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Bull Rally Confirmed

(August 1, 2004)

Dear Readers:

In my Wednesday's interim update, I stated: "I want to begin my commentary by reaffirming what I said on Sunday evening.  I am now bullish - not only because the market is oversold and not only because the cyclical bull market is not over yet, but because liquidity indicators are bullish as well.  Buybacks are increasing, and insider selling has and will be muted for the next weeks.  We are seeing more evidence of this everyday."

The action of the stock market over the last two trading days has again reaffirmed my bullishness.  Readers should note that my bullish call last Sunday was a very difficult call to make.  Deep down in my heart, I knew my bullish call had a high probability of being correct, but it was a (mostly psychological) difficult call anyway.  On the other hand, it is interesting to note that there are no easy, correct calls in the stock market.  All great decisions in history were difficult decisions at the time of their making - if the great calls were easy, then everyone on this Earth would be rich in no time.  I am not stating that my call was a great call (in fact, I can still be wrong).  I am only stating this in order to illustrate my point.

The purpose of this commentary is to reaffirm of my bullishness and to further illustrate my own reasons as to why we are still in a cyclical bull market.

I am going to begin this commentary with what I discussed in my July 25th commentary - that of the 50 DMA crossing below the 200 DMA on the DJIA and the subsequent bearish implications cited by several renowned analysts.  In that commentary, I dispelled that notion - citing the bullish action of the DJIA during and immediately after this initial crossing in both the 1967 to 1968 and the May 1970 to 1972 cyclical bull markets.  In this commentary, I want to reaffirm my argument by presenting another scenario - that of the cyclical bull market during the 1942 to 1946 period.  The reason why I am using this period is simple: Besides the two cyclical bull markets I have already discussed, this represented the only other period (aside from the cyclical bull market of today) where there was a cyclical bull market within a secular bear market, and which was (probably more importantly) accompanied by a great deal of government intervention in both the financial markets and in the American economy.  Following is the relevant chart:

In the instance of the 50 DMA crossing below the 200 DMA during the 1942 to 1946 cyclical bull market, the DJIA bottomed on the same day (at 129.60) as the actual crossing on November 30, 1943. The DJIA did not subsequently top until two-and-a-half years later at a level of 212.5 on May 29, 1946 - before the bear took over again.

The story is the same.  This cyclical bull market did not end on the initial crossing of the 50 DMA below the 200 DMA - nor did it during the initial crossings in both the 1967 to 1968 and the May 1970 to 1972 cyclical bull markets.  In fact, if the crossing of the 50 DMA below the 200 DMA had signified the end of the cyclical bull market on November 30, 1943 - then my guess is that it would have been COLD-BLOODEDLY discounting the eventual triumph of the Nazis and the Japanese in World War II.  My conjecture and prediction: If the recent 50 DMA crossing below the 200 DMA did signify the end of the current cyclical bull market, it will be discounting a calamity not seen since probably the Great Depression and World War II.  Like the author has mentioned numerous times before, I believe this is a very low probability event - an event which even the bears would not want to happen.  Moreover, even if the DJIA remains unchanged in tomorrow's trading, the 50 DMA would have crossed back above the 200 DMA - thus fully negating this "sell signal."

Another recent and highly popular bear argument has been that the high optimism readings in the Investors' Intelligence Surveys (consistent readings of over 50% bulls since mid 2003) reflect a topping out of the cyclical bull market.  Is this necessarily true?  Since the author does not possess Investors' Intelligence Survey data dating back before 1969 (if any one of my readers know where I can get this data, please let me know) I have chosen to look at this data during the May 1970 to 1972 cyclical bull period.  Specifically, I wanted to ask the question of how optimistic were these readings back in the May 1970 to 1972 cyclical bull market and how do those readings compare to those of today?  Let's take a look at the following two charts in order to answer that question.  I am going to first present the chart from the January 2003 to July 2004 period:

Bulls-Bears % differential consistently below 40% from January 2003 to present. The amount of optimism as reflected in the Investors' Intelligence Survey today - while consistently high - is not even close to the higher readings achieved during the cyclical bull of May 1970 to 1972. Back then, bullish readings of over 60% and even 70% were not uncommon.

Today's bears can cite the consistently high bullish readings of over 50% (with two weeks being slightly over 60%) within a secular bear market as being bearish.  But dear readers, please note that the author believes that this is a cyclical bull market, and in a cyclical bull market, it is not abnormal to see consistently high readings in bullish optimism.  Before I present the Investors' Intelligence data of the May 1970 to 1972 cyclical bull market, readers may want to read the following quote.  I believe this should be of high interest to my readers:

Quote from Richard Russell's January 20, 1971 "Dow Theory Letters" newsletter: "Speculation has been turning rampant, over-the-counter markets have been extremely active, the Administration has been bombarding the press with optimistic opinions, yet the market boiler has been churning.  The market has become overvalued (see section on the stock-bond ratio), but the majority of investment advisors have nevertheless turned highly bullish (according to Investors Intelligence the ratio of bullish to bearish services is now 68% highest since this study was started in 1963)."

