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The Cyclical Bull Continues

(November 7, 2004)

Please note we sold our 50% long position in our DJIA Timing System on November 4th at 10,188 (at a 308 point profit) and went 25% short on November 5th at DJIA 10,368. Obviously, we would have liked to hold our long position for more than two weeks, but circumstances would not let us. Longer-term, this is still a cyclical bull market, but the market is getting very overbought on both a ST and even intermediate term basis. I believe that we will at least need another consolidation period before we continue to maintain a sustainable uptrend again, but I would not be surprised if we see a more severe decline in the days ahead. That being said, any decline that develops from here should merely be a correction within the context of a cyclical bull market and should be viewed as a buying opportunity.

Dear Subscribers and Readers:

I want to first welcome readers who are subscribers of Mr. David Korn’s BeingInvesting.com weekly e-newsletter. Mr. Korn provides a newsletter which includes his summary and interpretation of Bob Brinker's Moneytalk, as well as his own model newsletter portfolio and discussion of all things related to personal finances.  Mr. Korn has graciously asked me to be a guest columnist on his newsletter this weekend (and which I am honored to be). As a result, this weekly commentary will be longer than usual since I want to summarize a lot of things that I have written in the past on why we are currently still in a cyclical bull market – and I also believe that this will be a useful exercise for both my subscribers and for me. To justify that we are still in a cyclical bull market, I will discuss things such as the Dow Theory, the action of the Fed Funds Rate, the debate about the 50-day moving average crossing below the 200-day moving average back in July earlier this year, and both the NYSE short interest ratio and the NYSE specialist short ratio.

Readers who have been with me for awhile know that I have always tried to incorporate the discussion of Dow Theory in our commentary. It should be noted here that the concept of values and the primary trend form the basis of the Dow Theory. Everything else such as the secondary trend, the use of the Dow Industrials and the Dow Transports as confirmation that a trend has authority, and the 200-day moving average or the “50% principle” initially used by the Dow Theorist E. George Schafer is secondary. Since the Dow Theory does not often give out strong signals, I have chosen to mostly discuss other indicators that I also believe are important in our weekly commentary.

That being said, the latest action of both the Dow Jones Industrial Average and the Dow Jones Transportation Average speaks volumes regarding the longer-term trend of the stock market. What do I mean? Let’s take a look at the following daily chart of the Dow Industrials vs. the Dow Transports dating back to January 1, 2003:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to November 5, 2004) - The Dow Transports made another 5-year high last week, closing at 3,572.50 for the week while the Dow Industrials has finally closed above its downtrend resistance line which dates back to February earlier this year - suggesting that the cyclical bull market is well and alive.  Readers may not realize this - but the Dow Transports has already appreciated more than 20% from its mid-August low.

First off: The Dow Industrials has finally closed above its downtrending resistance line which has acted as a huge resistance level dating back to February earlier this year. Moreover, the Dow Transports again closed at a five-year high last Friday – at a level not seen since May 1999. Readers may not realize this, but the Dow Transports has appreciated over 20% since the mid-August bottom – in a period of less than two months! Based on the action of the Dow Industrials and the Dow Transports, the author believes that the chances of this cyclical bull market continuing in the months ahead are very high.

I now want to go on and discuss the Fed Funds rate and the relationship that it has with the stock market – in particular, the popular myth of “Three hikes and a stumble” (of whatever you want to call it) – where if the Fed raises rates three times, the stock market always takes a tumble. Is this true? Readers know that I have believed right from the beginning that we are currently in a cyclical bull market within the context of a secular bear market – not unsimilar to the 1967 to 1968 and May 1970 to 1972 cyclical bull markets within the 1966 to 1974 secular bear market (and Mr Korn’s views). That being said, let’s take a look at the action and the relationship of the Fed Funds rate vs. the Dow Industrials during the two cyclical bull markets within the 1966 to 1974 secular bear market. We will first begin with the period January 1967 to December 1969 – the cyclical bull market subsequent to the huge bear market decline during the February to October 1966 period:

Monthly Chart of Fed Funds Rate vs. DJIA (January 1967 to December 1969) - The trough of the Fed Funds Rate was made in July 1967 at a rate of 3.79%.  The DJIA did not peak until 16 months later.  At the peak of the DJIA, the Fed Funds Rate was at 5.82% (a full 200 basis points higher).  Moreover, the DJIA did not decline substantially until the Fed Funds rate hit 8.67% - a full 22 months later.

