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Correction in the Works

(September 26, 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 only 25 points.  As my subscribers may have anticipated, I am now putting a stop loss on this long position at our entry point at 10,022 (an explanation will follow).  Please also note that an initial version of our redesigned website will be up and running by October 11th.  Subscribers and readers please stay tuned.  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.  We have now also activated private messaging.  Again, registration is free.

Dear Subscribers and Readers:

In my last market commentary and my individual stock commentary, I mentioned the possibility of an upcoming correction - and events over the last week have certainly increased the chances of a more significant correction in the days ahead.  I currently do not have a strict target on the major indices in terms of where they will bottom, but I will give my readers a glimpse of the indicators I am tracking and what kind of readings we should expect from them at or near the bottom.  Readers should know that in my humble opinion, we are still in a cyclical bull market, but given the lack of a sustainable uptrend from February to last week, we may need another (more severe?) correction in order to entice the smart money to commit on the long side.  The fact that the March, May, and August corrections failed to indicator "capitulation" should also suggest that we may possibly need a more severe correction in the days ahead.

In retrospect, the failure of the Dow Jones Industrial Average to confirm the Dow Jones Transportation Average on the upside was a particularly bearish omen.  This divergence of the two major Dow Averages is particularly significant given that while the Transports were making new five-year highs as late as last Tuesday, the Dow Industrials were severely lagging - failing to even clear the February high made more than seven months ago.  Following is the chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to September 24, 2004) - Despite the Dow Jones Transports making another new 52-week high as late as Tuesday, the Dow Jones Industrials still failed to confirm by closing above its linear downtrending resistance level - the elusive 10, 350 level I have emphasized for the last two weeks. Probability now suggests that the Dow Industrials will at least hit its lower downtrending support line in the coming days at approximately 9,500 (which should be a good support level since 9,500 also represents the 50% retracement level from the January 2000 top to the October 2002 bottom) - and most probably beyond that level if we are to achieve a sustainable bottom. For now, the author will take it one day at a time -although in my opinion, we are still in the midst of a cyclical bull market.

Again, probability now suggests that the Dow Industrials will at least retest its lower downtrend support line dating back to March earlier this year.  In the author's opinion, hedge funds and individuals alike have been too eager to buy at that level during the May and August bottoms.  We may or may not get another bottom at precisely that level again this time around (at approximately the 9,500 level) but in the author's opinion, we will probably need a more severe correction in order to have a sustainable bottom.  I do not currently have any specific targets - but my current guess is that a piercing of that line followed by another quick but sharp decline (to approximately the 9,000 to 9,250 level) would finally pave the way for a sustainable bottom.

I should emphasize, however, that I still believe that we are in the midst of a cyclical bull market, and therefore, the Dow Industrials will better its February 11th high of 10,737.70 in the months ahead.  I have discussed this at length in virtually all my previous commentaries but I will discuss this again at the end of weekly commentary.  For now, let's go ahead and discuss my reasons for an upcoming correction along with the indicators I am tracking and what kind of readings we should expect from them at or near the bottom of this upcoming correction.

Let's go ahead and discuss the McClellan Oscillator and the Summation Index.  Since these are breadth indicators, I have chosen to focus solely on the NASDAQ, as more than half of all issues traded on the NYSE are preferred stocks, closed-end funds, and foreign ADRs.  Let's take a look at the NASDAQ McClellan Oscillator and the Summation Index:

NASDAQ McClellan Oscillator and Summation Index - The last two rallies of the Nasdaq had all ended with the Summation Index reversing at or near the zero line - it now looks like that this time will be no different. At this point, I believe my readers should look for a penetration of the Summation Index below the low that was made in August.

