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When Will the Top Come?

(November 21, 2004)

Please note that we entered a 100% long position in our DJIA Timing System on November 19th at 10,474. While there may be a further correction this week, I expect the DJIA to rise significantly higher at least during the next couple of months.

Important news: I will be in Hong Kong during the latter part of December to the first week of January. I will try very hard to update my commentary during that time – and will let you know about our publishing schedule as it comes along. I don’t think I will have any problems updating our website during my stay there (except for the weekend during New Year’s when my partner will be in LA), but I will have a pretty hectic schedule while I am there. I may even bring in a guest commentator. I am also planning to speak to a few investment professionals while I am in Hong Kong and will appreciate it if our readers can act as a reference or recommend people that I can speak to (and which hopefully we can put up as another “interview” on our website) – on topics such as the future economic direction of China, Hong Kong, and her relationship with the United States, etc.

We will also be implementing a completely new section on our website this Tuesday evening. This is going to be a surprise. Readers please stay tuned!

We have also extended our survey/poll for one additional week. Please drop by and tell us what you want to see more of on our website!

Dear Subscribers and Readers:

I am always skeptical about the stock market analysts who are trying to call for a top in the stock market. I am even more skeptical when they try to blend their analysis with the current news of today – such as a potential terrorist attack, high energy prices, low consumer confidence, the falling greenback, and rising interest rates. Dear readers, they have all been virtually discounted by the markets. Heck, I do not even trust the published “leading indicators” too much, as the stock market is most probably the ultimate leading indicator we have. Unless one can come up with a crystal ball, I don’t think you can find a leading indicator that is actually useful in predicting where the market will be a few weeks or a few months from now.

All I trust is history and the art of using technical analysis (of which Dow Theory is a very useful tool) to try to push the odds in one’s favor – along with the gauging of the investing psychology of the public.  Let’s face it – no one indicator is infallible, but when a lot of indicators that I am currently watching (including the amount of liquidity and the psychology of the public) are saying that a top is not even close yet, then as a rule, I defer to them. In this commentary, I will again tell my readers what I am currently looking at – which is basically just an extension of what I have continuously emphasized and written over the last two weeks.

Remember what I wrote last week? The title of the commentary was “Liquidity Overwhelms All Else.” I still believe this is the case. For those who are interested, TrimTabs (the publication that solely uses the concept of stock market liquidity to make timing decisions) went 200% long in their model portfolio early last week. This is a rare development – even for TrimTabs. The argument for a very bullish liquidity scenario has been bolstered further last week by the merger of K-mart and Sears (as it is a partial takeover and promises to add as much as $5 billion in cash to the markets) and by the 61% approval of PeopleSoft’s shareholders to tender their shares to Oracle for $24 in cash per share (or the entire company for $9.2 billion in cash). Even though the board of PeopleSoft rejected the offer (for the sixth time) over the weekend, there is no doubt that corporate America is going on a buying spree, whether it is buying back their own stock or acquiring other companies with cash. This is the opposite extreme of the period 1999 to 2000 – when companies were doing IPOs or when insiders were selling their shares at a furious rate. The following chart courtesy of the Conference Board illustrates the cash situation facing today’s corporations:

chart courtesy of the Conference Board illustrates the cash situation facing today's corporations

Please note that the excess gap between cash flows and capital expenditures is currently even greater than the deficit gap of capital expenditures and cash flows during the late 1990s. The cash is definitely been spent somewhere and I believe that this cash is being spent on the stock market – whether it is companies buying back their own shares, increasing their dividends, or acquiring other companies with cash. This is the opposite extreme of the 1999 to 2000 period. Moreover, the IPO calendar will slow down dramatically next week and would not ramp up again until the second week of January (when I get back from Hong Kong). This can only be interpreted as bullish.

The concept of liquidity or potential liquidity can also be gauged by looking at the level of margin debt – a rising trend of margin debt is bullish, as long as it is not excessive. That being said, the latest NYSE margin debt data as of the end of October 2004 has been published, and it is a bullish number. Total margin debt reported by the NYSE member firms was at $185.7 billion at end of October, up from $180.1 billion at the end of September and $4.4 billion higher than the April high of $181.3 billion. This growth is not excessive, considering that the growth in margin debt has essentially been flat for the last six months. The following chart tracks the movement of total margin debt relative to the Wilshire 5000 from January 1997 to October 2004 (please note that we have estimated a margin debt amount of $13 billion reported for the NASD – bringing the total to approximately $199 billion in the following chart):

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

Readers may recall what I wrote in last week’s commentary – that the level of margin debt had made higher highs during both the October 1966 to 1968 and May 1970 to 1972 cyclical bull markets within the 1966 to 1974 secular bear market. Like Mark Twain so eloquently said, history doesn’t repeat itself, but it surely rhymes. Currently, total margin debt still needs to rise another 50% (to $300 billion) before it can surpass the all-time high set during March 2000. Before this is over, I expect margin debt to least make a run for the $300 billion mark – which means that there could be another $100 billion in potential new cash flooding into the markets over the next six to nine months.

