Market Thoughts
Links | Sitemap | Search:   
  Home  > Commentary  > Archive  > Market Commentary  

Liquidity Overwhelms All Else

(November 14, 2004)

Please note that we covered our 25% short position in our DJIA Timing System on November 11th at 10,450 (at an 82 point loss) and are currently flat. We are looking for an entry point back on the long side and are currently waiting for our ST indicators to at least go back to more neutral levels before jumping in. I also want to thank Mr. John Mauldin for graciously including a link to our interview with him on his latest weekly e-letter. I respect his work a lot – readers should check it out at his commentary website at

Dear Subscribers and Readers:

Despite the overbought short-time indicators, despite the bullish sentiment, and despite the potential bearish and bad economic news looming on the horizon, the broad market continues its relentless rise. A lot of bears who have been looking for a market top are getting killed on the short side, and some are just sitting here dumbfounded as the latest rise seemed to defy all logic. What can I say? My commentaries over the last six months or so have nearly always had a bullish bias, as I have emphasized and reemphasized that we are still in a cyclical bull market. BY DEFINITION, a cyclical bull market cannot be over until the last bear has been carried out on a stretcher, so to speak. The final rally always looks the best, and it is this final rally which sucks in everyone and their capital and which causes the widespread capitulation of all the bears on the short side. This has happened in every cyclical bull market in U.S. financial history and it is going to happen again. Right now, we are not even close.

I will show you in a minute on why I believe this market will get more speculative in the weeks ahead (and most likely, rise to heights that are unimaginable to both the bulls and bears of today), but I will first summarize the latest action of the Dow Jones Industrials vs. the Dow Jones Transports in the following daily chart:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to November 12, 2004) - The Dow Transports made another 5-year high last week, closing at 3,628.20 for the week while the Dow Industrials is trying to make up for lost time -- again rising and holding above its downtrend resistance line which dates back to February earlier this year.   The Dow Transports is now only 4.28% away from its all-time closing high - and I also currently believe that the Dow Transports making an all-time high during the next several months is inevitable.  This action can only be interpreted as bullish.

Over the last few weeks, I found myself having to continually adjust the scale for the Dow Jones Transports, as it continues its relentless rise from its August lows. Again, readers may not realize this but the Dow Jones Transports has rallied over 20% from its August lows and is currently only 4.28% away from its all-time closing high of 3,783.50 established on May 12, 1999! Given the points I will soon discuss, this author believes that the Dow Jones Transports bettering its all-time high is inevitable in the weeks ahead. Whether the Dow Jones Industrials will confirm on the upside by bettering its own all-time high (11,722.98 established on January 14, 2000) is up in the air, but for now, this latest development (and the above chart showing the breaking and holding of the Dow Jones Industrials above its downtrend resistance line) can only be interpreted as a bullish sign.

We initially sold our 50% long position in the DJIA because all our ST indicators were very overbought, while our sentiment indicators were coming in at the high end of recent readings. How overbought and what kind of readings were we getting? Let’s take a look at the following charts to get a better perspective.

We will first start off with the chart showing the daily percentage of stocks on the NYSE trading above its 200 EMA, 50 EMA, and 20 EMA, respectively:

Daily percentage of stocks on the NYSE trading above its 200 EMA, 50 EMA, and 20 EMA, respectively.

The above chart was one of the very small number of reasons why we initiated a 25% short position at a DJIA level of 10,368 on November 5th. This short-term indicator was flashing a very overbought signal as early as a week ago – along with analogous indicators showing the percentage of stocks in the DJIA, DJTA, and DJUA (Dow Jones Utility Average) trading above their 20 EMA, 50 EMA, and 200 EMAs.

Historically, indicators such as the percentage of stocks above or below their moving averages have historically been more successful in calling bottoms than tops in the stock market. They have also been very early as the market can still rise in the face of declining breadth. This same argument also applied to the 10-day and 21-day moving averages of the NYSE ARMS Index, shown in the following chart:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - Both the 10-day and 21-day moving averages of the NYSE ARMS Index are also at very overbought levels.  However, these indicators have historically been more successful at calling bottoms than tops in the stock market.