Please note the Fed Funds Rate bottomed at 3.79% in July 1967. Since that time, the Fed took a pretty aggressive stance of raising the Fed Funds Rate – rising to 6.11% by May 1968. The stock market (as shown by the Dow Industrials) did not peak until 16 moths later – when the Fed Funds Rate had reached 5.82% (a full 200 basis points higher than at the bottom in July 1967). Moreover, the stock market did not really start to decline in a substantial way until a full 22 months later – when the Fed Funds Rate hit a high of 8.67%.

Now, for the second cyclical bull market during the 1966 to 1974 secular bear market – let’s take a look at the following chart showing the Fed Funds Rate vs. the Dow Industrials during the January 1971 to December 1973 period – showing the cyclical bull market subsequent to the huge bear market decline during the 1969 to May 1970 period:

Monthly Chart of Fed Funds Rate vs. DJIA (January 1971 to December 1973) - The trough of the Fed Funds Rate was made in February 1972 at a rate of 3.29%.  The DJIA did not peak until 10 months later.  At the peak of the DJIA, the Fed Funds Rate was at 5.33% (approximately 200 basis points higher).  Moreover, the DJIA did not decline substantially until the Fed Funds rate hit 6.58% - a full 12 months later.

Again, the above chart shows a similar experience of the Fed Funds Rate vs. the Dow Industrials during the second cyclical bull market within the 1966 to 1974 secular bear market. The Fed Funds rate bottomed at 3.29% during February 1972 and again, the Fed took a rather aggressive stance towards this overnight rate subsequent to that bottom. By the time the market peaked (again, as shown by the Dow Industrials), the Fed Funds Rate has again risen a full 200 basis points – rising to 5.33% ten months after the February 1972 bottom. Moreover, the stock market did not start to decline in a substantial way until a full 12 months later when the Fed Funds Rate hit 6.58%.

How about the present experience, you may ask? The Fed Funds Rate recently bottomed at 1.0% - with the Federal Reserve starting to adopt a hawkish Fed Funds Rate policy starting in July earlier this year. Today, the Fed Funds Rate stands at 1.75% - with the expectation that it will be at 2.00% next week. With respect to both the magnitude and the time duration of the current increase, we are definitely not close to the end of this cyclical bull market if we are to follow the timeline of the two cyclical bull markets within the 1966 to 1974 secular bear market. The following chart provides a good illustration:

Monthly Chart of Fed Funds Rate vs. DJIA (January 2001 to October 2004) - The Fed Funds Rate did not start rising until June earlier this year.  If history is to hold true, then the market (as shown by the DJIA) will not top out until during the period April to October 2005, or when the Fed Funds Rate reaches at least 3% (a full 200 basis point higher than at the trough of 1%). 

If history is to hold true, then the Dow Industrials will not top out until the period April to October of next year at the earliest or if the Fed Funds Rate reaches at least 3% - a full 200 basis points higher than the trough at 1.00%. Moreover, the Dow Industrials should not decline in any substantial way unless the Federal Reserve chooses to further increase the Fed Funds Rate from that point onwards.

Based on the historical relationship between the Fed Funds Rate and the Dow Industrials (and the stock market), anyone who is calling for a top in the stock market based on the “Three hikes and a stumble” rule is grasping for straws, at best.

I now want to take the opportunity to debunk the second popular myth that the bearish crossing of the 50-day simple moving average below the 200-day simple moving average is always a bearish omen. In fact, in the early parts of a bull market, the 50-day moving average crossing below the 200-day moving average actually represents a buying opportunity (as it logically should), not as a signal to sell all your holdings. The recent “bearish crossing” of the 50-day moving average below the 200-day moving average in July (on both the Dow Industrials and the S&P 500) had many bears coming out of the closet claiming that this cyclical bull market (or “bear market rally” – whatever one wants to call it – depending on whether you are a bull or a bear) is over and that a watershed decline is approaching.

Is this necessarily true? To get a good answer, I again defer to the action of the Dow Jones Industrials during the two cyclical bull markets of the 1966 to 1974 secular bear market. Following is chart of the daily action of the Dow Jones Industrials vs. its 50 and 200 DMA during the January 1966 to December 1968 period:

Daily DJIA Chart (January 1966 to December 1968) - In the instance of a bearish cross (50 DMA crossing below the 200 DMA) during the 1967 to 1968 cyclical bull market, the DJIA had a weak rally before subsequently bottoming at approx. 6.5% below its cross over point.  It then subsequently went for a retest of its all-time high before the secular bear took over again.