Moreover, cash in all brokerage accounts of NYSE member firms (both cash and margin account) as a ratio of total margin debt are still at twice the levels as they were during the late 1999 to 2000 period, as evident by the following chart:

Wilshire 5000 vs. Cash and Margin Debt Ratios (January 1997 to October 2004) - Cash levels in all accounts to the level of margin debt are still twice as much as they were during the late 1999 to 2000 period.

A major market top in the making? Definitely not yet. In fact, current cash levels as a ratio of margin debt are even higher than they were during the bottom of the October 1998 crash. This chart still looks bullish to me.

Of course, the liquidity argument will not be complete without a discussion of short interest. Short interest information for the NYSE at the end of October has now been released. Short interest decreased 130 million shares from the end of September to the end of October. Despite this monthly decline, short interest is still currently only 380 million short of the all-time high set on October 2002. Make no mistake: The market is still currently in an uptrend, and this uptrend should continue to force the bears to cover in the weeks ahead (according to TrimTabs, hedge funds are estimated to be $100 billion net short the domestic stock market). Following is a chart showing the NYSE short interest vs. the Dow Jones Industrial Average from the period November 15, 2000 to November 15, 2004:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to November 15, 2004) - For the month ending November 15, 2004, total short interest on the NYSE decreased by 130 million shares.  Again, short interest on the NYSE is still very close to the all-time high (380 million shares less) in short interest set on October 15, 2002 - which should provide further 'fuel' for the bulls as the bears are forced to cover.

The 8-week moving average of the NYSE Specialist Short Ratio is showing the same trend – this ratio ticked up in the latest week and I believe we are definitely in an uptrend after coming off of the lowest reading in this ratio in the history of the NYSE. This is bullish. Following is a weekly chart of the 8-week moving average of the NYSE Specialist Short Ratio vs. the DJIA:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to November 19, 2004) - The 8-week moving average of the NYSE Specialist Short Ratio increased slightly from 24.80% to 25.11% last Friday (accompanied by the highest one-week reading since March earlier this year)- further suggesting that we have now reversed from an all-time low reading in this ratio.

The liquidity situation has been building up for weeks and months, but it has only chosen to assert itself after the outcome of the election. The current trend is now up. The bears will point to Friday’s correction as the beginning of a new downtrend, but so far, Friday’s decline appears only as a normal correction to me. Even if my liquidity indicators had “bear” written all over it, I would not be so quick to adopt a bearish conclusion, as evident by the following chart showing the Dow Jones Industrials vs. the Dow Jones Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to November 19, 2004) - The Dow Transports made another 5-year high as late as the Friday before last at 3,628.20 while the Dow Industrials made a 9-month high as late as last Thursday (at 10,572.55).  Friday's decline -- coming on the heels of the recent uptrend is simply a normal correction in a cyclical bull market.  Friday's action should actually be intrepreted as bullish, as any further up-move on Friday would have triggered a hugely, severely overbought situation in the major indices.

Like I mentioned above, the Dow Transports made another 5-year high as late as the Friday before last, while the DJIA made a 9-month high only last Thursday. Friday’s correction only appears as a normal correction to me. In fact, if the major indices had experienced an up day on Friday instead, it would have rendered a severely overbought situation – indicating an uptrend that may be getting out of control. A significant uptrend involves climbing a wall of worry, and this is what we are currently experiencing.

Okay, let’s get back to the topic of this commentary: When can we reasonably expect a stock market top? Like I have said before, I want to see a more speculative period and a shift away from risk-aversion on the part of retail investors before I can reasonably call a top. I want to see a greater rise in margin debt (preferably at least a retest of the March 2000 highs of $300 billion in total margin debt). I want to see more speculation in nanotechnology and Chinese stocks (similar to the huge speculation of biotech and superconductor stocks during the January to March 2000 period). Now Henry, did I hear you right? Yes, I meant superconductor stocks, not semiconductor stocks. Does anyone remember SCON? The speculative mood was euphoric indeed, and we have gotten nowhere close to that so far. I also want to see a collapse in breadth, not dissimilar to the topping of the NYSE Advance-Decline line as early as April 1998 before the March 2000 top of the S&P 500 and the NASDAQ Composite.

