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Let the Games Begin!

(September 5, 2004)

Please note that our DJIA timing system initiated a 100% long position in the Dow Industrials at 10,022 on the afternoon of August 19th.  As of the close on Friday, our DJIA timing system is up a total of 238 points (or approximately 2.4%).  Not too shabby.  Readers may also be happy in finding out that we are in the process of redesigning our website - and that an initial version of it would be up and running within the next couple of weeks.  Again, please continue to forward this commentary to anyone who you think may be interested in our services.  We still need all the subscribers that we can get.  Our discussion forum is now also online.  Please post all your questions about the market and individual stocks in our discussion forum from now on - this will also encourage more discussion and will also help other subscribers and readers in their analyses of the stock market.  Registration is free.

Dear Subscribers and Readers:

Some of my readers may have expressed surprise in that I hardly discussed the stock market in last week's commentary.  The only update I gave was the latest reading in the Investors Intelligence data - and the only reason why I gave the update was because the pessimistic reading in the Investors Intelligence Bulls-Bears% Differential suggested that bearish sentiment had reached a level not seen since March or April of last year.  The readings during the March and May lows don't even come close - and I thought it was an important enough development to update my readers.

In my last commentary, instead of the topic of the stock market, I discussed what I thought were the three most important trends of our current time: that of the aging population - not only in the European countries, the U.S, and Japan, but across the world; the upcoming rise in fossil fuel prices; knowing your own psychology when it comes to investing or trading in the stock market - given that we are currently in a secular bear market (and that buy-and-hold will no longer work).  Once in awhile, this author likes to shift away from discussing the stock market to discussing broader economic trends - trends that will have a great impact on my subscribers.  I have no political agenda.  I sincerely feel that these topics are worth discussing and hopefully readers have had time to reflect on these issues and will be able to make the "correct" economic decisions in due time.  Of course, as of last Sunday, I also felt that I had nothing new to say regarding the stock market (William P. Hamilton, one of the great Dow Theorists and the fourth editor of the Wall Street Journal would sometimes not publish an editorial for weeks or even months - preferring to publish only when he has something new to offer - such as announcing a potential change in the trend of the stock market) since I believe that the intermediate trend was firmly up and remained up.

I would focus on the stock market again in this week's commentary - so let's cut right to the chase.  From a classic Dow Theory standpoint (and using the purely technical method of reading the Dow Jones Industrial Average vs. the Dow Jones Transportation Average) I would like to point out a couple of things in the pricing action of the Dow Industrials and the Dow Transports in the following chart:

First thing: The Dow Transports has now confirmed the Dow Industrials on the upside by bettering its recent peak of 3,134.15 established on August 2nd - when the Transports closed at a level of 3,162.49 last Thursday. Second thing: Not everything is perfect, however, as the Dow Industrials is once again hitting resistance -a linear downtrending resistance level which has capped all rallies dating back to February earlier this year. A convincing rally taking the Industrials to a close above 10,350 or so would mark the confirmation of a sustainable uptrend.

Like I mentioned in the above chart, the Dow Transports confirming the Dow Industrials last Thursday was a pretty bullish event - especially so considering that Richard Russell (the last living "Dean" of the Dow Theory) has been worried about this non-confirmation for more than a week (and also considering that crude oil prices are still relatively high at nearly $44 a barrel).  Not everything is perfect, however, as the Dow Industrials is now sitting right at resistance - a resistance which the Dow Industrials has failed to surpass in two prior instances already.  Coincidentally, the Dow Industrials is also sitting right at the 200-day moving average - which can also act as a very important psychological level.  Based on the above chart alone, the author's position is that only a convincing rally taking the Industrials to a close above the 10,350 level would mark the confirmation of a sustainable uptrend.  A far more bullish signal, however, would be a rise above the prior peak of 10,443.81 made on June 24th.  In fact, if the DJIA is to close above that level, then the burden of proof would then shift from the bulls to the bears as the downtrend of the last seven months would have officially reversed.

Fortunately, we do not need to rely solely on the above chart.  I have, in all my past commentaries, discussed the various stock market indicators and analytical tools that I like to use and that have been successful in the past in calling the intermediate term action of the stock market.  In my recent commentaries, I have discussed the similarity of the current market to the cyclical bull markets of the 1966 to 1974 secular bear market (I have invoked a lot of history and have thought about it quite a bit before I made those comparisons), indicators such as liquidity and bullish/bearish sentiment, and other types of technical analyses.  I have already concluded that we are in still in a cyclical bull market, and this is precisely why our DJIA timing system is 100% long.  This is also why traders who are currently short and who are going to stay short during the next two months leading up to the election should seriously re-think their positions - either that or keep very tight stop losses.