The 50-day moving average first crossed below the 200-day moving average in December 1967 – a full 14 months after the beginning of the October 1966 to December 1968 cyclical bull market. The DJIA subsequently declined 6.5% below its crossover point before resuming its uptrend. Moreover, this cyclical bull market would not end until 12 months after this initial crossing. 

What about the second cyclical bull market of the 1966 to 1974 secular bear market, you may ask?   Following is chart of the daily action of the Dow Jones Industrials vs. its 50 and 200 DMA during the January 1970 to December 1972 period:

Daily DJIA Chart (January 1970 to December 1972) - In the instance of a bearish cross (50 DMA crossing below the 200 DMA) during the 1970 to 1972 cyclical bull market, the DJIA again had a weak rally before subsequently bottoming at approx. 11.5% below its cross over point.  It then subsequently broke its all-time high (which was unconfirmed by the Dow Transports) before the secular bear took over again.

The 50-day moving average first crossed below the 200-day moving average in September 1971 – a full 16 months after the beginning of the May 1970 to December 1972 cyclical bull market.  The DJIA subsequently declined 11.5% below its crossover point before resuming its uptrend. Moreover, this cyclical bull market would not end until 14 months after this initial crossing. 

So where are we now? The 50 DMA of the DJIA initially crossed below its 200 DMA back in July. This represented the first time that the 50 DMA has crossed below its 200 DMA in the current cyclical bull market. At its lowest close on October 25th, the DJIA was approximately 4.5% below this crossover point. The following chart illustrates the current situation perfectly:

Daily DJIA Chart (January 2002 to Present) - The 50 DMA crossed below the 200 DMA back in late July 2004.  Given the experience of past cyclical bull markets that are within a secular bear market, chances are that this is still a cyclical bull market despite this bearish crossing.  Moreover, if history is to hold true, then this current cyclical bull market could last another nine months to over a year.

If we are to follow historical precedent, then this cyclical bull market would not end until the period July to September 2005, at the earliest. This peak in the Dow Jones Industrials would be consistent with the peak as projected by the Fed Funds Rate analysis I have mentioned earlier. More importantly, this historical analysis suggests that we are currently still in a cyclical bull market (given the fact that the first crossing of the 50 DMA below the 200 DMA has rarely meant a reversal of the bull market) and that we are at least six to twelve months away from an important stock market peak. While this does not mean that we cannot make a lower low in the DJIA in the upcoming weeks, probability suggests that we will ultimately make a new high in the Dow Industrials in the months ahead.

While the following topic may not be as important, I believe it is important for my readers to keep in mind – that is, the topic of the NYSE short interest ratio (total amount of shares shorted on the NYSE divided by average daily trading volume for that month) and the 8-week moving average of the NYSE specialist short ratio that I have discussed in the past. The former is a contrarian indicator, while the latter represents a coincident indicator – since a low specialist short ratio represents that fact that the public is doing most of the short-selling. Both these indicators have worked well in the past. I will now again talk about the NYSE short-interest ratio even though I have already discussed this two weeks ago. This is important, and I believe my readers should keep this in mind. Following is the relevant chart:

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present)

Dear readers, please recall that there was a very significant spike in the New York Stock Exchange short interest ratio a few weeks ago. This spike took the NYSE short interest ratio to a reading of 6.7 – a reading not seen since October 2002 (at the bottom of the last cyclical bear market). This is significant. My comments from two weeks ago: “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.”

Again, while this indicator does not discount the fact that we will not have a more severe correction before we maintain a sustainable uptrend again, it does say that ultimately we should have a very strong rally in the months ahead. The conclusion of this indicator is consistent with another study involving short interest – namely the 8-week moving average of the specialist short interest ratio. Following is a study which I discussed in my September 12th commentary. Please note that the following entire section on the NYSE specialist short ratio is from my September 12th commentary:

Section on the NYSE Specialist Short Ratio

I now want to discuss the specialist short-sale ratio, an indicator which I discussed in my August 15th commentary. I have outlined in my previous commentaries of the immense short interest on both the NYSE and on the Nasdaq – particularly so on the Nasdaq. The specialist short-sale ratio is published each week and represents the percentage of all shares sold short during that week by the NYSE specialist firms – who are the brokers appointed by the NYSE to maintain orderly markets in individual stocks traded on the NYSE. The NYSE specialist short-sale ratio may not represent the bullishness or bearishness of professional traders, but it is definitely representative of the bullishness or bearishness of the public – as these specialists are generally forced to short-sell when the public is bullish (and thus buy stocks) and to buy when the public is bearish. The historically low readings we are currently experiencing in the specialist short-sale ratio represent huge bearish sentiment of the public – as this indicates that the specialists are not forced to do much short-selling in order to maintain the integrity of the stock market.

