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Market Still at Crossroads

(October 3, 2004)

Please note that the 100% long position initiated on August 19th was stopped out last Monday morning at our entry point.  No new signals as of now.

Great news: Mr. John Mauldin of www.frontlinethoughts.com is coming to Houston the coming weekend and I am tentatively scheduled to meet him - I am planning to conduct an "interview" with him on a one-on-one basis (he has currently agreed to it).  Again, I have always admired and respected his work a lot and I am very excited to be able to meet him in person.  Readers who are interested may send me their questions - I will attempt to ask them for you when I meet Mr. Mauldin.  Because of the need for me to finalize my preparation for this "interview," I am writing an abbreviated commentary today.  Thank you for your patience!

Also, Mr. Dion Archibald of the business motivation website Woopidoo! expressed an interest in my Dow Theory article and has published it on his website.  There are also tons of very interesting business articles on his website (along with biographies of various successful business people) - things on time management, marketing, leadership, etc., that I believe my readers may find of interest. 

Dear Subscribers and Readers:

I still need to finish preparing for my "interview" with Mr. John Mauldin so let's cut right to the chase today.  The markets are as confusing as ever, but I am still of the position that we will need a significant correction in the broad market before we can have a sustainable bottom and subsequent sustainable uptrend.  True, the Dow Transports, the S&P 400, the S&P 600, and the equal-weighted S&P 500 are all near 52-week highs (all-time highs in most of these cases) but these indices were also near 52-week highs just prior to the March and May corrections.  The broad market was also near an all-time high prior to the 1969 to May 1970 and 1973 to 1974 cyclical bear markets.  In all of these cases, the one thing that provided a clue as to where the near-time direction of the market is heading was the Dow Theory.

So what is the Dow Theory saying now?  Let's take a look at the following chart which my readers should be familiar with:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to October 1, 2004)

The Dow Jones Transports made a five-year high on Friday - but the Dow Jones Industrials once again failed to confirm on the upside.  More importantly, the latest non-confirmation by the DJIA continues the recent trend of higher highs on the DJTA accompanied at the same time by lower highs on the DJIA.  Please also notice the four declining peaks traced out by the DJIA and the fact that the DJIA is still trading within its downtrend channel dating back to February of this year.  All of this is unprecedented and suggests the high possibility of an upcoming correction in the broad market.  At the least, the DJIA should again touch the support of the downward channel before we can embark on an uptrend again, but the author's guess is that the DJIA will need to briefly penetrate this support before we can achieve "capitulation" and maintain a sustainable bottom and subsequent uptrend in the market.  Let me say this: The refusal of the DJIA to maintain a strong uptrend is something that should be taken seriously.  The failure of the 30 most prestigious companies in the United States to perform well is significant - if they can't perform well, who can?

In Wednesday's commentary, I re-introduced to my readers the M-3 vs. the DJIA chart I have shown in the past - and the significance and implications of slow or lack of M-3 growth.  Conclusion: The market has not done well when M-3 growth has slowed during the last few years.  The data for the week ending September 20th was updated Thursday evening.  During the week, M-3 (seasonally adjusted) increased a whopping $44.1 billion!  M-3 is now at an all-time high but given the recent lack of growth in this monetary indicator, I believe we will need to see continued, consistent growth before this will have a positive effect on the stock market.  While the latest increase is a positive development, a one-week growth of $44.1 billion is not significant in the grand scheme of things.  Heck, it doesn't even stand out on the latest chart:

Weekly M-3 vs. Dow Industrials (January 1, 1999 to September 20, 2004)

Even if M-3 continues to grow consistently during the next few weeks, the effects of this growth probably won't be felt in the stock market until a couple of months from now.  For now, the recent lack of M-3 growth still reaffirms my position that a correction is just up ahead.

I also want to point out to my readers the recent experience of the 10-Day ARMS Index.  Following is a chart outlining the daily action of the 10-Day and 21-Day ARMS Index vs. the Dow Jones Industrials from January 2003 to the present:

10-Day & 21-Day ARMS Index vs. the Dow Jones Industrials (January 2003 to Present)

Dear readers, please consider this: The huge spike in the 10-day and the 21-day ARMS Index was not enough to put in a sustainable bottom for the DJIA back in March.  Again, the recent two spikes during July and August of this year also failed to put in a bottom - exemplified by the fact that the rally from the August lows has not been very strong so far.  The DJIA is also still within the trend of four declining peaks.  Probability-wise, can one seriously say that the recent spike was a sign of sustainable bottom?  No - logic tells me that we will need another spike in both the 10-day and the 21-day ARMS Index (one that will be comparable to the spikes during March 2003 and March 2004) before we can achieve a sustainable bottom and subsequent uptrend.

Readers haven't seen the following chart in about a month.  However, I believe the following chart is important - in that the following indicator may have turned bearish after being so bullish during the period from April to August.  Before I go further, following is the chart of the Insider Sell-to-Buy Ratio vs. the Month-End Closing of the S&P 500:

Insider Sell-to-Buy Ratio vs. the Month-End Closing of the S&P 500 (December 2002 to September 2004)

Readers may criticize the usefulness of the insider sell-to-buy ratio by pointing out to the fact that the market has not been able to rally during the April to August period - despite the bullishness of this indicator.  If this indicator was not useful during that period, then we do not need to listen to it now, even though this indicator is now flashing bearish signals.

I disagree with this hypothesis.  This indicator was flashing very bearish signals prior to the March 2000 top, and this indicator again called a top during February earlier this year.  My hypothesis is as follows: The failure of this indicator (the lack of a market rally despite the bullish signals flashed by this indicator) during the April to August period indicates that the market is inherently weak.  In other words, if insider selling has not been subdued, the market would have tanked further.  It all depends on what the current trend is.  If the market is in an uptrend, then a high insider sell-to-buy ratio may only indicate consolidation before a further rally.  Conversely, if the market is in a downtrend, a low insider sell-to-buy ratio may also represent consolidation before an upcoming plunge.  The recent high insider sell-to-buy ratio during September reinforces my belief that there should be a significant correction right up ahead.

The sustainability of high oil prices continues to bother me.  The fact that the November NYMEX contract closed at an all-time high while the Dow Transports made a new five-year high is also fascinating.  The willingness to pay premium prices to transport commodities and basic materials and consumer goods from other countries continues - but all this time, our "old Industrials" are suffering.  Can this go on?  At some point, something will have to give.  World demand data for the second quarter still has not been released by the EIA yet, but I will alert my readers once this data has been released.  At this point, it is difficult to envision a decline in crude oil and natural gas prices unless the market suffers a significant correction.  Following is the updated chart of the relative strength of the American Exchange Oil Index vs. the S&P 500 - relative strength again made a new 13-year high at the close on Friday:

Relative Strength (Weekly Chart) of the American Exchange Oil Index vs. the S&P 500 (August 1983 to Present)

The American Exchange Oil Index made an all-time high on Friday - and this is now the second week that relative strength has broken out of its resistance level - a resistance level which has held since late 1991!  Can the Dow Transports and the broad market continue to go up even as oil prices maintain its current level or continue to increase?  I have said this before and I will say this again: The relative strength of the American Exchange Oil Index vs. the S&P 500 breaking out of its 13-year resistance level is no small matter, and it should be taken seriously.

Bottom line: This author believes we will need a significant correction before the cyclical bull market can resume.  The action of the last week or so does not change my beliefs - and chances are that we will have the correction sooner than later.

Signing off,

Henry K. To, CFA

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