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The Bull Market Continues

(September 12, 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 291 points (or approximately 2.9%).  Readers should also stay tuned over the next couple of weeks as we are also in the process of redesigning our website - and that an initial version of it should be up and running pretty soon.  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:

The market continued to do well during the last week - even as signs of an overbought market, the stubbornness of high oil prices and terrorism concerns continue to overhang the market.  I will get to the more speculative index (the Nasdaq and the SOX) later on but from a Dow Theory standpoint, the big news of the week was the Dow Jones Transportation Average making a new 52-week high at the close on Friday - providing further confirmation that the cyclical bull market is still intact:

The big news: During the latest week, the Dow Transports made a new 52-week high on Friday - closing at 3,224.38 and bettering its recent peak on June 30th at 3204.31. At the same time, however, the DJIA is still meeting resistance at its linear downtrending resistance level. The DJIA actually closed at a high of 10,341.16 last Tuesday but has been unsuccessful in convincingly penetrating resistance since that time - despite the Dow Transports making a new 52-week high and despite a further 36-point rally in the Nasdaq Composite form the close on Tuesday to the close on Friday.

Such a breakout in the Dow Jones Transportation Average should not be taken lightly, especially given the fact that this news has not been reported in the mainstream media one single bit.  The mainstream media is still too worried about high oil prices, even as the Dow Transports (which obviously consists of companies that have crude oil as a major component of their cost structures) continues its relentless upward march.  Moreover, in my previous commentaries, I have stated that I believe crude oil prices will continue to correct in the short-run, as current fundamentals definitely does not support an oil price of over $40 a barrel.  I continue to stand by this position.

The Dow Jones Industrials Average is currently the weaker index, as it actually made a peak on Tuesday at the close at 10,341.16 and subsequently diverged from both the Dow Transports and the Nasdaq Composite throughout the remainder of the week - closing at a slightly lower level of 10,313.07 on Friday.  Readers may recall my stated position last week.  The position is as follows: From a classic Dow Theory standpoint (and utilizing a purely mechanical methodology of interpreting the Averages), if the DJIA closes above 10,350 in the days ahead, then this would mark the confirmation of a sustainable uptrend.  We are now only 37 DJIA points away from this confirmation on a closing basis.  Given the bullishness of all my other technical indicators and the backup of U.S. stock market history, I believe this will confirm in due time (possibly next week).  Readers should note that such a confirmation would in all likelihood pull a significant number of investors back into the stock market and/or force these same investors to cover their short positions - further propelling the market in its current upward trend.

I cannot emphasize enough the importance of the new 52-week high of the Dow Transports and the upside confirmation of the Dow Industrials.  If I was forced to only cover one thing in this week's commentary, my discussion would definitely focus on this topic.  But of course, I always have more for my readers - so let's cut straight to the chase.

I have previously mentioned the Nasdaq - the Nasdaq Composite definitely surprised everyone this week by staging a pretty impressive performance - up 50 points or approximately 2.7% for the week.  However, the prize goes to the SOX (the Philadelphia Semiconductor Index).  After underperforming every major index during 2004, the SOX surged approximately 8.8% during the last two trading days of last week!  This is no small feat - as the underperformance of the SOX has been the one sole thing that has bothered me with regards to the sustainability of this uptrend in the stock market.  The question is: Is this the beginning of a new uptrend in semiconductors?  My guess is that it is, given the hugely oversold conditions in the SOX as of the middle of last week and given the strong upsurge seen on Thursday and Friday.  The SOX has also led the stock market in every major rally for the last ten years, and since I believe that we are in the midst of a sustainable uptrend, the SOX will have to participate.  Let's take a look at the following two charts in order to get a better perspective:

Semiconductor Index - Philiadelphia (SOX) - PPO now suggests the beginning of a new uptrend but the SOX still needs to surge past 394.58 in order for this 'buy signal' to be valid.

Relative strength (Weekly chart) of the SOX vs. the S&P 500 (May 1994 to Present) - My guess is that the relative strength of the SOX vs. the S&P 500 will have to approach the March 2001 and the March 2002 levels (and then reverse) before we can reasonably call an intermediate top in both the SOX and the stock market.