I also want to see a more overbought situation. Some of my ST indicators may have been indicating a very overbought market lately (such as the percentage of stocks above the 20 EMA, etc.), but over the longer-term, the market is only moderate overbought. In fact, given the current bullish liquidity situation and in light of Friday’s correction, the market may not be so overbought after all. The following chart showing the percentage deviation of the Dow Jones Industrial Average from both its 50-day and 200-day moving averages does not currently indicate an overbought market (relative to the deviations seen during most of 2003), especially given Friday’s correction:

Daily DJIA Closing Values vs. its % Deviation from its 50 and 200 DMAs (January 2003 to Present) - Taking into account Friday's correction, the DJIA is currently 'only' 2.91% and 2.07% above its 50 DMA and 200 DMA, respectively (a drop of 1.03% and 0.81%, respectively, from last week's levels).  Again, this is still a far cry from the % deviations seen during most of 2003.  Per the % deviation from the 50 DMA, we are still somewhat overbought - but over the longer run (per the % deviation from the 200 DMA), there is still a lot of potential for a much further rise in the DJIA.

You may now ask: what about sentiment indicators? The percentage of bulls in the Investors Intelligence Survey has outnumbered the percentage of bears for weeks. The Bulls-Bears% Differential increased again this week from 35.5% to 35.8%. Surely, this is indicative of a top in the stock market? Maybe – but any intelligent analysis of the stock market (especially when trying to call for a top – which as I have mentioned before is an inherently difficult thing to do – much more difficult than calling a bottom) should utilize much more indicators, especially since the Bulls-Bears% Differential in this survey has gotten much more lopsided before (and also during most of 2003):

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 35.5% to 35.8% this week.  This reading has increased eleven out of the last twelve 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

While the latest reading of 35.8% is relatively high, it is interesting to note that this reading stayed high during most of 2003. In fact, this reading can get much higher before this cyclical bull market tops, as shown by the following chart illustrating the action in the Bulls-Bears% Differential vs. the Dow Jones Industrial Average during the January 1970 to December 1973 (which covers the 1970 to 1972 cyclical bull market):

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 1970 to December 1973) - 1) Bulls-Bears% Differential consistently OVER 40%! 2) Differential actually an extremely high reading of 58.3% before topping!

Dear readers, please note the extremely high reading of 61.8% that we got in March of 1971 – 17 months after the January 1966 to October 1966 cyclical bear market has ended. That was indicative of a ST top, but the market came back after a year and proceeded to make a much higher high in December 1972. The December 1972 top was accompanied by a Bulls-Bears% Differential in the Investors Intelligence Survey of 58.3%. If one was to solely look at this indicator for signs of a top, the current reading of 35.8% is nowhere close, and is definitely not something I would rely on if my life depended on it. The latest reading in the American Association of Individual Investors also shows a similar reading to last week’s – again, readers may be interested in knowing that similar readings during most of 2003 did not stop the market from rising, as long as there was ample liquidity.

It is also interesting to note that a lot of analysts nowadays are discussing the deceleration of earnings as a potential obstacle to the market going higher or as a prelude to another bear market. Perhaps so, but please take a look at the following chart and let me know what you see. I have posted this chart before – this chart shows the absolute value of corporate profits (orange line) as well as corporate profits a percentage of GDP (blue line) during the last 25 years:

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 2Q 2004) - Corporate profits as a % of GDP is now at 8.5% - definitely in the high range of these readings over the last 25 years.  The recent absolute growth in earnings has also been extraordinary - can this growth sustain itself given only 3 to 4% GDP growth going forward?

On first glance, this chart may look bearish as corporate profits as a percentage of GDP is now very close to the high-end of its 25-year range.  Is this sustainable? Is a slowdown inevitable? Probably not. But dear readers, please take a look at the action of these two lines during the latter part of the 1990s. Both corporate profits and corporate profits as a percentage of GDP peaked in the third quarter of 1997, and bumped around until they both completely collapsed starting in the first quarter of 2000 (coincidence? Probably not). My point is: The major market indices do not have to tank even as TOTAL earnings decelerate. What is probably inevitable is that breadth is going to get narrower as weaker companies start losing money or start losing market share, while the stronger companies continue to increase their profits. This is usually what happens as a bull market matures. Once corporate profits start turning down, we know the end is near, but there is no telling when the bull trend will exactly end. In the late 1990s, this turning down of corporate profits was nearly three years early in calling the top!

Bottom line: Our ST indicators remain overbought, but while there may be more need of a consolidation (the Naz futures are down 9 points while I am writing this) the market still looks good over the next several weeks and months. Again, I would like to emphasize this: 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. I would also like my readers to stay away from shorting the market. All this recent panic over the decline in the U.S. dollar is probably overdone as everyone and their neighbors and their neighbors’ dogs are now talking about it.  In fact, it would not surprise me if the U.S. dollar actually starts a rally as early as tomorrow morning (I am writing this on Sunday night). Crazier things have happened. Please stay tuned.

Signing off,

Henry K. To, CFA

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