In my August 15th commentary, I stated: “… I have done extensive research to see when the market experienced similar readings in the specialist short-sale ratio. The lowest reading (prior to the most recent readings) of the 8-week moving average of the specialist short-sale ratio was November 10, 1944 – when the ratio touched 29.95%. The Dow Industrials subsequently staged a rally of over 30% in the next 12 months. The second lowest reading came on July 16, 1982 when the ratio touched 30.75%. Again, the implications were bullish and the Dow Industrials subsequently staged another rally of 30% -- this time in a period of six months instead of twelve months. The only instance when this indicator erred was on January 6, 1984 (when the 8-week moving average of the specialist short-sale ratio touched a low of 30.92%) – the Dow Industrials proceeded to decline nearly 20% in the next two months (however, the Dow Industrials traded at the top of its 52-week range immediately before we got this reading). Two other low readings (32.21% on July 27, 1984 and 31.65% on July 5, 1996) that occurred had hugely bullish implications. Using this indicator, the law of probability states that we are probably near a bottom – but most importantly, that the cyclical bull market is not over yet and that higher prices are still in store.”

I would like to take the opportunity to take my studies one step further by showing my readers graphically what happened during the months subsequent to November 10, 1944 and July 16, 1982 – when the 8-week moving average specialist short-sale ratio registered the lowest and the second lowest reading in history (at least since records were kept starting in 1943) – prior to the current reading, of course. Following is a chart depicting the 8-week moving average of the specialist short-sale ratio vs. the Dow Jones Industrials during the February 1943 to December 1946 period:

(Weekly DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (February 1943 to December 1946) - The 8-week MA of the NYSE Specialist Short Ratio bottomed at 29.95% - on November 10, 1944 - preceding a rise of 30% in the DJIA over the next 12 months and an ultimate top of the 1942 to 1946 cyclical bull market in May 1946 - at a DJIA level of 212.50 and a rise of 43% in the DJIA in the space of 18 months.

Dear readers – not only did the DJIA enjoy a 30% rise over the next 12 months subsequent to the bottom of the 8-week moving average of the specialist short-sale ratio at 29.95%, it ultimately rose 43% within the space of 18 months before the broad market topped in May 1946. The second chart depicts the 8-week moving average of the specialist short-sale ratio vs. the Dow Jones Industrials during the January 1981 to December 1983 period:

(Weekly DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 1981 to December 1983) - The 8-week MA of the NYSE Specialist Short Ratio bottomed at 30.75% - on July 16, 1982 - preceding a rise of 30% in the DJIA over the next 6 months and an intermediate top of the 1982 to 1983 bull swing in November 1983 - at a DJIA level of 1277.40 and a rise of 54% in the DJIA in the space of 16 months.

The months subsequent to the bottoming of the specialist short-sale ratio at 30.75% on July 16, 1982 was even more explosive – as not only did the DJIA surged 30% over the next six months, it ultimately rose a staggering 54% before an intermediate top was registered. As I mentioned before, “the only instance when this indicator erred was on January 6, 1984 (when the 8-week moving average of the specialist short-sale ratio touched a low of 30.92%) – the Dow Industrials proceeded to decline nearly 20% in the next two months (however, the Dow Industrials traded at the top of its 52-week range immediately before we got this reading).” Readers should note, however, that the DJIA had recovered this loss by the beginning of 1985, and that over the next 18 months, the DJIA rallied another 110% before finally surrendering to the October 1987 crash. Again, the two other low readings (32.21% on July 27, 1984 and 31.65% on July 5, 1996) that occurred had hugely bullish implications.

[End Section from my September 12th commentary]

So what is the NYSE Specialist Short Ratio saying now? Recall that the 8-week moving average specialist short-sale ratio made a bottom at 21.80% on August 27, 2004 - the lowest reading in the history of the NYSE! The following chart illustrates this perfectly:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to November 5, 2004) - The 8-week moving average of the NYSE Specialist Short Ratio declined slightly from 25.16% to 24.56% last Friday but even though this ratio may continue to decline in the next few weeks, probability still 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.

The 8-week moving average of the NYSE Specialist Short Ratio declined slightly from 25.16% to 24.56% last Friday – representing the second week that this ratio has again declined. However, while this does not mean we cannot have another correction going forward, probability does suggest that the reversal off the August 27th level was a legitimate reversal. Coupled with the bullishness of all the other indicators I have previously mentioned, I believe that this indicator will, again, have hugely bullish implications over at least the next six to twelve months.

