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25% Short Position in the DJIA Covered

(October 24, 2004)

Please note we covered our 25% short position in our DJIA Timing System on the morning of October 23rd at DJIA 9,880 (at a 205 point profit) and subsequently went 50% long at the same price. Obviously, we were early – but since I believe this is still a cyclical bull market, I believe this position will work out. More details to follow in this commentary.

Dear Subscribers and Readers:

This will be an abbreviated commentary, but this does not mean that this commentary will not be important. In fact, what I am about to communicate to you may be (I think) one of the most potentially important developments in the domestic stock market in recent months. Why? Please read on and find out.

Readers who have read and followed my commentaries know that I have maintained that we are still in a cyclical bull market – a bull market which began in October 2002 and which should still have more room to run. That being said, I still believe that this cyclical bull market is occurring in the midst of a secular bear market, not unsimilar to the two cyclical bull markets (1967 to 1968 and May 1970 to 1972) that we had during the 1966 to 1974 secular bear. At some point, this cyclical bull market will end – and it would give way to another bear market – a two to three-year bear market which should be similar to the 2000 to 2002 period.

It should be said here that major tops in the stock market are inherently difficult to call. Bottoms are usually easier – as they tend to develop much quicker (the fear of losing money is a much stronger emotion than the fear of missing out a chance to make money), while tops are much more difficult to call because it is a process which takes longer to develop, as investors tend to get into the stock market over time. That is, unless a panic near the bottom, they do not try to get in or get out at once.

The late 1990s was a grand example of many “early calls” of an impending top in the stock market – only to see the major indices make high after high – even throughout the many major crisis such as the 1997 Asian Flu, the 1998 Russia, Brazilian, and LTCM crises, and the fear of a Y2K crisis in late 1999. When the P/E ratio of the S&P 500 surpassed the level of 20 in early 1997, people thought it was the sign of an impending top, as it was a level in which a lot of prior major tops were made – such as the major tops in late 1929, mid-1946, early 1973, and August 1987. Following is a chart courtesy of showing the current and historical level of the S&P 500 over the last 30 years – with a comparison where the S&P 500 would hypothetically be should it be trading at a P/E ratio of 10 (historically undervalued), 15 (historically fair valued), or 20 (historically overvalued).

S&P 500 Index Relative to Normal P/E Range - The P/E ratio of the S&P 500 surpassed its traditional overvalued level of 20 in early 1997, and yet the S&P 500 continued to make high after high, even as earnings growth decelerated into late 1999.

In retrospect, these many calls for a top were wrong, especially the many people who called for a top simply because of the P/E ratio surpassing the historically overvalued level of 20. They then said: “Surely, the collapse of the Asian Tigers starting in mid 1997 would spell the demise of the stock market?” At the time, commodities and basic material prices collapsed around the world, and capital fled and steered away from risk – including from the global and U.S. equity markets. The earnings of all public companies in America as a percentage of GDP also topped out in the third quarter of 1997. The advance-decline line on the NYSE topped out as early as April 1998 – suggesting that the majority of stocks on the NYSE has already topped. The Asian Flu and the collapse of the world commodity markets started a chain reaction, and soon after, both Russia and Brazil were mired in a crisis of their own. In the midst of all these crises, the high-profile hedge fund led by John Meriwether nearly collapsed, and eventually had to be bailed out by the Federal Reserve and the major investment banks in the United States. All the major stock market indices collapse. The S&P 500 violated its 200-day moving average – a technical violation which was only last seen in 1994. The major investment banks laid off thousands of people. Surely this was the end, they ask?

Well, not really. The best was yet to come, as the S&P 500 bottomed in late 1998 and proceeded to rise approximately 50% over the next 18 months. This “blow off top” killed many of the bearish traders and bearish stock market analysts. The bull market did not end until the last bear was carried out by a stretcher, so to speak. In my March 5, 2000 “Special Report”, I stated at the time that all the bears have been ostracized or ignored and even the last bear was “in.” This was exemplified by the ousting of Dr. Doom (Tony Dye), who at the time was Chief Investment Officer at Phillips & Drew (an investment firm based in London), and who adopted a pessimistic stance on the UK stock market as early as 1995.