Please note that the last two rallies had both terminated with the Summation Index at or close to the zero line - it now looks like that this time will be no different - as both the Nasdaq Composite and the breadth of the Nasdaq have been weakening.  The McClellan Oscillator is also now below the zero line, after having been in overbought territory for the last three weeks.  While breadth on both the NYSE and NASDAQ has been strong recently, the large caps have not been participating.  Historically, when the large caps had not participated, it usually means that the rally does not have that much further to go.  At this point, it is difficult to tell when the Summation Index will bottom, but as of right now, I believe that the Nasdaq Composite most probably will not bottom until we have hit a new 2004 low in the Summation Index.  Time will tell (and I reserve the right to change my mind next week as new developments occur).

Before I go further, I want to say this: Trying to time the stock market is all a matter of evaluating all the possible scenarios and correctly (hopefully) assigning the probability to the occurrence of each scenario.  The stock market is all about playing the odds and if the odds suddenly change against you, you get out and ask questions later.  It is part science and part art (mostly the latter).  The developments over the last four trading days have caused me to change my short-term views, and that is why I am choosing to sit it out - as per my stop loss of 10,022 on our DJIA trading system effective at the open on Monday morning.  The above analysis of the Nasdaq McClellan Oscillator and Summation Index is mostly science but the following is not.  I will now list out four points on why I think the market will experience a ST (but possibly severe) correction and chances are that a significant portion of my readers will disagree with me (just like some of the readers who disagree with me that this is still a cyclical bull market).  Please note that there are no scientific explanations to my views.  Rather, the following four points are the cumulation of a combination of "gut feel," experience, intense study and pondering, and my knowledge of stock market history and crowd psychology.  Here goes:

  • The recent strength in airline stocks (as shown by the $XAL, the American Exchange Airlines Index) despite a continued high oil price and the recent strength in insurance stocks (as shown by the $IUX, the S&P Insurance Index) despite the huge destruction wrecked by the four hurricanes is actually a sign of denial by fund managers and individual investors - not a sign of great technical strength in the market.  Usually, a sign of great technical strength is a huge rally off of a bottom in the sign of very bad news, but since both the XAL and the IUX have recently been trading new the top of their ranges, I believe it is a sign of denial instead.  First example: The huge gap down in the Nasdaq when Intel announced an anticipation of a one-penny earnings miss in September 2000, and then a subsequent rally off that gap down.  Novice traders thought that this was a sign of great technical strength, but alas, the Nasdaq immediately made low after low in the coming months.  Second example: The initial lack of a reaction in the stock market immediately after the Great San Francisco Earthquake of 1906.  Again, the market immediately gapped down but it subsequently rallied and made up most of its losses by the end of the day.  However, the market started a huge decline immediately afterwards as traders and investors alike started realizing how much damage was done to San Francisco and to a number of great railroads.  Ironically, the San Francisco Earthquake of 1906 most probably extended the 1903 to 1907 bull market, and I believe the current "twin problems" of high oil prices and the four hurricanes will ultimately also serve to lengthen the current cyclical bull market.
  • The significant weakness of the Dow Transports on Wednesday.  This is all the more important given that the Dow Transports has been one of the strongest market indices in 2004.  Also, the weakness of the semiconductors (as observed by the $SOX) on Thursday and Friday, even though semiconductors have held up well recently (and on Wednesday).  The market is just getting narrower and narrower - even Google (GOOG) succumbed to this technical weakness when it made an all-time high on Friday morning but subsequently closed in negative territory.  The general list is also soft and mushy, as technically weak stocks like WIN and DAL are getting clobbered as sentiment turns bearish.  In the coming few days, I would watch the IBD Top Ten list closely - if these ten stocks start to develop significant weakness, then watch out below.  These stocks currently are (in order): TZOO, UPL (oil stock), CME, CRDN, PETD (oil stock), SMF, MBT, AMED, URBN, and WIBC.  Please note that since both UPL and PETD are oil stocks, they may actually go against the general trend of the stock market.
  • My fear and "gut feel" are that the March, May, and August lows were not deep enough to squeeze the margin buyers and speculative traders out of the market - and therefore this current uptrend is not sustainable until we have achieved that.  Moreover, recent sentiment surveys (AAII and Investors Intelligence) suggest that more people are getting bullish, despite the huge down day experienced last Wednesday (coincidentally, these surveys were all conducted at the close on Wednesday).  Like I said in my "special alert" posted on Thursday evening, the Hulbert Stock Newsletter Sentiment Index (HSNSI) increased from 21.4% on Tuesday evening to 27.9% on Wednesday evening, suggesting that the ST market timers monitored by Mark Hulbert of cbs.marketwatch.com have actually increased their exposure on the long side DESPITE the significant decline on Wednesday - a bearish sign given that the timing of the majority of newsletter writers is usually not that great.  The probability is now high for a correction, and we will most probably need a deeper correction in order to have a sustainable bottom and subsequent uptrend.  Lower prices should also bring in the "smart money" and the professional managers back on the long side.
  • Oil, oil, and oil.  Again, I believe that the recent strength in airlines and in the Dow Transports despite a high oil price is a sign of denial rather than a sign of great technical strength in the market.  However, I am not listing this fourth point just to be verbose; rather I want to show my readers the following chart - that of the relative strength of the $XOI vs. the S&P 500.  Believe me, this chart is scary:

