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A Word of Caution

(December 5, 2004)

Please note that we switched to a 50% long position from a 100% long position in our DJIA Timing System on Friday at 10,592 (at a 118-point profit). The combination of declining liquidity and an overbought market is currently concerning this author. We will continue to hold the 50% long position since we believe the cyclical bull market isn’t over yet.

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Important news: I will be leaving for Hong Kong on December 19th and will not be back until January 7th, 2005. I will try very hard to update my commentary during that time – but my current publishing schedule is December 18th, December 26th, and December 28th. My partner will be in Los Angeles from December 29th to January 5th so I don’t anticipate updating our website after December 28th until I get back from Hong Kong on January 7th. 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.

The market has certainly had its share of good news during the week, as the Intel mid-quarter update on Thursday evening and the three-day slide (of $8 a barrel) in oil prices can certainly demonstrate. It is also interesting to note that the $32 billion of Microsoft’s huge one-time dividend was distributed on Thursday evening. Readers should keep in mind that the recent bottom of the market on October 26th was no coincidence, as $41 billion in cash was distributed to AT&T Wireless shareholders during the subsequent two days following the October 26th closing date of the AT&T Wireless buyout by Cingular. The huge $32 billion dividend from MSFT *should* be bullish for the stock market at least in the short-run.

All this has not been lost on the stock market, as the Dow Jones Industrials made another 9-month high last Friday while the Dow Jones Transports made another five-year high last Thursday:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to December 3, 2004) - The Dow Transports made another 5-year high last Thursday at 3,729.94 while the Dow Industrials made a 9-month high last Friday at 10,592.21.  The relentless rise in these two popular indices continues (especially in the Transports) but the weakness in basic materials and in retailers over the last week should be a cause for concern - especially in light of the 26% rally of the Dow Transports over the last three to four months.

I have discussed this with my readers before – but over the last few weeks, I found myself having to continually adjust the y-axis for the Dow Jones Transports in the above chart. Readers should keep in mind that the Dow Transports has appreciated approximately 26% from its August bottom – a very overextended rally any way you look at it. Of course, this does not mean that the Dow Transports cannot get more overextended, especially if oil prices continue to decline going forward.

So why the “word of caution” that I choose to emphasize in this weekend’s commentary? Dear readers, please note my emphasis on the word “should” in my above bullish mentioning of the one-time dividend from MSFT. Given the bullish news from Intel on Thursday evening, this should have combined for a sizable rally in the stock market on Friday, especially as oil prices continued to decline during the day. However, the market pretty much made its high during the early morning and fizzled during the afternoon. Intel also made its high near the open – with a close actually very near to its low of the day. Bullish traders may mention that the jobs report did the market in, but it is interesting to note that pre-market futures have already been deteriorating prior to the release of the jobs report at 8:30am ET – along with the fact that the Hong Kong Hang Seng Index actually had a negative close the night before.

The fact that both the Intel news and the MSFT one-time dividend failed to boost the market on Friday is a huge concern. Moreover, given the recent weakness in retail and in basic materials stocks – as well as the deterioration of some of my ST technical and liquidity indicators – I believe we should take a wait-and-see approach before initiating further long positions in the stock market. This commentary will mostly focus on my concerns regarding at least the short-term visibility of the U.S. stock market.

Before I begin my analysis, I would first like to say this: There are a great number of bears who have lost a lot of money trying to call tops in the stock market based on the fact that market is overbought. Yes, the market is currently overbought and this is one of my reasons why I am urging caution, but a better reason I have is the fact that a lot of my technical and liquidity indicators are also deteriorating at the same time. I am also not asking my readers to indiscriminately short every technology stock that they see. That being said, let’s cut right to the chase and begin my analysis (a bit of warning: my following analysis contains a lot of charts that come straight from – one of the best chart services out there).

The following chart shows the daily closing values of the NASDAQ Composite vs. the percentage deviation from its 50-day and 200-day moving averages. This chart is more of an intermediate indicator – the deviation from its 50-day moving average is suggesting that the NASDAQ Composite is getting as overbought as it was back in January 2004 (although on a longer-term basis, the percentage deviation from its 200-day moving average is indicating a much less overbought situation):

Daily NASDAQ Closing Values vs. its % Deviation from its 50 and 200 DMAs (January 2003 to December 3, 2004) - The % deviation from its 50 DMA is now at 7.56% - just slightly under the 8.37% that was reached on January 20, 2004.

As one can see, the % deviation of the NASDAQ from its 50 DMA is 7.56%, just slightly below its January 20th high of 8.37% (when the NASDAQ made its peak just 0.02 points from last Friday’s close!). Unless the NASDAQ plunges 3 to 5% in the next few trading days, the NASDAQ market is now overbought on both a ST and even an intermediate basis based on this indicator.

Something which I have not covered extensively before is the put/call ratio and the 10-day moving average of the put/call ratio. The put/call ratio is mostly used as a contrarian and overbought/oversold indicator. Readers should note that the 10-day moving average of the equity put/call ratio touched a reading of 0.53 during the last week – a level which has marked at least a ST top (all except during the August 2003 period) during the last two and a half years (all circled in the below chart). The following chart is courtesy of

S&P 100 Index - Not exactly a ST top but it was good for a few days of weakness.

Readers should keep in mind that I am only basing this “ST caution” analysis on the last three years of trading history. In prior bull markets, and especially during the years before the year 2000, the 10-day moving average equity put/call ratios have reached levels of 0.35 before the market topped. It is not out of the question that we may experience similar readings of the put/call ratio before we see a significant top. Remember - crazier things have happened before.

