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Short-Term Targets for the Market

(August 8, 2004)

Dear Readers:

I am going to keep this commentary brief - in this commentary, I will briefly discuss the action of last week, discuss its implications, and also give ST targets as to when the market may possibly bottom.  That said, let's cut to the chase and take a look at the following chart:

The Dow Transports has finally broken dwon - confirming the Dow Industrials on the downside. Support for the Industrials is immediately below - at around 9750 - but the author believes that in order to have a sustainable bottom, we will need to break that downtrend line to create some panic and capitulation.

After the ST bottom made on Monday, the market rallied for four straight days - triggering a ST buy signal per the Lowry's trading index and per the NYSE McClellan Oscillator turning positive on Friday.  Combined with my bullish liquidity indicators and the fact that I don't believe (and I still don't) the cyclical bull market was over yet, I stated that the bull rally was confirmed.  In retrospect, that turned out to be an early signal - as evident by the action of last week.  Since last week, the major indices have made new lows - with the Dow Transports (although not making a new low for the year) confirming on the downside with the Dow Industrials as well.  As I mentioned in the above chart, there is some support for the Dow Industrials immediately below - at around the 9,750 level - but I believe that if we are to have a sustainable bottom (one that will eventually break us out of this downward trading range that has been in existence for the last seven months), then we will need to see DJIA 9,750 decisively broken.  I will not give any DJIA target at this point, but based on the above chart, I believe that readers can get a hint of a potential bottom by watching the Dow Transports.  A persistent refusal of the Dow Transports to break to new lows for the year (similar to what happened in May) could mean that a bottom is close at hand.

To continue: Obviously the action of last week suggested that buyers were still not willing to step in and that it now definitely requires lower prices in the major indices in order to attract these buyers.  The acceleration of the decline and the accompanied increase in volume (volume actually was not very high - which does not suggest capitulation) still suggests we will see more downside at least in the next couple of weeks.  The author now believes that the next bottom will be a sustainable bottom, and such a bottom usually requires a few things.  I will now outline what I believe those few things are.  Let's take a look at the following chart:

The NYSE Summation Index (Ratio Adjusted) - The NYSE Summation Index will probably need to reach at least the zero line in order to have a sustainable bottom.

There is currently no support for the NYSE Composite until the NYSE McClellan Summation Index has at least reached the zero line.  Readers should keep in mind that approximately half of the NYSE issues are preferred stocks, bond funds, or REITs, and therefore, unless interest rates skyrocket, there is no reason to believe that the Summation Index may reached levels that are significantly below the zero line (like what happened during the May bottom).  The zero line is only a ST and potential target.  For now, we will note that it is there and there is a possibility that we will bottom there but let's just take it one day at a time.

Let's now turn to the use of sentiment indicators.  While extreme readings in these indicators alone are not indicative of either a corresponding top or a bottom in the stock market, it is interesting (and profitable) to note that all sustainable bottoms have been accompanied by "extreme" readings in these sentiment indicators.  We will now cover the VIX, the Investors' Intelligence Surveys, and Consumer Confidence Data (as issued by The Conference Board) in the following paragraphs.  Let's first take a look at the VIX:

The author's guess is that we will at least see a retest (the most bullish will be a false breakout) of the September 2003 and the March 2004 highs in the VIX before we can have a sustainable bottom.

Currently, the level of the VIX is not indicative of a stock market bottom.  The ultimately bullish scenario will be another upside spike sometime in the next couple of weeks that will take the VIX above the September 2003 and March 2004 highs - but which will result in a false breakout.  Such a scenario will be indicative of a quick ST panic in the stock market followed by a corresponding quick reversal.

The next chart is the data from the Investors' Intelligence Survey that is conducted at the end of the week each week:

It looks like the Bulls-Bears % Differential in the Investors' Intelligence Survey will have to at least test (or break) its march lows in order for us to have a sustainable bottom in the market.

The Bulls-Bears% differential reading (the percentage of bulls minus the percentage of bears) in the Investors' Intelligence Survey is currently 24% -- slightly above the bottoming readings of 21 to 22% during March earlier this year.  Note that during the May 2004 bottom, this reading was only at 15%.  At the bottom of the cyclical bull market correction in November 1971 (the DJIA would rally by approximately 30% within the next 14 months), this reading was actually at 0% -- with the percentage of bulls equaling the percentage of bears at 37% apiece!  Therefore, this author would like to see another downside spike in this reading before I am comfortable in calling for a sustainable bottom.

