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Election Jitters

(October 31, 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.  The DJIA closed at 10,027 on Friday - giving us a 147 point profit on our long position so far.  Since I believe this is still a cyclical bull market, I believe this long position will continue to do well.

Dear Subscribers and Readers:

It is good to be back after two weeks of intensive studying for my actuarial exam.  I would first like to take this opportunity to thank our subscribers for the continued support of this website and for our commentary.  We are currently thinking of more ways to improve our website and we would like your input and suggestions.  Specifically, we would like to see what kind of content you like and what things you would like to see featured more often on our website.

For example, would you like to see more book reviews?  Or more individual stocks commentary?  A history of Gann and his tools, perhaps a study of Jesse Livermore's trading, or an evaluation of Philip Fisher's methods in analyzing companies?  We are currently also thinking of providing a chart page where we will update the charts that we care about the most more often - such as every Tuesday and Thursday evening, for example.  These are just examples we have thought about - we would definitely like to see what our readers have been wanting the most.  Please participate in our poll being currently conducted on our discussion forum and let us know what you think (please note that you have to be a registered poster before you can cast your vote on our discussion forum)!  Alternatively, you can also respond by sending me an email at hto@marketthoughts.com.  We appreciate your input and your support!

Let's now go straight to our commentary.

No doubt both Wall Street and Main Street will be focused on the upcoming election this Tuesday.  Since everyone will be talking about the election and its impact on the stock market over the next one-and-a-half days, I will refrain from doing that.  I don't believe any further additional analysis will provide much value, but that being said, I would like to point out a couple of things.

In last week's commentary, I discussed the fact that the futures market has been more accurate than various polls conducted during the time leading up to a Presidential election.  Specifically, I mentioned that "While polls show that the election race may be very close, the betting odds at TradeSports.com 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."  As I am writing this (Monday morning), however, the odds of Bush winning (per TradeSports.com) has declined into the 55 to 56% area, suggesting that the election's results are now more uncertain than before.

Secondly, the following chart shows the historical action of the Dow Jones Industrial Average during election years.  Specifically, it shows 1) the average performance of the DJIA during an election year 2) the average performance of the DJIA when an incumbent party had won 3) the average performance of the DJIA when an incumbent had lost.  The red dot near the bottom right-hand corner shows the level of the DJIA as of the close on October 26th - suggesting that the DJIA is currently out of whack compared to the average performance of the DJIA during all election years (no matter who had won).

Historical action of the Dow Jones Industrial Average during election

So how would one interpret the above chart?  If you are a bear, then you may say that this chart shows the bulls have been wrong, and that they will continue to be wrong since we are currently in a secular bear market.  If you believe that we are currently still in a cyclical bull market (which I still believe in), then you will most probably think that the latest action has been out of whack, and that a regression to the mean is in order for the Dow Jones Industrials.  I believe that no matter who wins on Tuesday, the market as shown by the Dow Jones Industrials, the Nasdaq, and the S&P 500 will ultimately rally into the end of this year.

At first glance, one may think that a Kerry win will be bearish for the stock market, at least on a ST basis.  This may be true, but historically, a Democratic President accompanied by a Republican-controlled Congress has been the most bullish combination for the stock market on a longer-term basis.

I am now going to update my readers on the action of the Dow Jones Industrials vs. the Dow Jones Transports over the last week or so.  Following is the familiar chart - a very important chart from a classic/mechanical Dow Theory point of view:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to October 29, 2004) - The Dow Transports made another 5-year high last week, closing at 3,497.42 for the week.  The three-week divergence in the two Dow Indices finally ended (with the Dow Industrials closing lower every week for the last three weeks at the same time that the Dow Transports was making high after high) - with the Dow Industrials closing 2.76% higher for the week.  Next target for the Industrials: The 10,239.92 minor high made on October 6th.

