The Bull Market Continues - Part II
(September 19, 2004)
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Dear Subscribers and Readers:
Excuse my lack of creativity over the title of this week's commentary, but I truly believe that this title fits the bill perfectly - given the fact that my discussion this week is very much just a further extension of last week's commentary. The most significant news this week from a Dow Theory standpoint is the two-week divergence in the Dow Jones Industrial Average and the Dow Jones Transportation Average - as the Dow Transports rose to another 52-week high and as the Dow Jones Industrials again closed down - registering a 29-point decline for the week. This divergence may (or may not) act as a prelude for a more serious correction in the major indices (chances are high given the overbought conditions in the market), but since this author believes that we are still in the midst of a cyclical bull market, the Dow Jones Industrials will confirm in due time. Let's take a look at the relevant chart:
While chances of a correction in the market are still high, longer-term investors should continue to hold on to their long positions (unless your individual stock positions are technically very weak). We are still in a cyclical bull market - with the Dow Transports making another 52-week high last week. More importantly, the Dow Transports actually made a 5-year high. We are now at a level not seen since August 1999. The Dow Transports actually acted as a leading indicator to the 2000 to 2002 cyclical bear market when it topped out in May 1999, and this author believes that the Dow Transports is now leading the market to the upside - as the Transports has historically been more sensitive to changing economic conditions. Moreover, the Dow Jones Utilities (which historically has also tended to lead the market) also made a new 52-week high last week - suggesting that the Dow Industrials and the broad market has further room to run on the upside.
In the short-run, the bull case will be substantially strengthened once the DJIA closes above 10,350 - which would put the DJIA above the downtrending resistance line. Again, 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 now want to update my readers on the current reading on the specialist short-sale ratio - a ratio which I covered extensively in last week's commentary. The latest one-week reading for this indicator is 25.40% - a decrease from last week's reading of 27.09%. This signals the best of both worlds, as this indicates that the public continues to short, while the 8-week moving average has increased again to a reading of 23.57% from last week's reading of 22.97% - suggesting that the 8-week moving average of the specialist short-sale ratio has most probably bottomed at 21.80% four weeks ago. If this is the case, then the market should continue its sustainable uptrend even as the shorts continue to provide "fuel" for the bulls:
Given the trend of this indicator and all the other indicators I have studied, again, 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. Of course, there is always a chance that I am wrong, but shorts should know this: If you did not make money during the 2000 to 2002 bear market by going short, then chances are that you will never make money going short over a sustained period of time. All of a sudden, it is now "fashionable" to short stocks. I do not think that this "fad" will last long.
I am now going to update two of my favorite sentiment indicators - that of 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) and the American Association of Individual Investors Bulls-Bears% Differential (which is calculated using the same methodology). Dear readers, let's cut right to the chase. The first chart (that of the Investors Intelligence Bulls-Bears% Differential) is as follows:
The Bulls-Bears% Differential reading rose from 19.4% to 25.5% during the latest week. This reading is pretty much a neutral reading in a cyclical bull market, but given the severity of the dip in this indicator during the late August period, I expect this reading to experience more upside before we can reasonably call a top in the stock market.
The second chart (that of the American Association of Individual Investors Bulls-Bears% Differential) is as follows:
Interestingly, the Bulls-Bears% Differential reading in the AAII survey during the latest week actually decreased from 27% to 14% - which is pretty bullish given that most of the market indices rose (with the except of the DJIA) during the week. More importantly, the 10-week moving average for this indicator (taking a moving average for this reading is a very sensible thing to do given the fact that the sentiment of individual investors is inherently volatile) is now at a low of 9.6% - the lowest reading since May 2, 2003. Together, these two sentiment indicators suggest that the public is still leaning towards the bearish side - a very positive development given that the market is still in an uptrend - all the more so given the bullishness of all my other technical indicators.