So why the verbose talk? If you meet me in real life, you will find out that I tend to repeat myself very often when I am illustrating an important point. Perhaps I am wasting my breath, but I believe this is important: Bull market tops (even tops in cyclical bull markets) are inherently difficult to call. A lot of the best traders have tried to do it, and they have failed more than they have succeeded. Some of them have made money on the net, but not before they have failed many times in calling for a top. A market rarely tops out concurrently with bad news. More often than not, a market tops out when there is an abundance of good news – such as the many rosy earnings reports that we got during the spring to summer 2000 period. With the huge uncertainty over the supply/demand situation of crude oil, natural gas (we will come to that in a minute), the elections (and all that comes with it), I can say that a lot of investors are now staying on the sidelines (or even shorting stocks in general). At the same time, the differential between Lowry’s buying power and selling pressure has been making multi-year lows. The positive momentum of earnings growth is still strong, and the Fed Funds rate is still currently sitting at 1.75%. Again, let me say this: Probability suggests that the cyclical bull market has not topped out yet – and it will not top out until we have seen a more speculative period in U.S. stocks – similar to the huge upsurge in small cap stocks in the 1968 to 1969 period or the rise of the “Nifty Fifty one-decision stocks” during the May 1970 to 1972 period.

Following is a list of reasons why I think we are near at least a ST bottom and why that it actually may be sustainable (some of these are repeated from my “Special Alert” on Friday morning):

1)     Some stocks that we have been shorting or intending to short are exhibiting some relative strength. For example, the action of Fannie Mae (FNM) has been considerably favorable even after the announcement of an official SEC investigation into its accounting. We also recently shorted Nordstrom (JWN) precisely because of its recently lousy technical action and because of a good entry point right below its 50-day moving average (which has acted as resistance). The stock proceeded to gap up above its 50 DMA and has managed to stay there even with the weakness of the stock market over the last couple of weeks.

2)     The high possibility of a breakout in the relative strength of the RTH (the Retail HOLDRS being traded on the American Exchange) vs. the S&P 500. Relative strength of the RTH vs. the S&P 500 has tended to lead the stock market over the last two years. If oil prices are hampering the retailers, then we are not seeing it in the following chart. My advice: Watch the action in the RTH over the next week or so for more clues of a sustainable bottom in the U.S. stock market!

Relative Strength (Weekly Chart) of the Retail HOLDRs vs. the S&P 500 (May 2001 to Present) - 1)Relative Strength of the RTH bottomed and reversed in January 2003 - providing clues a major market rally was under way. 2)Relative Strength of the RTH topped and reversed a few months before the broad market topped. 3) Is the relative Strength of the RTH in the midst of a breakout of its recent trading range?  Again, a decisive breakout here would be very positive for the stock market.

3)     The bearishness of individual investors as indicated by the net outflows of $267 million from domestic equity funds for the week ending last Wednesday. Moreover, I do not remember individual investors being super bullish (a weekly inflow greater than $2 billion) since the bounce from the August lows. Over the last 12 months, it has usually been a good time to buy stocks following a weekly net outflow of money from domestic equity funds.

4)     A spike in the New York Stock Exchange short interest ratio (total number of shares shorted over average daily trading volume) has recently spiked to 6.7 – a reading not seen since October 2002 (at the bottom of the last cyclical bear market):

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present) - Note that the SI ratio as of last week spiked to a level not seen since the October 2002 level.