Now, I would like to discuss the title of this commentary: "Let the Games Begin!"  Is this writer three weeks late or what?  No, I am not talking about the Olympic Games here.  I am talking about the stock market and stock market action.  Historically, volume in the stock market does not pick up until after the Labor Day weekend, and with volume comes action.  A number of stock market analysts have cast doubt on the recent rally by noting the low volume that was experienced during the recent uptrend.  Like I have said before, there is no perfect scenario when it comes to the stock market - if these writers want to see high volume during historically slow volume months, then so be it.  Coincidentally, some of these same writers did not mention the relatively low volume when the market was going down earlier last month.  If the only fault that these writers can find is with low volume, then that is really not saying much.  Following is an interesting chart constructed by Mark Hulbert of tracking the average monthly trading volume relative to the trailing twelve month's volume on the NYSE from 1888 to 2003:

NYSE Average monthly trading volume 1888-2003

The chart plainly says it - volume during the summer months - June, July, and August is just low, period.  In his article, Mark Hulbert states that writers who think the recent low volume is a bearish omen is "just plain silly" -- akin to stating that August (or June, July, and August) "is in itself a bearish omen."  One thing is for sure, though: If we see bullish action starting this week, then this bullish action will most probably be accompanied by high-enough volume to quiet down the critics.

This author would like to offer his own conjecture.  High or low trading volume, my liquidity and my sentiment indicators tell me that there is potential for a sustainable uptrend.  The bears have had their chances during mid March, mid May, and the early and mid part of August.  It is now the bull's turn.  A sustainable uptrend needs demand and increasing volume.  Once volume starts coming in next week, the emergence of a sustainable uptrend will start to become clearer to more traders - and the bullish thesis will be proven correct.  Bottom line: The recent low trading volume has actually been an impediment to a sustainable uptrend, but this will be over starting next week.

I want to take this opportunity to update my sentiment analyses and to present new ones.  At the end of last week's commentary, I stated that the Bulls-Bears% Differential has declined to 9.4% -- a historically low reading (given a cyclical bull market) and a reading which we haven't quite seen since the March to April 2003 period.  This and the latest reading that came out last Thursday provides further confirmation that we are in a period of a sustainable uptrend:

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present) The Bulls-Bears% Differential in the Investors Intelligence Survey for the latest week rose to 15.9% - still a historically low level and suggests more upside to go. I urge my readers to keep an eye of this reading - if optimism does not experience any huge jumps going forward, then it is most probably indicative of a sustainable uptrend.

Please note that despite the latest rise from 9.4% to 15.9% in the Investors Intelligence Bulls-Bears% Differential, the reading of 15.9% is still at a historically low level - and a level which is far lower than the levels we were seeing during the recent February, April and June peaks.  Bears who are looking for a decline here do not know what they are talking about.

The results of this survey are further confirmed by the readings in the sentiment survey of the American Association of Individual Investors (AAII).  A brief description of the AAII sentiment survey and how it is conducted can be found from the link (relevant quote: "The AAII sentiment survey is a weekly poll conducted by that organization which intends to gauge the overall sentiment of their membership.  They ask their membership where they think the market will be in six months, and group the responses into three categories:  bullish, bearish or neutral.  Like most contrarian indicators, when the survey shows too many investors as being bullish, it very often corresponds to market highs.  Conversely, too many bears suggest that the market may soon find a low.").  Please note that since this survey is a survey taken of individual investors, it tends to be more volatile but also very contrarian in nature.  Following is the weekly chart of the AAII sentiment survey readings (expressed again as a bulls-bears% differential) vs. the Dow Jones Industrials from January 2003 to the present:

DJIA vs. Bulls-Bears% Differential in the AAII Sentiment Survey (January 2003 to Present) While the recent low readings in the Bulls-Bears% Differential in the AAII survey did not surpass the March and May low readings, they were low enough to be comparable to the March to April 2003 readings. More importantly, the lack of a rise in bullish sentiment in recent weeks suggests that we have further upside to go in the major indices.

Like I said above - while the recent low readings in the AAII sentiment survey were not as pessimistic as the readings during the March and May readings (unless one takes the four-week moving average - which may be a good thing to do since the results of this survey are so volatile from week to week), readers should understand that these readings were pessimistic enough to be comparable to the March to April 2003 readings.  More importantly, the lack of a rise in bullish sentiment in the last couple of weeks suggests that there is more upside to go in both the Dow Jones Industrials and in other major indices.  The hit taken by Intel and by the semiconductor index (all favorite trading stocks of retail investors) suggests that this reading should be currently lower should we have taken another survey at the close on Friday.

I now want to discuss a little bit about consumer confidence.  Consumer confidence declined from a revised July reading of 105.7 to an August reading of 98.2 - which was way below what was forecasted by all the "experts" at 103.4.  This actual "low" reading of 98.2 did not come as a surprise to me - in fact, I have been looking for it, as all the sentiment surveys I have been previously looking at (including the Investors Intelligence and AAII sentiment surveys) suggests a far lower number than what was forecasted (apparently, the major economists were asleep at the wheel again).  In my August 8th commentary, I stated that: ". based on the latest reading of 106.1 [this reading was subsequently revised to 105.7] (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."  Following is the most updated chart of Consumer Confidence vs. the Dow Jones Industrials:

Montly Chart of Consumer Confidence vs. DJIA (January 1981 to August 2004) Consumer Confidence declined froma revised July reading of 105.7 to the current level of 98.2 - confirming the pessimism in the stock market survey readings.