Please note that as of the close on Friday, both the 10-day and 21-day moving averages of the NYSE ARMS Index are at levels that would indicate a ST top in the stock market – based on the action of the stock market since February earlier this year. However, in a strong uptrend such as the March 2003 to February 2004 uptrend, readings like this in the ARMS Index are basically moot, as the market can just keep on rising if mutual fund managers put their excess cash to work or if new money keeps on coming in. Again, readings such as these have historically been more successful in calling bottoms than tops in the stock market.

A favorite sentiment indicator of mine is the bullish and bearish readings of the Investors Intelligence Survey. The Bulls-Bears% Differential that I cite regularly in my weekly commentaries is simply the difference between the percentage of advisors that are bullish and the percentage of advisors that are bearish. Following is the latest weekly chart showing the bulls-bears% differential from January 2003 to last week:

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey increased from 33.3% to 35.5% this week.  This reading has increased ten out of the last eleven weeks and is at a level consistent with readings that have indicated a ST top during the last eight months.  In a strong uptrend, however, this indicator can stay

My point remains the same. Our short position that we initiated on November 5th was based on the FALSE premise that we needed one more correction before the market can maintain a sustainable uptrend – and based on this sentiment indicator and all the previous ST indicators that I have discussed, it was a good entry point for a short position – if we were to maintain the trading range that we have experienced over the last nine months. The subsequent breakout last week weaken the bears’ case considerably – and with all the liquidity that is going into the market (and with a historically high short interest), I believe the sustainable uptrend is here. This is why we covered our short position at 10,460 last Thursday, despite our very overbought ST indicators. Again, such readings in the Investors Intelligence Survey can remain overbought for weeks, as shown by the readings of the Bulls-Bears% Differential from the May 2003 to February 2004 period.

The sentiment as shown by the American Association of Individual Investors Survey is also indicating a very optimistic public:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The latest reading of only 41% in the Bulls-Bears% Differential in the AAII survey is definitely showing a good optimism in the public - but there is definitely no way to see if we can call a top on this indicator (and other sentiment indicators) alone, given the fact that liquidity is starting to come into the market again.  Readers should note that similar readings during most of 2003 did not stop this market from continuing to rise.

A reading of 41% in the Bulls-Bears% Differential in this survey is a high reading any way you look at it, but please note that similar readings during most of 2003 did not stop the market from rising, as long as there was ample liquidity.

Okay, now that I have shown my readers four charts and written as many paragraphs, just what is my point, you may ask? My point is this: These technical and sentiment indicators that I have just outlined (and which are also used by many popular stock market newsletters) are VERY SHORT-TERM indicators and can stay “overbought” for weeks if new money continues to come in (or if hedge fund managers and individuals are forced to cover the huge outstanding short interest we currently have in both the NYSE and the NASDAQ).  Moreover, from a longer-term standpoint, I do not believe the market is that overbought. Sure, the DJIA appreciated quickly during the last two weeks, but it is still relatively flat compared to its level in the beginning of this year. Perhaps this following chart should put things into proper perspective:

Daily DJIA Closing Values vs. its % Deviation from its 50 and 200 DMAs (January 2003 to Present) - Dear readers: please note that while the DJIA is currently 3.94% and 2.88% above its 50 DMA and 200 DMA, respectively, this is still a far cry from the % deviations seen during most of 2003.  Since the deviation from its 50 DMA is moderately high, I do expect a correction at some point.  The question is: How big a correction can we expect?  My guess is 250 to 300 points (from today's level) at the most.  Given that we are nowhere near overbought per the % deviation from the 200 DMA, I think we are safe in the longer run - for now.

The above chart is a daily chart showing the closing levels of the DJIA vs. its percentage deviation from both its 50-day and 200-day moving averages. Based on its 50 DMA and 200 DMA, the DJIA is really not that overbought. From a ST standpoint, the DJIA is pretty overbought relative to its 50 DMA, but over a longer-term basis, the DJIA is only at a neutral level (neither overbought nor oversold) relative to its 200 DMA.