A bullish reading of 68% is high any way you read it, and yet the market (as represented by the DJIA) did not peak until January 11, 1973 - a two years later.  Readers should note that the highest bullish reading we have had so far in this cyclical bull market is 60.2% - registered on only two weeks -- June 20, 2003 and more recently, February 27, 2004.  The following chart illustrates my point perfectly: The "optimistic" readings we are getting in today's cyclical bull market are - in most ways - even lower than the readings during the cyclical bull market of May 1970 to 1972:

Bulls-Bears % differential consistently over 40% during May 1970 to December 1973. The amount of optimism as reflected in the Investors' Intelligence Survey were at relatively high levels (circled) during the early parts of the May 1970 to 1972 cyclical bull market - not unsimilar to the situation of today. Bottom line: A high amount of optimism does not necessarily signal the end of a cyclical bull market.

Please note that the bulls-bears % differential readings (the percentage of bulls minus the percentage of bears) were consistently higher in the May 1970 to December 1972 cyclical bull market than the readings we are seeing today!  Again, I believe that anyone citing the "highly optimistic" readings in today's Investors' Intelligence data as a signal that the current cyclical bull market is about to end is making a big mistake.

I am going to conclude my longer-term analysis by taking the Fed Funds study (that I cited last Wednesday evening) further.  Readers may remember the Fed Funds chart (from that I posted last Wednesday evening.  That chart showed the lag time between the troughs of the Fed Funds rate to the subsequent tops of the S&P 500 for the last 40 years.  At the time, I remarked that the two cyclical bull markets within the 1966 to 1974 bear market took 16 and 10 months to top (after the trough in the Fed Funds rate), respectively - and that "if we are to maintain a similar schedule today, then the current cyclical bull market (as measured by the S&P 500) will not top out until April 2005 to October 2005."  The following two charts not only show the timeframe during those two cyclical bull markets, but they also show the magnitude of the rise in the Fed Funds rate. 

The trough of the Fed Funds Rate was made in July 1967 at a rate of 3.79%. The DJIA did not peak until 16 months later. At the peak of the DJIA, the Fed Funds Rate was at 5.82% (a full 200 basis points higher). Moreover, the DJIA did not decline substantially until the Fed Funds rate hit 8.67% - a full 22 months later.

The trough of the Fed Funds Rate was made in February 1972 at a rate of 3.29%. The DJIA did not peak until 10 months later. At the peak of the DJIA, the Fed Funds Rate was at 5.33% (approximately 200 basis points higher). Moreover, the DJIA did not decline substantially until the Fed Funds rate hit 6.58% - a full 12 months later.

I believe the above two charts showing the average monthly fed funds rate vs. the DJIA further illustrate my point - that the current cyclical bull market is not over yet.  Please note that the DJIA did not subsequently peak until the Fed Funds Rate was a full 200 basis points higher than it was at the troughs of both cyclical bull markets.  Please also note that it took a rise of another 275 basis points and 125 basis points (respectively) before the DJIA finally broke and started declining in a substantial way.  Today, the Fed Funds Rate is only 25 basis points higher, and only two months has passed since the Fed Funds Rate has bottomed.  The author believes that in terms of both the timeframe and the magnitude of the rise in the Fed Funds Rate, we are still months away from a cyclical peak in the DJIA.

In the short run, things have started looking more promising after the "scare" of the last two weeks.  As of Friday at the close, a ST buy signal was triggered by Lowry's, along with an uptick in the 10-day moving average of the Nasdaq after declining for 17 consecutive trading sessions.  These "buy signals" are all the more authoritative given the hugely oversold conditions in the Nasdaq.  The Nasdaq McClellan Oscillator and Summation Index confirm these two buy signals:

The Nasdaq McClellan Oscillator turns positive after spending a month in negative territory! The Nasdaq McClellan Summation Index is in very oversold territory and is in the midst of reversing!

To conclude, the author likes both the action of the market in both the short run and the long run, although in the short-run, we are probably still not out of the woods given the stubbornness of high oil prices and terrorism concerns.  However, my liquidity indicators are still more bullish than ever - with the case for the bulls growing more authoritative once the DJIA can penetrate its 50 DMA and 200 DMA, at about 85 points higher than the close on Friday.  Meanwhile, longer-term investors should stay focused on the longer run - the weight of the evidence currently point to a continuation of the cyclical bull market, and investors should not panic until the market has given a definite sell signal - which may still be months away.

Signing off,

Henry K. To, CFA

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