The Rydex Cash Flow Ratio (Cumulative cash flows into bear and money market funds divided by cumulative cash flows into bull and sector funds) has also been giving us extreme readings – at least compared to the readings we have been experiencing during the last two years. Please note that Friday’s reading of 0.63 in this indicator (courtesy of is the lowest reading that we have experienced in the last two years (even less so to what was experienced during the January 2004 top):

S&P 500 Large Cap Index

The argument that I made in my analysis of the put/call ratio also applies to the above analysis of the Rydex Cash Flow Ratio. The argument is – that the Rydex Cash Flow Ratio has provided us much lower readings in the past (< 0.50) before making a significant reversal. However, based on the current reading, there is no doubt that the market is overbought – at least on a ST basis.

The percentage of stocks on the NYSE above their 20-EMA and 50-EMA is also indicating to us the same thing – that the market is overbought – but more significantly, that the price action of various stocks on the NYSE is deteriorating. This is evident by the fact that the percentage of stocks on the NYSE above their 20-EMA previously made a reading of 90% but has since deteriorated to only slightly above 80% as of last Friday (even as the NYSE Composite Index made a new high). The following chart from illustrates this recent price action of all the stocks on the NYSE relative to their 20, 50, and 200-EMAs:

NYSE Stocks Above 50-EMA - Still making or at new highs. But the more sensitive 20-EMA reading is already deteriorating

Readers should note that the indicator showing the percentage of NYSE stocks above its 20-EMA is very sensitive, and has been notoriously early in calling tops in the past. That being said, the fact that this indicator has spent nearly a month between the 80% and 90% range is telling me that the market is getting overbought. Moreover, the fact that the NYSE Composite making a new high without a corresponding high in this indicator is signaling technical deterioration.

Another important indicator which is signaling technical deterioration is the NYSE McClellan Oscillator. Since the rally began in late October, the NYSE Composite has made four significant higher highs accompanied by four lower highs from the NYSE McClellan Oscillator (all circled in the following chart again courtesy of

NYSE McClellan Oscillator

Most importantly, the latest high on the NYSE Composite was accompanied by a reading of minus 8.38 – a day that saw interest yields collapsed (which should have been beneficial to the many bond funds and preferred stocks being traded on the NYSE), good news from Intel, and $32 billion in fresh money coming from the one-time MSFT dividend payout. The fact that the McClellan Oscillator is now in negative territory tells us that the majority of stocks on the NYSE is now in a downtrend.

Hopefully, my readers have made it this far in our commentary! What I am about to show you may be one of the more important charts that I will show you in the next few weeks. I will now take the opportunity to illustrate why – please look at the following weekly relative strength chart of the Retail HOLDRS (RTH) vs. the S&P 500. As I have mentioned before, please note that the relative strength of the RTH vs. the S&P 500 has served as a pretty good leading indicator of the stock market for the last few years (ever since it was incepted). What is it saying right now? Bulls (or at least those holding stocks such as KMRT) probably don’t want to know:

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) Six weeks after breaking out above its recent upside resistance line, the relative strength of the RTH has again declined below that same line - suggesting that investors should exercise caution going forward, as the retailers have historically led the market in price action by approximately a couple of months.

The weekly relative strength chart of the Retail HOLDRS (RTH) vs. the S&P 500 is probably not encouraging for the bulls. Since earlier this year, relative strength of the retailers has been struggling very hard to break out of its resistance line to no avail. Was the action of the last six weeks a fluke? Are consumers really cutting down? We will know better as Christmas arrives, but so far, the news (and the price action of the retailers) have not been very good (as also evident by the fact that the latest reading of Consumer Confidence was below expectations – more analysis on this next week).

My point is basically this: The fact that the market is overbought coupled with technical deterioration in numerous indicators that I track do not make a good combination – at least in the short-run. Finally, the liquidity pillar also looks to be deteriorating, as evident by the huge increase in insider selling during November and the fact that the IPO and the secondary offering calendar will be ramping up this week – after a brief hiatus for the last few weeks. This current pace of insider selling is expected to continue until the middle of December – as insiders are usually prevented by company policy to sell their shares before the companies release their quarterly earnings reports. The pace of offerings (primary as well as secondary) is expected to continue for the next three weeks – right up until the Christmas Holidays.

Readers should take this huge increase in insider selling seriously. As a rule, do not think of insiders as contrarian indicators. In that same article, please note the following (taken straight from the article): “November's insider sales were the highest monthly total since August 2000, when insiders sold off $7.7 billion worth of shares, according to Thomson data … The high-tech industry saw the greatest sell-off, with technology insiders selling $1.5 billion worth of shares in November. That represents an increase of 126 percent from October and the highest level of insider selling since May 2001.” I am sure that most of my readers will be familiar with the subsequent price action of the major market indices following August 2000 and May 2001, but if not, then I encourage you to go back and check out some historical charts. Trust me, it will be a very useful and money-saving exercise!

That being said, I am still longer-term bullish on the stock market. However, if we are to have a healthier stock market going forward (in at least the next few months) then we will need a correction sooner or later – and now is the “perfect time” to have that correction – as evident by a significant deterioration in my technical indicators and in my liquidity indicators. Finally, 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 (again a reading of over 40% in the former and over 50% in the latter), 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 increased slightly from 33.6% to 34.4% 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' 32% in the Bulls-Bears% Differential in the AAII survey shows that the public is still not too euphoric about the stock market - suggesting the potential for further gains to come in the next few months.  Again, based on this indicator alone, I would not be too brave to call the absolute top in the stock market unless we get a one-week reading of >50%.

Signing off,

Henry K. To, CFA

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