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The Trouble with the VIX

(November 28, 2004)

Please note that we entered a 100% long position in our DJIA Timing System on November 19th at 10,474. We will continue to hold this position but we reserve the right to change our position if the market remains overbought going into December and market liquidity starts to decline.

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 have also started an entirely new charts section on our website! Please let us know what other charts you would like to see updated by either emailing me at hto@marketthoughts.com or by voicing your opinions on our Discussion Forum!

First of all, I hope all my readers have had a great Thanksgiving (if you’re not in the U.S. or a U.S. citizen, then I hope you had a great weekend!). It is times like this that we should cherish what we have. Consider that the majority of the population today do not have internet access, and also consider that most of these same people have to scrape by with less than two dollars a day. Countries that were once great like China and India totally missed out on the Industrial Revolution – but fortunately, the advent of the information age (and specifically the advent of the internet) is helping these countries catch up. Today, China has approximately 80 million internet users – the second largest internet population in the world by country – only behind the U.S. In four to five years time, the internet population in China is projected to surpass that of the U.S. – thus propelling China to the number one in the world in terms of internet users. Sure, penetration is still relatively low (80 million people represents only about 6.5% of the total population in China), but since the “opening up” of China in 1978, the country has made great progress and should continue to do so for the foreseeable future.

Make no mistake, both China and India is the real thing. Both the Chinese and the Indian civilizations were once great trading civilizations – and both the Chinese and Indians are as capitalistic as they can get. It is engrained in their DNA.

Readers who have not done so should go ahead and read a recently featured article on John Mauldin’s Outside the Box columns called “China Misconceptions” by Mr. Louis Vincent Gave from GaveKal Research – an investment advisory firm based in Hong Kong. In fact, I am scheduled to meet Mr. Gave during my upcoming trip to Hong Kong in late December/early January. I will post my “interview” with Mr. Gave on this website once I come back from Hong Kong. Readers who want to participate can send me questions they have about China or Hong Kong and I will try my hardest to ask Mr. Gave those questions. I believe this will be a very useful and educational exercise – and am definitely looking forward to it. There will be many opportunities to make money in Chinese companies over the next twenty years – probably even more so than investing in domestic, U.S. companies. I sincerely hope that my readers will try their hardest to learn about both the Chinese and Indian economies (and culture) in due time – trust me, it will be a very rewarding exercise!

The main topic of this commentary is the VIX, but I would first like to clear up a few things regarding globalization and China before we begin our analysis of the stock market. First of all, the trend of increasing globalization and world trade will continue – whether one likes it or not. I also believe this trend will increase living standards of the general population around the world – especially the general population of China and India. Secondly, today’s high levels of foreign investments in developing countries by the developed countries are nothing new. We are not in uncharted territory, so to speak. According to a Fondad’s (Forum on Debt and Development) publication, “China's Role in Asia and the World Economy: Fostering Financial Stability and Growth”, the level of today’s foreign capital inflows to developing countries is, in fact, far below than what was achieved before World War I. In 1914, the value of foreign capital stock was at 32.4% of the developing countries’ GDP. This ratio decreased to a mere 4.4% in 1950 and only stood at 21.7% as late as 1998. My point is: Today’s developing countries are actually less open to foreign capital inflows than they were 100 years ago.

As far as China exporting deflation to the rest of the world, I also do not think this will be a significant phenomenon (nor is or will be a significant problem). In the same publication, the authors argue that China’s total exports only account for 4.3% of the world’s total exports in 2001. Moreover, there is a significant difference between something being actually made in China or assembled in China. Both products have a “Made in China” label no matter whether all its components are made in China or whether its components came from different countries, such as South Korea, Hong Kong, or Japan. Both type of products are lumped into this 4.3% of exports and counted in their trade balance with the United States, for example. Thus, while China has a huge trade surplus with the United States, it is interesting to note that a significant portion of this surplus (or finished goods) contains components that are actually made somewhere else – such as South Korea, Hong Kong, or Japan, for example. This is evident by the fact that while China runs a huge trade surplus with the United States; at the same time, it actually runs a trade deficit with most of its Asian neighbors. Bottom line: China’s exports as a percentage of world exports are next to negligible in causing worldwide deflation.

Now, onto our main discussion - specifically on the troubles of using the VIX as a reliable sentiment or overbought/oversold indicator. Readers who are not familiar with the VIX can read about this indicator on our Education – Stock Market Indicators page of this website. Traders who have gotten used to the action of the VIX during the late 1990s have been caught by surprise by the consistently “low readings” from the VIX ever since April of last year. During the late 1990s and up to the end of 2002, VIX readings of approximately 20 and under were considered an indication of an overbought market. A reading of below 20 has nearly been always right in calling for at least a ST top in the stock market. But all of this changed with the beginning of the current cyclical bull market in March 2003. Following is a daily chart of the VIX vs. the Dow Jones Industrial Average which illustrates the history and the behavior of the VIX from January 1990 to last Friday:

DJIA vs. the VIX (January 2, 1990 to November 26, 2004) - The current experience of the VIX - is it too low and is it unprecendented? Not so if you look at the experience of the VIX in the 1990s.