Now, onto Consumer Confidence data straight from The Conference Board.  I have posted this chart before - I initially got the idea of constructing this chart from Mr. Richard McCabe, Chief Market Strategist at Merrill Lynch.  In a presentation that he made earlier this year in Houston, he suggested that we used the Consumer Confidence data as a contrarian indicator.  So far, history has backed his justification - it has been a pretty reliable contrarian indicator so far.  Following is the chart of Consumer Confidence vs. the action of the DJIA from January 1981 to July 2004 (the latest Consumer Confidence level was updated as of July 27, 2004):

Monthly Chart of Consumer Confidence vs. DJIA (January 1981 to July 2004) - Current level of 106.1 is the highest level since June 2002. My guess is that consumer confidence will have to come down before we get a sustainable bottom in the DJIA.

Again, based on the latest reading of 106.1 (the highest since June 2002), the Consumer Confidence data is currently not suggestive of a significant bottom in the stock market.  Similar with the other sentiment indicators I have mentioned, I would like to see a downside spike in this index before I can comfortable call for a bottom in the stock market.  Please note that since the August reading will not be updated until the end of this month, it is probably not a good idea to use this indicator as a basis for your everyday trading.  For longer-term investors, this indicator can be useful - if it does have a downside spike at the end of this month, it can act as a confirmation of the other sentiment indicators (assuming that they do act the way that I am expecting) I have mentioned above.

Since approximately half the issues traded on the NYSE are preferred stocks, bond funds, or REITs, things such as a high-low (number of 52-week highs vs. the number of 52-week lows) analysis or an A/D line study may be distorted if we were to do them on the NYSE.  Since the Nasdaq does not suffer from this distinction and since the QQQ is a favorite trading vehicle for some people, I am now providing a high-low analysis of the Nasdaq.  Following is a chart of the Daily High-Low Differential Ratio of the Nasdaq (the daily number of 52-week highs minus the daily number of 52-week lows divided by the total number issues on the Nasdaq) vs. the level of the Nasdaq from January 2003 to the present:

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 2003 to August 6, 2004) - Current High-Low Differential Ratio of (7.81)% suggests the correction is not over yet but is within striking distance of the (8) to (14)% range!

The current high-low differential ratio of negative 7.81% represents the most oversold condition in over 18 months (from the perspective of the number of 52-week lows being made).  It is interesting to note that during a bull market, the typical range of a correction is accompanied by a high-low differential ratio of around negative 8% to negative 14% -- unless the correction was accompanied by very negative news items.  The following chart covers the January 1995 to December 1998 period and acts as backup to what I just mentioned:

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 1995 to December 1998) - A High-Low Differential Ratio of (8) to (14)% is within the normal range of a correction within a bull market. Any ratio of under (20)% is either indicative of the end of a bull market or a severe correction during a bull market in the midst of highly negative news.

Based on this high-low analysis - and if we are to follow the 1996 or the 1997 correction scenario, then the Nasdaq may be within a week of bottoming (please keep in mind that during a cyclical/secular bull market, corrections tend to be swift and sharp - which helps to shake out the majority of investors in the process).  My initial guess would be a Nasdaq Composite bottom at around the 1,700 level in such a scenario.  Of course, if YUKOS is forced to stop pumping oil tomorrow or if there is a significant terrorist event in the upcoming Olympics, then all bets are off.

It is interesting to note that TrimTabs is still bullish based on the relatively small amount of insider selling and the huge number of buybacks and cash takeovers of companies.  In their latest analysis, they also discussed the latest jobs report (which was blamed as the trigger for Friday's huge decline) and that based on their own analysis, the BLS is actually understating job growth by more than 100,000 job positions.  Because of this and because of what I have mentioned in my numerous prior commentaries, I believe we are still in a cyclical bull market, but for now, downside momentum reigns (although we should experience some sort of a bounce on Monday given the super high ARMS Index reading of 3.21 we saw on Friday).  Readers should also keep in mind that the earnings reports of Cisco (Tuesday AH), Disney (Tuesday AH), Wal-Mart (Thursday AH), and Dell (Thursday AH) will also be due this week (ironically, a sustainable bottom may be possible here if investors react negatively to these reports in a huge way resulting in the continuation of the downside momentum from last week).

To my dear readers: I will not have a set publishing schedule this week because of current market conditions.  Instead, I will publish a commentary or a quick update as I see fit and I will also give my readers more price targets as we go on (for now, I believe readers should watch for the 9,500 level on the DJIA - which represents the 50% retracement level from the January 2000 high to the October 2002 low).  These are interesting and dangerous times but if my readers can catch the upcoming bottom at a pretty decent time, then I believe tremendous profits can be reaped.  Stay tuned!

Signing off,

Henry K. To, CFA

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