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The Top Calling Continues

(December 18, 2004)

Please note that we switched to a 100% long position from a 25% short position in our DJIA Timing System last Tuesday at 10,640. The new section on our DJIA Timing System will be delayed until I get back from Hong Kong on January 7th.

Dear readers, please note that 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. My publishing schedule from last week still stands. That is, from this commentary onwards, I will update on 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 will, however, continue to post to our Discussion Forum during that time and may also find some time to provide a short-term update. I am also scheduled to speak to a couple of investment professionals while I am in Hong Kong and will appreciate it if our any readers can act as a reference or recommend more investment professionals 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 top-calling crowd continues their relentless bashing of the stock market. I have said this before and I will say this again: Tops are inherently difficult to call. After all, who has consistently made money by shorting stocks over the long-run? Probably not many – especially not in the post WWII days of Fed intervention. In his latest weekly commentary “Canary in the Coal Mine”, Mr. John Mauldin of Millennium Wave Investments presents a very good case for being bearish on the UK for the foreseeable future. His justification? The appearance of an inverted yield curve in that country.

Mauldin cites a Federal Reserve study which concluded that the best predictor of an upcoming economic recession has been the appearance of an inverted yield curve (one that lasts over 90 days – thus taking late 1998 out of the picture). We currently have one in the UK. Mauldin also mentions that we should now on the lookout, as an inverted yield curve in the UK may be a pre-cursor to one here in the United States as well. Mauldin is also careful in his analysis, however, in that he mentions that we are still currently very far away from an inverted yield curve here in the United States. I would greatly recommend reading John Mauldin’s latest weekly commentary if you have not already done so.

Now, I know John Mauldin isn’t an alarmist by any means. But I have a feeling that there are some people out there who would take the UK study out of context and predict impending doom for the United States as well. Like Mauldin said, we are currently experiencing nowhere near an inverted yield curve, even though the yield curve is definitely flattening as can be witnessed by the following chart:

Differential Between the Long Bonds and the Fed Funds Rate vs. the DJIA (January 1998 to Present) - The spread between the long bond and the Fed Funds rate has now broken its October 2002 and June 2003 lows - a level not seen since November 2001. But the spread is still many basis points over the differential experienced during the 1995 to 2000 period.

The above chart shows the weekly long bond and Fed Funds rate differentials for 1998 up to the present. Sure, the spread (as represented by the red line) is definitely shrinking, but please note that relative over the 1998 to 2000 period, the current spread of approximately 2.6% is still many basis points higher. In fact, the spread between the long bond and the Fed Funds rate is still at a level not seen (excluding the recent three years) since late 1994 – just as the greatest bull run in stock market history was about to begin.

Long-time readers of my commentary may recall the study that we did earlier regarding the raising of the Fed Funds rate vs. the performance of the stock market (as shown by the Dow Jones Industrial Average). I last talked about that relationship in my November 7th commentary. In that study, we looked at the relationship between the raising of the Fed Funds rate and the stock market during the two cyclical bull markets (October 1966 to 1968 and May 1970 to 1972) within the context of the 1966 to 1974 secular bear market (note that I have done various comparisons between the current cyclical bull market and those two cyclical bull markets since I still currently believe we are in the midst of a secular bear market as well). Basically, the conclusion was this: If we are to follow the paths of the two cyclical bull markets in the late 1960s and early 1970s, then this market will not top out until the Fed Funds rate has appreciated 200 basis points from the trough – that is, at a rate of 3% (we are currently at 2.25%). Moreover, the market will not decline substantially until the Fed Funds rate rises a further 125 to 300 basis points (that is, to 4.25% to 6.00%). From the look of this study, I guess we are safe – but readers may now logically ask: what about the spread between the long bond and the Fed Funds rate during that time? Did the market go down substantially when the spread was still positive but in decline or did it not top out until the spread has reached the zero line? I will now attempt to answer these questions.

The following chart shows the spread between the long bond and the Fed Funds vs. the DJIA from January 1965 to December 1969 – a chart which covers the October 1966 to 1968 cyclical bull market:

Differential Between the Fed Funds and the Long Bonds vs. the DJIA (January 1965 to December 1969) - The spread between the long bond and the Fed Funds rate dropped to negative territory as early as April 1968, but the October 1966 to 1968 cyclical bull market (within the context of the 1966 to 1974 secular bear market) did not top out until eight months later.  Moreover, the DJIA ultimately rose 15% from its April 1968 levels before topping out eight months later.

It is interesting to note that even as the differential declined below the zero line, the DJIA brushed it off and resumed its uptrend. In fact, the differential hit the zero line as early as April 1968, but the DJIA did not top until eight months later – at a level that was 15% higher from the time that the Fed Funds rate rose above the long bond rate.