The question to ask is: Is the current action of the VIX indicating an impending collapse of the stock market or has the character of the VIX changed from its character during the late 1990s? Dear readers, please note that action and behavior of the VIX (concurrent with the behavior of the Dow Jones Industrial Average) during the early 1990s to as late as 1996. The general decline of the VIX (ultimately to a level below 10) and the subsequent rise of the VIX happened concurrently with one of the biggest bull markets in stocks in U.S. history. Let us take a closer look – following is the same chart but with a closer look at the period from January 1992 to December 1996:

DJIA vs. the VIX (January 1992 to December 1996)

My argument is two-folds. First of all, the VIX reading of 12.79 as of last Friday is not necessarily low and does not necessarily signal an impending collapse if we go by the action of the VIX during the first half of the 1990s. In fact, it is interesting to note that the VIX actually hit the level we are experiencing now as early as July 1992, and yet the market continue to do well up until at least during the early parts of 1994 (right before the huge correction of 1994) – just right after the VIX made an all-time low reading of 9.31 in December 2003. Second of all, the VIX more or less subsequently traded around the 10 to 20 range for the next three years – coinciding with one of the greatest bull swings in U.S. stock market history. My point is: The option writers are not stupid (if they were, they wouldn’t have lasted in this business for even one second) and while they may have gotten caught off guard during the 2000 to 2002 bear market, I do not believe they can be consistently used as a contrarian indicator.  Now may be one of those times.

I believe the above analysis about the VIX makes a very important point about a sentiment indicator that is currently very popular with traders and speculators – said indicator being the SPX (S&P 500)/VIX ratio. Both Mark Hulbert from Marketwatch.com and Carl Swenlin from Decisionpoint.com have covered this indicator and both of them concluded that using this indicator to predict tops in the stock market makes no logical sense at all. I agree with them – not only because the experience of the VIX during the 1990s indicates to me that the SPX/VIX ratio can go higher but also because saying the SPX/VIX ratio can only go up to such a level is like saying the S&P 500 is too high simply because it closed at 1,182.65 last Friday. In fact, a very credible argument can be made suggesting that the SPX/VIX ratio making new highs is actually a bullish sign, as evident by the consistently new highs the SPX/VIX ratio was making in the early to mid 1990s.

Now, since there have been no significant developments since I wrote an abbreviated market commentary on Wednesday evening, I am not going to write much further in this commentary either. Instead, I will use this commentary as an opportunity to update a few charts that I consistently show each week, along with the weekly relative strength chart of the Bank Index (BKX) vs. the S&P 500 that I have discussed previously. Readers may remember my discussion of the SOX and RTH vs. the S&P 500 relative strength charts that I discussed on Wednesday evening. For those that do not remember, the relative strength chart of the BKX vs. the S&P 500 works the same way, in that it has historically been a very reliable leading indicator of the stock market. Following is the relative strength chart of the BKX vs. the S&P 500 from February 1993 to last Friday:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 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. Relative strength of the Bank Index still has not violated support -- suggesting the cyclical bull markeet should continue.

Please note the decline of this indicator starting in the early part of 1998 – just as the A/D line of the NYSE was topping (not shown on this chart). In retrospect, the decline of this indicator foresaw the Brazilian, the Russian, and the LTCM crises – along with beginning of the bear market in spring of 2000 (if only people were paying attention back then). Please also note that the relative strength of the BKX vs. the S&P 500 has a huge support line dating back to early 2003 – when the current cyclical bull market began. I have emphasized this before and I will do so again. Bull market tops are inherently difficult to call – so I won’t do it until at least the relative strength of the BKX vs. the S&P 500 has violated this support line, something which we have not done so yet. Dear readers, the bull is most probably maturing but it still continues to live on.

As I stated in my Wednesday evening’s commentary: “I currently believe the market is still moderately overbought, despite the recent “consolidation days” that we have seen over the last week or so in the major indices. Both bulls and bears will need to be careful here – a further rally is definitely possible in the short-term but if it materializes, then it will render the market in an even more overbought situation and will definitely not be a good time to initiate long positions. The market is still currently awash with liquidity – but this could change if a new flood of offerings start appearing in early December to “take advantage” of the huge dividend payout by Microsoft on December 2nd. This is what TrimTabs is currently predicting. For the next few trading days, however, offerings will be non-existent.” I continue to believe that this is the case, although TrimTabs has gotten slightly more bullish since that time and the IPO calendar now looks non-existent for the rest of this week (not just during the next few trading days). The liquidity pillar still looks intact, although I will definitely be on the watch for any signs of this cracking over the next few weeks (even while I am in Hong Kong).