The Flow of Funds Accounts 2Q report was just released by the Federal Reserve last Thursday, and I would now take a little bit of time to illustrate a number in this report - that of the ratio of equities and mutual funds as a percentage of total household financial assets. History has shown that this is a great contrarian indicator - namely that when households choose to hold only a little bit of equities or mutual funds as a percentage of their total financial assets (including cash, bonds, and annuities) it is a great time to buy stocks. The same argument holds when households choose to hold a significant amount of equities or mutual funds in their financial asset portfolios. Following is a chart of this ratio covering the 1Q 1962 to 4Q 1974 period. I have included this chart for one purpose: to illustrate to my readers how this ratio behaved during the 1966 to 1974 secular bear market and how the experience over that period compares with the experience of today:
As readers can see, this ratio experienced a bounce of over 6% from the bottom in the third quarter of 1966 to the fourth quarter of 1968 (a bounce that lasted for two years and one quarter) - just as the same time the 1967 to 1968 cyclical bull market was topping. Same goes for the experience of the May 1970 to January 1973 cyclical bull market. Again, this ratio experienced a bounce of approximately 6% from the second quarter of 1970 to the fourth quarter of 1972 - a bounce that lasted for two and a half years. More importantly, this ratio jumped approximately 2% in the final quarter of both cyclical bull markets - concurrent with the two "blow off phases" - when the DJIA climbed 13.1% from a ST bottom on August 2, 1968 to the top on December 3, 1968 and 12.4% from a ST bottom on October 16, 1972 to the top on December 11, 1972, respectively.
So what is the current experience of this ratio, one may ask? Let's take a look at the following chart of the same ratio - from the first quarter of 1992 updated to the second quarter of 2004:
From the bottom at 23.42% in the third quarter of 2002, this ratio increased to 27.23% in the fourth quarter of 2003 - an increase of slightly less than 4%. This ratio stood at 27.03% in the second quarter of 2004. The upswing in this indicator has now lasted one year and three quarters. In terms of both the absolute rise and in the duration of the rise in this ratio, the latest upswing has been mediocre; especially given the ferociousness of the March 2000 to October 2002 cyclical bear market. It is my contention that this ratio will need to increase another 2% before we can reasonably expect a top in the stock market. Moreover, history has shown that a significant top in the stock market has been accompanied by a final one-quarter upsurge of two to three percent (concurrent with a "blowoff phase" in the DJIA and other major indices) in this ratio. We are currently still not there.
Readers may be getting tired of this, but I am going to write another paragraph on the oil price this week. The spike in the crude oil price on Friday took out a two-week high but this author is still of the belief that prices will decline - as soon as hurricane season ends and as soon as people realize that the YUKOS situation will not (even if the company does go bankrupt) significantly affect Russian oil exports. Following is a chart published by the Bank Credit Analyst last Thursday - illustrating the immense increase in global oil production vs. the potentially declining demand in oil demand in the emerging Asian economies (which have historically been the leading driver in the growth of oil demand):
The BCA Emerging Asia Leading Economic Indicator seems to be rolling over. Both the U.S. and China has in recent days continued to fill their strategic reserves even as crude oil prices are near record highs. Moreover, as discussed in my last week's commentary, there is a potential oversupply of crude oil in the world's markets of two million barrels per day. This is a significant number, as a commodity such as crude oil is priced at the margin. Readers should note that even though China is the world's second largest consumer of crude oil, it only consumed on average 5.6 million barrels per day in 2003, with net imports of approximately two million barrels per day. In the short-run, continued growth in places such as China and South Korea will not make one dent on world oil demand. I will update my readers once more recent world oil demand data becomes available.
Bottom line: The author believes that the current rally still has more room to run, despite the two-week divergence in the Dow Industrials and ST overbought conditions in the stock market. Longer-term investors should continue to hold on to their long positions, unless the individual stocks one is holding are technically weak. Finally, I would like to alert my readers to a Mark Hulbert's article from cbs.marketwatch.com in a discussion of the VIX. In the article, he argues against the general bearishness regarding the recent low VIX readings, invoking the historical readings of the VIX and their implications during the period of the early to mid 1990s. Readers who do not have the time to read this article should just note that during the period from 1992 to 1997, the "normal range" of VIX readings was in the 10 to 20 area, and therefore the recent "low" readings of the VIX in the 13 to 15 area may not necessarily have bearish implications. In fact, the last time that the VIX was this low was in early 1996, and as Mr. Hulbert pointed out, 1996 was a very good year for stocks in general.
Henry K. To, CFA