Readers who have read last week’s commentary should now know my standpoint – that we are still in a cyclical bull market and that we are currently nowhere near the top yet. Of course, we would need to take this one day at a time but my current guess right now would be for a top during the May to September 2004 period at the earliest. If we do not get a “blowoff top” during the next nine months, then the cyclical bull market could potentially extend into 2006. In my October 31st commentary, I stated: 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.”

Question: What exactly do I mean by more P/E expansion? Or a more speculative period? Can margin debt again cross above its all-time high made in March 2000? My answer: It is very possible. One of the popular myths out there that have found a very receptive audience is that it takes a long time for the public to get speculative again after a bull market has ended or once a bubble has burst. Is this the case? Let’s again turn to the 1966 to 1974 bear market period and see what the P/E ratio of the S&P 500 was during that time. The following chart courtesy of shows the performance of the S&P 500 vs. what its performance should have been if it was trading at a P/E of 10 (historically undervalued), 15 (historically fair valued), and 20 (historically overvalued), respectively:

S&P 500 Index Relative to Normal P/E Range 1950-1980 - Dear readers - please note the 1949 to 1966 secular bull market terminated in January 1966 with the P/E of the S&P 500 near 20.  During subsequent cyclical bull markets (or bear market rallies as bears like to call them) within the 1966 to 1974 secular bear market, the P/E of the S&P 500 actually made somewhat higher highs than at the January 1966 peak.  Could history repeat again this time?

People who claim that a bubble cannot happen again in such a short time (within a few years of the last major top) because people “have learned” do not know what they are talking about. Of course, they do learn, and that is why most of the popular stocks this time are actually showing a profit, as opposed to the pure crap that everyone was buying during late 1999 (of course, I cannot guarantee that this phenomena will not happen again during the next six months if my scenario comes to pass). Okay, I apologize for being sarcastic. My point is: If both the P/E ratio and the level of the S&P 500 made a higher high in each successful cyclical bull market during the 1966 to 1974 secular bear market, then chances are that this can very well happen again today, especially given the huge amount of short interest and liquidity that should be coming into the stock market over the next several months:

S&P 500 Index Relative to Normal P/E Range - Given the historical precedent of the 1966 to 1974 secular bear market, I would not be surprised if the S&P 500 attempts to challenge its all-time high of >1,500 over the next six to nine months - as long as earnings continue to rise.

If we follow the 1966 to 1974 historical precedent, then there is a very real chance of the S&P 500 challenging its all-time high again.

As for the amount of margin debt, it sounds preposterous that we can ever surpass the all-time highs set in March 2000 during the next decade, at the least. In my special report “The Perfect Crash Scenario” written on April 2nd, 2000, I stated that: “From November 1 to February 29, 2000, outstanding margin debt increased nearly 45%. Year-over-year, this figure increased >75%. Never has outstanding margin debt increased so much so quickly. Prior to the peak in September, 1929, outstanding margin debt only increased 55% year-over-year.” Can the markets get this crazy again? Can margin debt increased so quickly in such a short time again? Will people ever learn? Yes, yes, and no. I have shown the following chart in our commentaries before but I will now show it again. The following is a chart showing outstanding margin debt during the 1966 to 1974 secular bear market:

Margin Debt (January 1966 to December 1974)

Please note that while we were in a secular bear market during the January 1966 to December 1974 period, margin debt actually rose to an all-time high during each successful cyclical bull market (or bear market rally) within the secular bear market. The patterns in outstanding margin debt during this fateful period are consistent with the patterns in the P/E ratio of the S&P 500 as well. Again, there is no rule from preventing the P/E ratio and/or margin debt from rising to an all-time high during the next six to nine months before this cyclical bull market tops out – even though we are currently in a secular bear market. Currently, we are nowhere near close to making an all-time high in margin debt:

Wilshire 5000 vs. Margin Debt (January 1997 to September 2004) - Still on an uptrend and most probably more room to run.  Margin debt would need to rise another 50% to surpass its all-time high.