Please note that over the last ten years, a spike in the NYSE short interest ratio to such a level has nearly been always bullish for the stock market, with the exception of the July 1998 spike. Readers should keep in mind, however, that the subsequent decline occurred after a near-unprecedented 3 ½ year run in the stock market which saw the DJIA more than double from a level of 3,900 in January 1995 to more than 9,000 in July 1998. Moreover, this decline only brought the DJIA back to the 7,500 level, which was the level that the DJIA began from during 1998. Because of this, I believe the recent spike in the short interest ratio has very bullish implications.

5)     An increase of 200 million shares in the NYSE from August to September 2004. NYSE short interest is now just 250 million shares shy of the all-time high in October 2002, as shown by the following chart:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to October 15, 2004) - For the month ending October 15, 2004, total short interest on the NYSE rose by more than 200 million shares.  Again, short interest on the NYSE is now at a high not seen since June 13, 2003 -- and just 250 million shares shy of the all-time high in short interest set on October 15, 2002.

6)     The recent spike in insider buying and cash takeovers as reported by TrimTabs over the last week – along with the lack of IPOs and offerings should be another bullish pillar that will support stock market liquidity. TrimTabs has reported that whenever the Dow Industrials has fallen below the 10,000 level, corporate executives have opened their wallets and either used cash to buy back their own shares or shares in other companies.

7)     The reversal of the 8-week moving average of the specialist short ratio from an unprecedented low level of 21.8% and the continued rise over the last eight weeks:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to October 22, 2004) - Probability now suggests that the reversal off of the historically low 21.8% level made on August 27th was a legitimate reversal.  If this is true, then the implications for the stock market over the next several months will be very bullish.

Please note that during the reversal from the July 1982 bottom, the Dow Industrials dropped a further 5.5% before reversing to stage a rally of more than 30% during the next six months. Thus, this current delayed reaction from an index such as the Dow Industrials is not unprecedented.

8)     The further spike in oil prices and natural gas prices over the last week or so is driven by fear more than anything else (it really doesn’t matter that these same analysts who are now calling for $75 a barrel oil prices did not see oil >$45 a barrel before it was too late). The spike in natural gas, in particular, was mostly due to fear from short-covering and the fear of colder weather this winter – despite the fact that winter weather predictions that are made in October has historically been very unreliable. The weekly natural gas storage report released by the Energy Information Administration suggests that current inventories in natural gas are 5.1% higher than year-ago levels and 7.4% higher than the 5-year average in this same period during the year. Moreover, the Strategic Petroleum Reserves is now filled with 670 million barrels of oil, just 57 million barrels short of its total capacity and is now at a historically high level (the President has continued to fill up the SPR even with historically high oil prices). The fact that oil and natural gas prices have spiked again suggests that fear on the part of individuals is high, even though the VIX may be indicating otherwise.

9)     While polls show that the election race may be very close, the betting odds at and the Iowa Electronic Markets show that Bush has a 59% and a 58% chance of winning the election, respectively. Historically, the forecasting abilities of futures markets in a Presidential election have been much more accurate than national polls. Don’t shoot me – I am only the messenger. The closer we are to the election, the more apparent we will know who the winner is. Once this uncertainty is lifted, we should finally see a sustainable uptrend developing in the stock market.

Bottom line: The more I think about it, the more that I think the latest correction ended (or will end) with a “whimper” instead of a hard thud. The market did not really get too overbought from the August lows so the chances of an acceleration in the downside over the next couple of weeks is not that high. If you have absolute faith that this cyclical bull market has already topped out, and that we are due to enter into a period similar to the 2000 to 2002 bear market, then by all means, stay in cash – but do not short the U.S. stock markets. We reverse our 25% short position in our DJIA Timing system on Friday morning because the DJIA was oversold, and also because we believe that this is a cyclical bull market. Of course, the correction may (or should?) continue further this week – but we intend to establish a 100% long position in the DJIA at some point in the next five to ten trading days – precisely because I do not think the cyclical bull market has topped out yet.

Signing off,

Henry K. To, CFA

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