 cyclical bull markets was approximately 12% from the most recent 52-week high.  The most recent 52-week closing high is 10,737.70 (reached on February 11, 2004) and a 12% correction from that level would result in a DJIA reading of 9,450.  Please also note that the 50% retracement level (taking a page from E. George Schafer's 50% Principle) from the all-time closing high of 11,723 (reached on January 14, 2000) and the most recent closing low of 7,286 (reached on October 9, 2002) is approximately 9,500 - which should also be a good support level.  The author's conclusion from this study is that any further correction here should bottom at around the 9,450 and 9,500 level, which would represent a correction of a further 5% from here, at the most.

4) During the declines of the two cyclical bull markets which I just mentioned above, oversold readings did not get anywhere close to those of today, per the 21-day ARMS Index.  Following are charts of the DJIA vs. the 21-day ARMS Index during those periods:

The highest reading of the 21-day ARMS during the 1967 to 1968 cyclical bull market was only 1.09

The highest reading of the 21-day ARMS during the 1971 to 1972 cyclical bull market was only 1.23

Please note during the declines of the 1967 to 1968 and the 1971 to 1972 cyclical bull markets, the highest reading of the 21-day ARMS Index was only 1.09 and 1.23, respectively.  Again, as of Friday, the 21-day ARMS Index is already at a super level of 1.48.  Given the huge downside momentum from Friday, another 5% downside in the DJIA is possible but even then, the author would not put too much money on it - especially given the currently bullish liquidity indicators.

The July 9th short interest for the NYSE was just released on Friday.  Short interest on the NYSE declined slightly, while the short interest ratio of the DJIA components (using June data for MSFT and INTC since Nasdaq data has not been released yet) also only declined slightly - from an average of 3.19 in June to 3.05 in July.  This is bullish.

The first piece of the liquidity puzzle was good; we now turn to the second piece.  NYSE margin debt data for June 2004 was also released on Friday.  Let's take a look at the following chart constructed by the author.

Cash in All Accounts to Wilshire 5000 Ratio highest since March 2003

Total credit in cash and margin accounts increased more than $4 billion during June - a very bullish sign.  The author then attempted to project the numbers to what they are estimated to be today - the closing level on Friday was used for the Wilshire 5000 while the month-end cash and margin debt data was estimated given the recent performance of the stock market.  The author believes that margin debt may have dropped slightly (about a billion dollars) while the amount of free credit should at least experience the same increase as in June - that is, about $4 billion or so.  If that is indeed true (and there is a high probably then it is, or even better), then the total cash to Wilshire 5000 ratio should be the most bullish since the end of March 2003, while the cash in margin accounts and cash in all accounts to margin debt ratios should be at their most bullish since the end of April 2003.

The final piece in the liquidity puzzle involves the study of insider selling and initial and secondary offerings.  Let's first turn to the amount of insider offerings, as measured by the ratio of insider selling to insider buying.  The source of my data is Thomson Financial:

The dollar amount of insider selling ($2.3 billion) during July (so far) is the least amount of insider selling since the rally began in March last year.

Please note that except for April and May 2004, the insider sell-to-buy ratio for July so far is at a level of 9.4 - the lowest level experienced since March 2003.  More importantly, the absolute amount of insider selling only totals $2.3 billion so far - significantly less than the April and May periods when insiders sold $5.9 billion and $5.1 billion worth of equities, respectively (not shown on chart).  Since companies are announcing earnings and thus are collectively in a "quiet period," the amount of insider selling should remain very low for the next few weeks.  Trimtabs also noted that the number and amount of IPOs and secondary offerings during the upcoming week will be one of the quietest on record, further boosting the already bullish liquidity indicators (where they will stay during August as well).  Finally, from a supply and demand standpoint, the recent dividend and buyback announcement by Microsoft is really (excuse the cliché) icing on the cake.

As I noted in the final paragraph from my commentary last week:  "Finally, in his July 14th daily commentary, the Dow Theorist Richard Russell pointed out to an interesting study posted by one of his subscribers.  In that study, the subscriber pointed out to a study that was done by Richard Russell in September 1972, when he noted that the 1972 YTD intra-year volatility for the DJIA was only a mere 8% -- which is the same as today's YTD intra-year volatility for the DJIA as well.  Readers may know that the 1973 to 1974 bear market was the worst bear market since the 1937 to 1938 bear market, when the DJIA declined by approximately 45% in two years.  Russell notes that this very narrow intra-year volatility suggests either accumulation or distribution and he is betting for the latter -- which would mean that a vicious bear market decline may be close at hand.  What Russell did not mention, however, was the fact that the DJIA proceeded to make a temporary bottom in mid-October before it proceeded to blow off over 12% to an all-time high of 1,036 before the vicious 1973 to 1973 bear market set in."  Since my commentary last week, I have noted that two prominent analysts have cited the work of this study, with both of them failing to mention the subsequent hugely bullish action.  If we are to have a huge bear market vicious decline starting in 2005, then by definition, we should have a final rally that would kill the bears or entice the last bear to get in.  That is what happened in the final three months of the 1971 to 1972 cyclical bull market (with the final top on January 11, 1973), and it has always happened in every cyclical bull market.  The speculation and "euphoria" (if you can call it that) never reached a level that was high enough to be considered a stock market top (and there are of course tons of other great reasons which I have already previously mentioned which do not indicate a stock market top).  The top is yet to come, and I believe bulls will be greatly rewarded if they choose to stay in or buy now - assuming they get out in time before the vicious bear market comes.  The liquidity and psychological indicators (along with this article) which I have mentioned support a potential, sustainable rally in the upcoming months - definitely to a DJIA level of over 11,000 and possibly even surpassing the old all-time high of 11,723.

Signing off,

Henry K. To, CFA

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