As shown in the above chart, margin debt would need to rise another 50% to surpass its all-time high set in March 2000 at nearly $300 billion. We are still a long way away – at least in terms of dollar amounts anyway (the growth of margin debt tends to accelerate exponentially as the cyclical bull market comes to an end). Readers should keep an eye on this going forward (I will update this chart again once we have the October numbers – which could be as early as next week).

Okay, I have discussed the potential of a lot of liquidity coming into the stock market, but what about current liquidity? Readers should note that a lot of liquidity has been created in the world’s financial system in the last few years, even as stock markets around the world have underperformed under asset classes. Sure, the growth of M3 over the last few months has been flat, but M3 stands at $9.3 trillion, compared to “only” $6.7 trillion when the market topped out in March 2000. Inflation tends to beget more inflation, as the speculators of the world try to find the “next hot thing” to invest in or speculate on. A few months ago, it was crude oil and natural gas. I believe the “next hot thing” over the next several months will be the U.S. stock market – especially in light of the huge insider buying we have had and will continue to have over the next several months – as corporate balance sheets are now flushed with more cash than ever. The $10 billion Cisco and $11 billion Intel buybacks that were announced over the last two weeks is a sign of further strength to come. Moreover, the IPO calendar will slow considerably after this week, as investment bankers take off for the holidays. The lack of a new supply of shares (with the exception of a Google lockup period expiring and the China Netcom IPO this Tuesday) should continue to be beneficial to the stock market at least until the first week of January.

Of course, all this new money (and the renewed enthusiasm of retail investors) may not do much for the markets if it wasn’t for the bears helping out the bulls. What I do mean by this? TrimTabs has noted in the past that hedge funds are estimated to be net short to the tune of approximately $100 billion in common stocks. All of a sudden, it has become fashionable to short again – I have witnessed this sentiment on many a message board (these are not bear boards, mind you). Look, shorting should only be reserved for professionals, not part-time retail investors! The following two charts showing the outstanding short interest on both the NYSE and the NASDAQ illustrate this perfectly:

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.

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to October 15, 2004) - As of October15, 2004, short interest on the NASDAQ totaled 5.13 billion shares - 120 million shares short of last month's short interest but still the third highest on record.

Short interest on the NYSE is just 250 million shares short of the all-time high set on October 2002 (when the value of these shares were considerably lower) while short interest on the Nasdaq has kept on rising since October 2002, and is now sitting at 5.13 billion shares after making an all-time high in September. The bears, in their haste to make a quick buck on the short side, will ultimately help the bulls and cover at much higher prices. For a detailed discussion on the specialist short ratio and the NYSE short interest ratio, please refer to last week’s commentary – but readers should remember that the former declined to an all-time low (which has historically been very bullish) while a few weeks ago, the latter had risen to a high not seen since the October 2002 high – the month that the March 2000 to October 2002 cyclical bear market bottomed.

Bottom line: While our ST indicators are still overbought, the market still looks good over the next several weeks and months. This author is looking to get back in on the long side in our DJIA Timing System – preferably when our ST indicators at least go back to more neutral levels. Again, BY DEFINITION, the final rally that will mark a top in a bull market usually goes further than anyone thinks, and is usually the one final rally that kills all the shorts before it comes crashing down. This has been true without exception in U.S. financial history and this will happen again (ironically, if one thinks that the cyclical bull market is about to top in the next few months, then one should actually go long here instead of go short – as the final rally tends to rise in a parabolic curve as it sucks all the bulls in and kills the bears before dying in exhaustion). I would like my readers to stay away from shorting the market solely because of the overbought condition, but if you must have to, please don’t get greedy and always keep tight stops on your positions! 

Signing off,

Henry K. To, CFA


Article Tools

Subscribe to this FREE commentary

Discuss this page

E-mail this page to your friends

Printer-friendly version of this page

  Copyright © 2010 MarketThoughts LLC. | Privacy Policy | Terms & Conditions