Please note that the Dow Transports made another five-year high at the close on Friday.  The latest weekly uptick in the Dow Industrials ended a three-week divergence of the two popular Dow Indices, where the Dow Industrials have been declining every week while the Dow Transports have been rising at the same time.  The next upside target for the Dow Industrials is a close of 10,239.92.  A close above that level will be a serious reaffirmation of the recent uptrend in the stock market.  The action of the Dow Transports has also been spectacular, to say the least.  The recent peaking in crude oil prices should only help the Dow Transports going forward.  Readers who have not read not article highlighted by John Mauldin's "Outside the Box" feature should do so at the earliest moment - reading it will definitely give you a better perspective on the current supply/demand situation in oil.

Readers should recall what I wrote last week and reemphasized time and time again - that a bull market top is inherently difficult to call.  A lot of the smartest traders of the modern era has tried to do it and failed.  Perhaps you recall the story of Jesse Livermore who made a one million dollar fortune in the Panic of 1907 by shorting common stocks?  Why, at one point in the midst of the panic, there was not a single bid for Union Pacific.  Think of it, the Union Pacific was the most popular stock of that era, the bluest of the blue chips!  All Livermore had to do was send in a few more orders to short the most popular stocks of the time and the entire NYSE would have had to shut down - and possibly ushering a great smash in the general economy.  Of course, J.P. Morgan (who was undoubtedly the most powerful figure in America at that time - Teddy Roosevelt would come a distant second) eventually came in and saved the day, but not before he had to send a personal message to Livermore asking him not to short any more common stocks.  Livermore, of course, realized the gravity of the situation; and at the end of the day, not only did he not short any more common stocks, he actually covered all his positions and went fully long in his portfolio.  Livermore was only 30 at the time.

This great coup by Livermore made him more of a legend than ever before, but let's rewind this story a little bit - say, to six months earlier.  It is to be said here that Livermore actually tried to establish a sizable short position in the stock market three times before he succeeded on the fourth time.  The third time almost made him broke, and eventually had to borrow a sizable sum of money in order to finance his shorting activities.  Just think about it!  Jesse Livermore, one of the greatest traders who ever lived and dubbed "The Great Bear" by friends and foes alike - consistently making incorrect topping calls on the stock market!  By the fourth time, it was plainly obvious to him that the market was on its last legs - it was also plainly obvious to most people who are familiar with the stock market.  But they have been wrong too many times, and so they were cautious and possibly even had long positions in the stock market - not unlike during the January to March 2000 "blowoff" period.

Look - while I believe that we are still in a cyclical bull market, this cyclical bull market will top out in due time, but I do not intend to call a top in this bull market until it is plainly obvious to me.  And right now, I just do not see it.  When will this be obvious to me, you may ask?  Good question.  I want to see a more speculative period before I can reasonably call a top.  I want to see more P/E expansion.  I want to see more speculation in stocks that have no earnings.  I also want to see a test of the all-time high in margin debt and a huge decline in short interest.  I want to see huge monthly inflows into the most popular momentum funds.  From a Dow Theory point of view, I want to see an all-time high in the Dow Transports UNCONFIRMED on the upside by the Dow Industrials.  I also want to see this all happening while the Federal Reserve is raising interest rates.  This will be the best time to short common stocks, and not a moment before.

Next, I want to show my readers two charts which I believe are vitally important to our analysis and for gauging the health of the U.S. stock market.  I have previously discussed these two charts in our previous commentaries - one showing the relative strength of the semiconductors (as shown by the SOX) vs. the S&P 500 and one showing the relative strength of the retailers (as shown by the American Exchange HOLDR RTH) vs. the S&P 500.  Following is a weekly chart showing the relative strength of the SOX vs. the S&P 500 which I have updated from my September 12th commentary:

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. Relative strength of the SOX vs. the S&P 500 bottomed eight weeks ago at its lowest level since February 2003!

A little bit of a refresher.  In my September 12th commentary, I wrote: "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."