None of commentaries will be complete without the daily chart showing the action of the Dow Jones Industrial Average vs. the Dow Jones Transportation average. Without further ado, following is the relevant chart that my readers are probably the most familiar with:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to November 26, 2004) - The Dow Transports made another 5-year high last Friday at 3,647.99 while the Dow Industrials made a 9-month high as late as the Thursday before last (at 10,572.55).  This is not something to be trifled with - even though WMT may have announced lackluster sales over the weekend.  The author believes that before the top comes, the Dow Jones Industrials will have surpassed its February 11th closing high of 10,737.70 while the Dow Jones Transports will have surpassed its all-time closing high of 3.783.50 set on May 12, 1999.

As shown in the above chart, the Dow Jones Transportation Average is on track to make a new all-time high probably sometime within the next couple of months – despite the current overbought conditions of the index. It is also interesting to note that the Dow Jones Industrial Average made a new nine-month high as late as the Thursday before last. The recent action of these two indices can only be interpreted as bullish. Readers, however, should not act complacent – since in light this “parabolic move” in the Dow Transports, any reversal of the Dow Transports here may be quite serious.

Readers should note that I continue to carefully monitor the 8-week moving average of the NYSE Specialist Short Ratio every week, as most of the historically low readings that we have gotten since the development in 1943 have been VERY bullish as I outlined in this weekend commentary three weeks ago. As I have mentioned before, the 8-week moving average of the NYSE Specialist Short Ratio made an all-time low three months ago, and recent data (including the latest weekly data) suggests that this indicator has reversed back to the upside. Following is the relevant chart:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to November 26, 2004) - The 8-week moving average of the NYSE Specialist Short Ratio again increased slightly from 25.11% to  25.48% 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.

After making a historic all-time low three months ago, this indicator has now reversed on the upside. Based on 60 years of history of this indicator and the subsequent stock market action, the implications here are potentially very bullish.

The two popular sentiment indicators that I consistently look at – the Bulls-Bears% Differentials in both the Investors Intelligence Survey and the American Association of Individual Investors still suggest continued upside – as even though they are somewhat overbought, a lot of the gains have historically been accompanied by a somewhat bullish public. As long as these two sentiment indicators do not get too out of hand, I believe we are still safe here. Following are the latest charts of both the Bulls-Bears% Differentials in both the Investors Intelligence Survey and the American Association of Individual Investors vs. the Dow Jones Industrial Average:

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey decreased slightly from 35.8% to 33.6% this week.  In a strong uptrend (such as the one I believe we are currently having), this indicator can stay at these 'overbought' levels for weeks - and this is what happened during the strong 2003 uptrend.  The author believes that as long as this reading doesn't get out of hand (such as a reading of over 40%), then the market can continue to rise despite a 30%+ reading week after week.

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The latest reading of 'only' 23% in the Bulls-Bears% Differential in the AAII survey shows that the public is still hesitant with making long commitments in the market.  However, the author does not believe that this latest reading represents a reversal - merely, this latest reading represents further consolidation before the market is set to rise again.  Bottom line: The latest 'correction' in the latest reading of the Bulls-Bears% Differential in the AAII Survey is bullish.

Despite the “overbought” readings of these two popular sentiment indicators, history has shown that the market can continue to rise – despite the fact that we should still be in the midst of a great secular bear market. In fact, the latest one-week readings of both sentiment indicators actually declined slightly – suggesting that the market should be consolidating here before the next upswing. Again, I do not believe we can credibly call a top in the stock market unless these two sentiment indicators get way out of hand, such as a 40% reading in the former and a 50% reading in the latter.

Bottom line: As shown by the relative strength chart of the BKX vs. the S&P 500 (and the relative strength charts of both the RTH and the SOX in my Wednesday evening’s commentary), I believe the longer-term action of the market remains bullish. The latest liquidity developments, while not too significant, are actually showing more bullish signs – as evident by the lack of IPOs for the rest of this week and the successful completion of the self-tender offer made by the Limited Brands. In the short-term however, the current overbought conditions are still bothering me – although the stock market should still hold up unless the liquidity pillar weakens. Again, I will continue to monitor this liquidity pillar over the next few weeks, and will inform my readers as soon as I can if things start getting out of hand.

Signing off,

Henry K. To, CFA

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