The second chart again shows this differential vs. the DJIA but from January 1970 to December 1974 – which covers the May 1970 to 1972 cyclical bull market:

Differential Between the Fed Funds and the Long Bonds vs. the DJIA (January 1970 to December 1974) - The spread between the long bond and the Fed Funds rate actually dropped to negative territory as at the same time that the May 1970 to January 1973 cyclical bull market topped (within the context of the 1966 to 1974 secular bear market).  However, we are currently still very far away from this differential dropping into negative territory.

The May 1970 to 1972 experience was a bit different, as the DJIA topped at the same time that the differential between the long bond and the Fed Funds rate declined below the zero line. However, just like the October 1966 to 1968 experience, the market made a significant part of its gain when the spread was declining. This actually makes sense – as the rise before a major top is always the most speculative. During that final speculative rise, people are always overly optimistic (or euphoric) – this is also the phase where all the major bears will capitulate. In fact, things will get so rosy and speculative that everyone will ignore all the warning signs, such as the decline of the differential of the long bond and the Fed Funds rate which you are witnessing on this chart.

Based on this study and the fact that this differential is currently only at 2.6%, I believe we are still currently far off from a major top – we will see.

Another study that we have previously done and which I am not updating is a study that shows the relative strength of the Bank Index (BKX) vs. the S&P 500. Please 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:

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.  However, this definitely does bear watching going down the road.

Currently, the relative strength of the Bank Index vs. the S&P 500 is still above the support line which dates back to May 2003. This weekly relative strength chart bears watching, of course, but until the Bank Index relative strength line breaks below this support line, there is still room for the current cyclical bull market to grow. As a matter of fact, history has shown that the market can still rise even as the relative strength of the Bank Index vs. the S&P 500 has declined substantially, such as the period from mid August to early 2000 (which was accompanied by the Russia, Brazilian, LTCM crises but which was followed by the biggest blow-off in technology stocks in history).

Readers may know that the Flow of Funds data was released by the Federal Reserve on December 9th. The report as released by the Fed contained all kinds of goodies. I will now use the latest (third quarter) data to update a study which was initially on my September 19th commentary – a study showing the percentage of equities and mutual funds held by households and non-profit organizations as a percentage of their total financial assets. In both the October 1966 to 1968 and the May 1970 to 1972 cyclical bull markets, the final “blow-off” was accompanied by a 2% jump in this percentage in the final quarter. While the fourth quarter of 2003 was close, it did not meet this criterion in terms of speculative fever:

Equities and Mutual Funds as a Percentage of Total Household Financial Assets (1Q 1992 to 3Q 2004) - 1) The 'blow off phase' in late 1999 and early 2000 saw the equities and mutual funds as a percentage of total household financial assets ratio topping out at 34.84% - with a concurrent increase in this percentage of over 3% in just one quarter! 2) Equities and mutual funds as a percentage of total household financial assets bottomed at 23.42% in the third quarter of 2002 in the recent 2000 to 2002 cyclical bear market.  The current bounce of slightly less than 4% (and especially in light of the latest decrease from 27.03% in Q2 to 26.58% in Q3)in this percentage is mediocre (at least on an absolute basis) - suggesting that the current rally in the equity markets is not over yet - especially given the fact that we have not had a final 'blowoff phase' so far - a phase which has historically meant an increase of at least 2% in this percentage in just one quarter.

As readers can see, the latest third quarter data actually showed a decrease in this percentage – suggesting that we are still not close to a speculative top yet. Of course, the fourth quarter data may say otherwise, but I will not bet on it from the look of things. Sure, a lot of indicators have gotten overbought, but I still do not see a huge urge by the public to buy stocks yet (and still no urge to speculate in Chinese or nanotech stocks).

In terms of the price action of the both the Dow Industrials and the Dow Transports, the market still looks bullish, as both indices broke out on the upside last week from its previous four-week narrow trading ranges:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to December 17, 2004) - Both the Dow Industrials and the Dow Transports managed to break out on the upside of their narrow trading ranges last week - suggesting further room to run.  The former closed at another nine-month high on Thursday while the latter closed at another five-year high on Wednesday.  Please note that the Transports are currently only 32 points away from an all-time closing high.

In retrospect, the four-week trading range leading up to last week’s action was not distribution – as both the Industrials and Transports zoomed higher over the last week. This breakout should be interpreted as bullish, even though a lot of my ST indicators are still at moderately overbought levels.

Bottom line: I am going to leave for Hong Kong very soon so I will not make today’s commentary too long (I should already be on the plane once this commentary is published) but bottom line, the stock market still looks longer-term bullish. The Bulls-Bears% Differential in the Investors Intelligence Survey has risen to 41%, while the same reading in the AAII survey has risen to 34%. Moreover, the put/call ratio is still pretty overbought. However, liquidity should be bullish starting the middle of this week, as the IPO and secondary offerings calendar should effectively shut off and not reappear again until the second full week of January. The fact that the market also held well during the busiest week in IPOs since September 2000 is also a bullish sign.

Signing off,

Henry K. To, CFA

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