Relative Strength (Weekly Chart) of the Oil Index vs. the S&P 500 (August 1983 to Present) - Recent relative strength in the American Exchange Oil Index has broken out of its resistance level dating back to late 1991!!

Relative strength in the $XOI (the American Exchange Oil Index) vs. the S&P 500 has now broken out of its resistance level which dates back to late 1991 - just after the end of the initial Gulf War!  This may or may not currently have huge implications for oil or for the economy - but one thing is for sure - can one reasonably expect the stock market to be indifferent or to continue rising in the face of this development?  I don't think so.  Moreover, insured losses of Hurricane Jeanne is expected to be in the range of $4 to $8 billion, on top of the total insured losses of $14 to $17 billion caused by Hurricanes Charley, Frances, and Ivan.  Insurance companies will have to sell a significant portion of their bond and stock holdings in the days ahead as claims continue to trickle in.  At the least, the market should correct here.

Readers who disagree with me may either email it or post your views on the discussion forum, but now that I have gotten out of the way, let's focus on another breadth indicator I have previously used to call the bottom of the last correction - the Nasdaq High-Low Differential Ratio:

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 2003 to September 24, 2004 - Despite the Nasdaq High-Low Differential Ratio making a recent high of 3.23% on September 17th (surpassing the previous peak of 2.96% made on June 24th) - the Nasdaq Composite fell way short of confirming on the upside by bettering peak of 2,047.79 made on June 30th. This recent weakness in the large caps does not bode well for the broad market going forward - especially since the Nasdaq High-Low Differential Ratio is in the process of rolling over (it is now near the zero line).

Dear readers, please note that even as breadth (as indicated by the daily high-low differential ratio of the Nasdaq) made a new high of September 17th, the Nasdaq Composite failed (spectacularly, I may add) to confirm on the upside - suggesting that a great number of large caps on the Nasdaq has not been participating in the recent rally.  This is a bearish omen, and especially so since this ratio is now in the process of rolling over below the zero line.

The last correction ended with this ratio at (7.81%) on August 6th, but I have previously outlined that in a cyclical bull market, this ratio usually bottoms at a range of (8%) to (14%) (with the recent exception of late 1998 when this ratio bottomed at under (20%)).  History now suggests that in order to begin a sustainable uptrend, we will need this ratio to decline below the August 6th low - most probably between (8%) and (14%).  Such a reading in the Nasdaq High-Low Differential Ratio will also suggest a Nasdaq Summation Index reading below the previous low in the coming days.