The PPO of the SOX is looking good, and the strong rally over the last two trading days is especially encouraging given the huge oversold conditions in the SOX as of the middle of last week.  Readers may not know this, but relative strength (second chart) of the SOX vs. the S&P 500 as of the middle of last week was at a level not seen since February 2003 - suggesting a heavily oversold condition comparable to the October 2002 bottom on a relative strength basis.  Throughout the last ten years of stock market history, the SOX has always staged a very impressive performance after a reversal from such an oversold condition on a relative strength basis.  This includes the May 1994 to August 1995 period, the July 1996 to August 1997 period, the October 1998 to March 2000 period and finally the October 2002 to November 2003 period.  The bottoming of relative strength in the SOX ten months after the peak in relative strength would pretty much coincide with the average timing of the bottoming processes of the SOX in the past bull market.  History has also suggested that the next bull cycle of semiconductors should last anywhere from 13 to 19 months.  If this is the case, then both the SOX and the stock market (as represented by the major indices such as the Dow Jones Industrials and Transports, the Nasdaq, and the S&P 500) may not top out until September 2005.  Readers who want to take advantage of this cycle may want to purchase either the SMH or a basket of four to five technically strong semiconductor stocks and hold them for the next 13 months.

I now want to discuss the specialist short-sale ratio, an indicator which I discussed in my August 15th commentary.  I have outlined in my previous commentaries of the immense short interest on both the NYSE and on the Nasdaq - particularly so on the Nasdaq.  The specialist short-sale ratio is published each week and represents the percentage of all shares sold short during that week by the NYSE specialist firms - who are the brokers appointed by the NYSE to maintain orderly markets in individual stocks traded on the NYSE.  The NYSE specialist short-sale ratio may not represent the bullishness or bearishness of professional traders, but it is definitely representative of the bullishness or bearishness of the public - as these specialists are generally forced to short-sell when the public is bullish (and thus buy stocks) and to buy when the public is bearish.  The historically low readings we are currently experiencing in the specialist short-sale ratio represent huge bearish sentiment of the public - as this indicates that the specialists are not forced to do much short-selling in order to maintain the integrity of the stock market.

In my August 15th commentary, I stated: ". I have done extensive research to see when the market experienced similar readings in the specialist short-sale ratio.  The lowest reading (prior to the most recent readings) of the 8-week moving average of the specialist short-sale ratio was November 10, 1944 - when the ratio touched 29.95%.  The Dow Industrials subsequently staged a rally of over 30% in the next 12 months.  The second lowest reading came on July 16, 1982 when the ratio touched 30.75%.  Again, the implications were bullish and the Dow Industrials subsequently staged another rally of 30% -- this time in a period of six months instead of twelve months.  The only instance when this indicator erred was on January 6, 1984 (when the 8-week moving average of the specialist short-sale ratio touched a low of 30.92%) - the Dow Industrials proceeded to decline nearly 20% in the next two months (however, the Dow Industrials traded at the top of its 52-week range immediately before we got this reading).  Two other low readings (32.21% on July 27, 1984 and 31.65% on July 5, 1996) that occurred had hugely bullish implications.  Using this indicator, the law of probability states that we are probably near a bottom - but most importantly, that the cyclical bull market is not over yet and that higher prices are still in store."

I would like to take the opportunity to take my studies one step further by showing my readers graphically what happened during the months subsequent to November 10, 1944 and July 16, 1982 - when the 8-week moving average specialist short-sale ratio registered the lowest and the second lowest reading in history (at least since records were kept starting in 1943) - prior to the current reading, of course.  Following is a chart depicting the 8-week moving average of the specialist short-sale ratio vs. the Dow Jones Industrials during the February 1943 to December 1946 period:

(Weekly) DJIA vs. 8-week MA of the NYSE Specialist Short Ratio (February 1943 to December 1946) - The 8-week MA of the NYSE Specialist Short Ratio bottomed at 29.95%.