Since eight weeks ago, the relative strength of the SOX vs. the S&P 500 has indeed reversed to the upside and it now looks like that the recent down cycle in the semiconductor industry is over for now.  Since the semiconductor industry is a very cyclical industry and a very important leading indicator for the NASDAQ in general, I believe the continued upside in the relative strength of the SOX is a very positive development for both the broad stock market and in particular the NASDAQ Composite.

The second relative strength chart - the RTH (the American Exchange Retail HOLDR) vs. the S&P 500 - is a chart which I showed in my previous week's commentary and which I have updated to incorporate the latest weekly data:

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) The recent uptick is the second week that the relative strenght of the RTH has broken out above its recent upside resistance line.  While this is a good development for the stock market, the authority of the recent breakout is still somewhat questionable.  Again, a decisive breakout here would be very positive for the stock market.

Again, the relative strength of the RTH vs. the S&P 500 has acted as a very good leading indicator of the stock market over the last two years.  Please note that during the last week, RTH relative strength rose slightly and once again held firm above its latest upside resistance line.  While this recent breakout is still not totally convincing (yet), it nonetheless is a positive development for the overall stock market.

Now, onto sentiment indicators.  Consumer confidence data was released by the Conference Board last week, and now is a good time to update this monthly chart of Consumer Confidence vs. the Dow Jones Industrials:

Monthly Chart of Consumer Confidence vs. DJIA (January 1981 to October 2004) - The recent peak in Consumer Confidence was registered at 105.7 three months ago.  Consumer Confidence again fell from a revised September reading of 96.7 to an October reading of 92.8.  This latest washout, coupled with the recent action in the stock market suggests we have put in a sustainble bottom.

Please note that the consumer confidence readings have actually acted as a very reliable contrarian indicator over the last 20 years.  In my previous commentaries, I mentioned that we needed to see some downside in the Consumer Confidence readings before I could be comfortable in calling for a sustainable bottom.  Consumer Confidence actually declined from a level of 96.7 in September to a level of 92.8 in October - a pretty decent decline.  While my ideal reading was for a reading below 90 (and preferably a reading below the 88.5 reading that we got in February/March earlier this year), I now believe a reading of 92.8 would provide enough "fuel" to create a sustainable uptrend going forward.

Meanwhile, the Bulls-Bears% Differential in the Investors Intelligence Survey shows a slight downtick last week - declining slightly to 30.9% from a minor high of 35.4% registered the week before.  This slightly downtick also broke the eight consecutive week uptrend in this indicator.  Based on sentiment as registered in this survey, this slight downtick is a good development, although I would like to see lower numbers and more of a consolidation in the stock market before we move up again:

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present) - After a brief spike to 35.4% last week, the Bulls-Bears% Differential in the Investors Intelligence Survey declined slightly to 30.9% this week - breaking the streak of eight consecutive weekly increases in this sentiment indicator.

The Bulls-Bears% Differential in the American Association of Individual Investors is showing more pessimism, as it declined yet again from 14% to 10% late last week - a month-low reading.  Again, from a sentiment standpoint, this latest development is good, as it doesn't show any signs of the market being overbought even though the market has rallied somewhat during the last week or so.  This latest reading also should provide more "fuel" for the market to go up once the election uncertainty has been lifted.

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The latest reading of only 10% in the Bulls-Bears% Differential in the AAII survey is definitely not showing any overoptimism on the part of individual investors.  We are currently comfortable with our 50% long position in our Dow Jones Industrial Average Timing System.  This reading should tick higher next week as the next President is finally elected - barring any surprises in the upcoming election (such as another recount similar to the 2000 election).

Bottom line: While the market may be slightly overbought currently, I am pretty comfortable with out 50% long DJIA position and will most likely average down on any further weakness.  I will also set a stop loss on our 50% long DJIA position this Wednesday once the election results have been finalized (hopefully).  I still believe that the latest correction ended (or will end) with a "whimper" instead of a hard thud.  Readers please stay tuned.

Signing off,

Henry K. To, CFA

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