Another indicator which I have using in recent days is the Rydex Cash Flow Ratio, which is a measurement of cumulative cash flows into bear and money market funds over cumulative cash flows into bull and sector funds.  Again, this is used mostly as a contrarian indicator.  An updated chart (provided by www.decisionpoint.com) as of the close on Friday is as follows (please note that the scale of this ratio has been inverted):

Rydex Cash Flow Ratio - The recent low in this ratio is comparable to the March and July 2003 lows - but history now suggests that we should have further downside to go before we can achieve a sustainable bottom.

One major reason that I had initially thought that this rally was sustainable was because of the above indicators.  Please note that at the recent bottom, the reading of this indicator got to as low as the readings during March and July of last year, suggesting that a huge number of individual investors were in cash or in bear funds - a great contrarian sign.  However, if you look at the readings during the last cyclical bull market, they were actually significantly lower at the correction bottoms compared to the correction bottom readings during the 2000 to 2002 cyclical bull market (the stock market is always full of irony and paradoxes).  Ironically, since I believe that we are still in the midst of a cyclical bull market, the Rydex Cash Flow Ratio may have to experience more extreme readings on the downside before we can achieve a sustainable bottom.  How low?  I do not know at this point, but a reading of at least 1.25 (which would represent a reading not seen since October 1999) sounds reasonable.

Now, I want to discuss an indicator which we have not discussed in awhile - that of the 10-day and 21-day moving averages of the NYSE ARMS Index.  Historically, the ARMS Index has been a much better indicator at calling for a bottom than a top - this is precisely the reason why I have not used this indicator since early August.  Following is an updated chart of the 10-day and 21-day moving averages of the NYSE ARMS Index vs. the DJIA from January 2003 to September 24, 2004:

10-day and 21-day moving averages of the NYSE ARMS Index vs. the DJIA (January 2003 to September 24, 2004)

Readers should note that my main reason for posting this is to remind my subscribers of this indicator and to ask you to keep track of this going forward, as I believe that a bottom here should be accompanied by a spike in at least the 10 DMA of the ARMS Index.  My guess is that we would not see a sustainable bottom until we see at least a reading of 1.5 to 1.6 on the 10 DMA of the ARMS Index.  I would be more confident if the 10 DMA at least touched the 1.7 level, but we should take this one day at a time.  The current reading on the 10 DMA of the ARMS Index is only at 1.28, which is still very far off from traditional oversold levels.

Since our commentary is getting so long already, I will not post updated charts of both the Investors Intelligence and the AAII surveys, but I will say this: The Investors Intelligence Bulls-Bears% Differential increased from 25.5% to 27.1% while the American Association of Individual Investors Bulls-Bears% Differential increased from 14% to 24% even as the market took a huge beating last Wednesday (right before these surveys were conducted and finalize).  From a contrarian standpoint, this is ST bearish.

I have also spoken extensively about the fact that I still believe we are in a cyclical bull market.  Readers who are skeptical should go back and read our archives of commentaries.  For the readers who are still skeptical and for the people who believe in the myth of the "three strikes and you're out" rule (the market always tanks after the third Fed funds rate hike), they should take a look at the following chart, courtesy of www.chartoftheday.com:

S&P 500 Gain After Three Discount Rate Increases - On average, 'three steps and a stumble' appears to have merit if you allow for a slight delay.

Bottom line: These people may be right, but it all depends on your timeframe.  For now, this author still believes that we are in the midst of a cyclical bull market, and that despite my anticipation of a quick (but possibly sharp) correction, I believe that higher prices are in store for the major indices in the months ahead.  Since I do anticipate a sharp correction, however, I have decided to set a stop loss on the 100% long position in our DJIA Trading System effective at the open on Monday morning.  Readers who are currently sitting out and waiting to jump back in on the long side should check back often, as I will be watching the market very closely during the next few weeks for possible signs of a sustainable bottom.  Readers who can catch the next sustainable uptrend near the beginning and hold until the termination of the cyclical bull market should stand to make a small fortune.

Signing off,

Henry K. To, CFA

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