This bullish assessment of the stock market would not be complete without a couple of relative strength charts that I have discussed in the past. I would first update the relative strength of the retailers (as shown by the American Exchange HOLDR RTH) vs. the S&P 500. Following is the relevant chart:

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 latest uptick represents the third week that the relative strength of the RTH has broken out above its recent upside resistance line.  The magnitude of the jump also represents a very decisive breakout and suggest further gains ultimately for the stock market.

Dear readers, please recall that 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. Also note that during the last week, RTH relative strength again held firm above its latest upside resistance line for the third week in a row. More importantly, this latest uptick represents a decisive breakout of the sluggish performance of the RTH relative strength which had persisted since the beginning of this year. Not only is this a positive development for the overall stock market, this decisive breakout is implying that the cyclical bull market is definitely not over yet. The fact that the RTH made a new 52-week high on Friday makes this breakout doubly bullish.

Another relative strength chart which I had kept an eye on (especially in light of the Federal Reserve adopting a hawkish Fed Funds Rate policy) is the relative strength of the Bank Index vs. the S&P 500:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 2) Relative strength of the Bank Index still has not violated support -- suggesting the cyclical bull markeet should continue.

Again, please also note that the relative strength of the Bank Index vs. the S&P 500 has been a very good leading indicator of the stock market in general over the last ten years. Currently, the relative strength of the Bank Index vs. the S&P 500 is still above a support line which dates back to May 2003. Until the Bank Index relative strength line breaks below this support line, there is still room for the current cyclical bull market to grow.

Short-Term Considerations

While I am bullish on a longer-term basis, recent developments have convinced me that it is probably not a good idea to start purchasing common stocks following the latest rise in the stock market. Why? Pure and simple: The stock market is overbought – very overbought. For example, as of the close on Friday, 83% of all issues on the NYSE were above its 50-day EMA, something which has not happened since late January earlier this year. The percentage of stocks in the S&P 500 that was above its 20-day EMA and 50-day EMA was 92.2% and 88.6%, respectively. This is similar to the experience of the Dow Industrials, where the percentage of stocks that was above its 20-day EMA and 50-day EMA was 90.0% and 83.3%, respectively. The Dow Transports? 85% and 90% as of Friday at the close. How about the Dow Utilities? 93.3% and 100% as of Thursday at the close!

The Rydex Cash Flows ratio is now at 0.72 – a level which has not been seen since late June. I am not going to post this chart since there are so many charts in this commentary already, but after a slight decline to 30.9% last week, the Bulls-Bears% Differential in the Investors Intelligence Survey increased to 33.3% this week. This reading has increased nine out of the last ten weeks - suggesting that sentiment may need to correct (or consolidate) here before the market can maintain a more sustainable uptrend. This latest reading is also consistent with the readings that I am seeing in the American Association of Individual Investors Survey and in the Market Vane Bullish Consensus Survey. Moreover, the latest commentary from Mark Hulbert states that his proprietary HSNSI (the Hulbert Stock Newsletter Sentiment Index) is at a reading of 48.9% - which represents the highest reading since June 2003, or some 17 months ago. Since these sentiment indicators have all been pretty reliable contrarian indicators in the past, one should be very careful if one is thinking about purchasing stocks in the near-term.

Finally, Friday’s action of the IBD Top Ten Stocks leaves a lot to be desired, as they developed significant weakening during the day even though the overall market was strong. Following is a table illustrating this action – comparing the intraday high and the closing level on Friday:

IBD Top 10 Performance - November 5th

The most notable weakness occurred in Travelzoo, Google, and Monarch Casinos as they all closed significantly lower than the intraday high. Taser and the Chicago Mercantile Exchange were not far behind. Could momentum players be losing their infatuation of the stock market or is there an exhaustion of these players? Either way, this should not be bullish for the stock market at least in the short term if the strongest stocks cannot participant in a rally going forward.

Bottom line: While the cyclical bull market is definitely not over yet, investors who want to purchase some common stocks going forward should pick a better entry point, as the market is now very overbought on a ST basis. At the least, there should be more of a consolidation period ahead. However, I would not discount a more severe correction that may take us below the October 25th lows (readers should keep in mind that any such decline represents a buying opportunity, however). This is why we are currently 25% short in our DJIA Timing System. Again, we reserve the right to change this stance on an intraday basis but readers should keep in mind that we also post any such changes in real-time on our MarketThoughts.com discussion forum under the “Special Alerts” section. Please stay tuned.

Signing off,

Henry K. To, CFA

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