We got just such as downward spike in the latest August consumer confidence reading on August 31st.  In retrospect, the initial negative market reaction to the "worse-than-expected" consumer confidence report was a buying opportunity, not a sell signal.  The "low" reading of 98.2 confirms the recent pessimism in the Investors Intelligence and AAII stock market survey readings and paves the way for a sustainable uptrend in the stock market during the upcoming months.

To conclude my sentiment analyses, I want to present something which I have not discussed in detail before: the Rydex Cash Flow Ratio as created by the great people at  You can read about the definition and the justification for this indicator by pointing to this website but in a nutshell, this ratio was designed to track the cumulative and actual cash flows that have been entering or leaving the Rydex funds since they began trading in 1998.  The formula is as follows:

Rydex Cash Flow Ratio Formula:  (Money Market + Inferred Money Market + Bear Funds CCFL) / (Bull Funds CCFL + Sector Funds CCFL)

By definition, a higher ratio means that people have been putting more money into funds with a bearish orientation (including remaining in cash), and a lower ratio means the vice-versa.  You can read more about the Rydex family of funds at the Rydex Funds website.  The following chart depicting the Rydex Cash Flow Ratio from January 2001 to August 20, 2004 is also arguing for the high probability of a sustainable uptrend going forward:

Rydex Cash Flow Ratio (January 2001 to August 2004) is also arguing for the high probability of a sustainable uptrend going forward.

Readers should note that this latest pessimistic reading is suggesting that a great number of individual investors is putting their money into cash or even bear funds - which is a great contrarian indicator (look at what they do, not what they say).  Please also note that this ratio is now at a low not seen since February to March and August of last year.  The most recent readings suggest that this ratio remains on the low side - further arguing for the bull side and for my thesis of a sustainable uptrend.

Finally, the author believes that oil prices will continue to decline in the upcoming weeks, as current inventory levels definitely does not argue for an October price of over $44 a barrel.  It is also interesting to note that natural gas spot prices (a good substitute of crude oil in some industries) have declined considerably during the last two weeks:

Natural Gas Price (January 2003 to August 2004) The spot price for natural gas has declined a dollar per MMBtu (17.5%) over the last two weeks - suggesting lower energy costs for the majority of Americans during the Fall (no pun intended) as this type of technical deterioration is not usually easily repaired.

The spot price for natural gas is currently at approximately $4.70/MMBtu, which is equivalent to a crude oil price of only $27 a barrel (1 barrel of oil = 5.8 MMBtu).  A decline of a dollar in natural gas prices is equivalent to a decline of $5.80 per barrel in crude oil prices.  Readers should also note that natural gas today accounts for 23% of all total energy needs in the United States, compared to 40% for crude oil.  Thus, a decline from $5.70/MMBtu to $4.70/MMBtu in natural gas prices during the last two weeks is no small matter.  Moreover, this author believes that the recent decline in natural gas prices is a sign of things to come in crude oil prices.  If I was a futures trader, I would definitely be shorting the crude oil contract right now.  My belief is that the continuing decline in crude oil prices would provide further support of my thesis of a sustainable uptrend in the equity markets.

Finally, I want to clarify a couple of things.  There has been talk that Lowry's selling pressure is at a nine-year low, suggesting little urge to sell by investors.  The focus of one's analysis going forward (assuming the selling pressure index does not start increasing) should be the buying power index, as a sustainable uptrend in the stock market should be characterized by a consistent rise in the Lowry's buying power index.  On Thursday, we got our wish - as the Lowry's buying power index surged to a new rally high - a high not seen since July 2003.  This rally high in the Lowry's buying power index strengthens the case for a sustainable uptrend - and any further rally during the upcoming week will probably again make a new rally high (as I am writing this, the S&P futures is up 3.5 points while the Nasdaq-100 futures is up 6 points).  Secondly, TrimTabs has been doing a great job in keeping track of personal income and employment data - and their conclusion: the Bureau of Labor Statistics (BLS) has been understating both these numbers for the last 12 months.  This is contrary to popular thinking and to the reports of the financial media, who have previously suggested that both personal income and employment are worse than what the BLS suggests.  The author personally has not done any detailed analysis - I am merely pointing out to the studies that has been done by TrimTabs and which looks very credible.  If this is the case, then the case for a sustainable uptrend in the equity markets just got stronger yet again.  This would also be consistent with the readings in the CEO Economic Index - as presented by this CNN article - suggesting that CEOs plan to ramp up both hiring and capital spending in the upcoming six months.

Bottom line: The technicals look good.  The public is bearish.  My liquidity indicators are very bullish.  Volume is about to ramp up.  The market looks very good here - let the Games begin!

Signing off,

Henry K. To, CFA

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