Dear readers - not only did the DJIA enjoy a 30% rise over the next 12 months subsequent to the bottom of the 8-week moving average of the specialist short-sale ratio at 29.95%, it ultimately rose 43% within the space of 18 months before the broad market topped in May 1946.  The second chart depicts the 8-week moving average of the specialist short-sale ratio vs. the Dow Jones Industrials during the January 1981 to December 1983 period:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 1981 to December 1983)

The months subsequent to the bottoming of the specialist short-sale ratio at 30.75% on July 16, 1982 was even more explosive - as not only did the DJIA surged 30% over the next six months, it ultimately rose a staggering 54% before an intermediate top was registered.  As I mentioned before, "the only instance when this indicator erred was on January 6, 1984 (when the 8-week moving average of the specialist short-sale ratio touched a low of 30.92%) - the Dow Industrials proceeded to decline nearly 20% in the next two months (however, the Dow Industrials traded at the top of its 52-week range immediately before we got this reading)."  Readers should note, however, that the DJIA had recovered this loss by the beginning of 1985, and that over the next 18 months, the DJIA rallied another 110% before finally surrendering to the October 1987 crash.  Again, the two other low readings (32.21% on July 27, 1984 and 31.65% on July 5, 1996) that occurred had hugely bullish implications, and probably now suggests that we will enjoy a sustainable uptrend at least over the next six months:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to September 10, 2004)

Mark this date down: August 27, 2004.  This was the date when the 8-week moving average of the specialist short-sale ratio made a bottom at 21.80% - the lowest reading in the history of the NYSE!  Given the bullishness of my liquidity, technical, and sentiment indicators, I believe that this indicator will, again, have hugely bullish implications over at least the next six months.  Whether the DJIA will rise 10% or 20% I cannot tell you, but I would not be surprised if at least one of the Dow Jones Industrials or Dow Jones Transports Average make an all-time high, and I would also not be surprised if both Averages make an all-time high over the next six to twelve months. 

Now, onto one of my favorite sentiment indicators.  The Investors Intelligence Bulls-Bears% Differential (calculated by taking the absolute difference of the percentage of bulls and the percentage of bears in the latest Investors Intelligence Survey) rose slightly to 19.4% over the last week - still a historically low level and which definitely suggests more upside to go in the stock market:

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present)

Again, readers should keep track of this indicator going forward, as warning signs will pop up on this indicator first before we can reasonably anticipate a peak in the stock market.  Finally, this author would like to continue to make the case for lower crude oil prices.  The following chart was constructed using data straight from the Energy Information Administration (EIA) - illustrating the current world crude oil balance from the first quarter of 2003 to the second quarter of this year (the world oil demand number for the second quarter of this year has not yet been updated, however):

Total World Oil Supply vs. Total World Oil Demand (1Q 2003 to 2Q 2004)

As one can see, there could potentially be a current surplus of crude oil in the world markets to the tune of two million barrels per day - a substantial number given that a commodity such as crude oil is priced at the margin.  I have, in the past, emphasized that the currently high crude oil prices is probably due to the speculation of hedge funds and individual traders, and the above chart definitely illustrates this very clearly.  Over time, the true demand and supply situation ultimately wins, and this will be no different.  Readers should also note that crude oil prices (basis the NYMEX futures contract) were only briefly above $35 a barrel for four weeks for all of 2003, and this was during the period preceding the Iraqi invasion - when the fear of sabotage of the Iraqi oil structure was high and when supply from Iraqi fields had all but ceased.  Moreover, the current disparity in oil and natural gas prices is also high (as of this writing, the price of natural gas is equivalent to a $28 per barrel crude oil price).  The last time that this happened was during the winter of 2000/2001, when natural gas prices at the Henry Hub soared to over $10/MMBtu.  Natural gas prices subsequently crashed during the next twelve months.  Could this happen to oil, and if so, where can we reasonably expect a bottom?  This author does not know, but I would not be surprised if crude oil prices declines to $30 a barrel again during the next six to twelve months.

Bottom line: The public is still bearish.  This author still continues to believe that oil prices will continue to come down - contrary to what the mainstream media is saying.  A significant number of individual traders (and no doubt, hedge funds) is still shorting, to which I say: "Did you make any money shorting during the great bear market of 2000 to 2002?  Heck, did you even recognize that it was a bear market at the time?"  I did, as readers can verify on my Special Reports page.  Believe me, if you did not make money short-selling during that period, then you will NEVER make any money going short in the stock market, period.  The bears who are currently shorting will ultimately find out that they have merely helped the bulls, by currently creating artificial supply and having to ultimately cover at higher prices.  If you are not comfortable with the long side, then stay in cash, but please do not short - the sustainable uptrend that we are currently experiencing could go further than anyone can currently imagine.  

Signing off,

Henry K. To, CFA

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