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Liquidity Still Reigns

(December 26, 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.

Good news – our charts section is now interactive! We still currently provide only two studies – the % deviation from its 50 & 200 DMAs for the DJIA and for the NASDAQ Composite. But this will change as we seek to improve our website further and as we get more subscribers!

Dear readers, I am currently in Hong Kong and am greatly enjoying my stay here. This will be an abbreviated commentary since I am technically taking a vacation – although I have been and will be speaking to a few investment professionals here in order to get a better picture of the investment/economic climate in both China and Hong Kong. I will report back to my readers as more insights come along. The final commentary for this year will be on the 28th, and I don’t anticipate updating again until I get back from Hong Kong on January 7th. Please check our Discussion Forum for any current tidbits on Hong Kong and Macau.

The market continued its uptrend last week on low holiday day type volume, but from a Dow Theory standpoint, the market still looks very bullish (aside from the expensive valuations) – as the Dow Jones Industrial Average made a closing high not seen since June 2001 while the Dow Jones Transportation Average actually made AN ALL-TIME HIGH last Tuesday. The following chart shows the day-to-day action of the Dow Industrials vs. the Dow Transports from January 1, 2003 up to last Thursday:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to December 23, 2004) - Both the Dow Industrials and the Dow Transports continue their relentless uptrend after breaking out on the upside of their narrow trading ranges last week - suggesting further room to run.  The former closed at a high not seen since June 2001 while the latter closed at AN ALL-TIME HIGH high on Tuesday.  This author has been continually making the case that we will see an all-time high in the Dow Transports.  This new high has now materialized.  The next important thing to watch will be to see whether the Dow Industrials will confirm the Dow Transports in making an all-time high as well.

As I mentioned in the above chart, the fact that both the Dow Industrials and the Dow Transports made significant new highs during the last week is technically bullish – there is just no other way to interpret this action. Caution, however, should be exercised going forward, as the Dow Transports is now a huge 28% above its August lows – while the Dow Industrials still has not confirmed the Dow Transports by also making an all-time high (at 11,723). We will definitely give the Dow Industrials some time, but please bear in mind that the October 1966 to 1968 cyclical bull market top was preceded by a primary non-confirmation of the Dow Jones Rails (the present-day Transports) by the Dow Industrials while the May 1970 to 1972 cyclical bull market top was preceded by a primary non-confirmation of the Dow Industrials by the Dow Transports. I have mentioned this little factoid before in my previous commentaries – I am surprised that no-one else has mentioned this fact – aside from a brief mention of this by Richard Russell a few days ago in his daily commentaries.

Bears would mention that the market is now overextended. Sure, some of my shorter-term indicators are definitely overextended, as evident by indicators such as the put/call ratio, Rydex cash flow ratio, and the sentiment readings in various surveys such as the Investors Intelligence Survey. What the bears should keep in mind is that in cyclical bull markets, these sentiment readings can get even more extended on the upside – and unfortunately for the bears, the market usually accelerates on the upside in the face of all these optimistic readings before forming a significant top.

Let’s now take a look at a couple of sentiment readings that we keep track of on a weekly basis. We will first start off with the Bulls-Bears% Differential in the Investors Intelligence Survey:

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey has been over 40% for the last two weeks (at 41.0% and 40.8%, respectively) - suggesting that sentiment (per this survey) is getting a bit excessive on the bullish side.  As long as there is ample liquidity - such as what we are experiencing now - however, we are still not too worried about this bullish optimism yet.

As shown in the above chart, the Bulls-Bears% Differential in the Investors Intelligence Survey has been over 40% for the last couple of weeks – suggesting that caution should now be warranted. As long as there is ample liquidity, however, we are still too not worried about this indicator at the moment – as this reading can stay overextended for weeks in a typical cyclical bull market.

I would be much more worried if the Bulls-Bears% Differential in the American Association of Individual Investors (AAII) Survey was concurrently showing a very overextended reading, but as of last Wednesday evening, this was not the case. During the last week, Bulls-Bears% Differential in the AAII Survey increased from 34% to 42%. As I have mentioned in my prior commentaries, I would not be overly worried about this survey unless we see a one-week reading of 50% or over. We are currently not there yet:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey rose from 34% to 42% in the latest week, suggesting that the bullish optimism reading in this survey is also getting a bit excessive.  Again, as long as there is ample liquidity, we are still not too worried about this high reading.  Readers should be VERY CAUTIOUS, however, if this reading ever reaches 50% or over in the upcoming weeks.

On a longer-term basis, however, there is definitely still room for any upside in the major stock market indices. In my previous commentaries, I have stated that the topping range of the S&P 500 is most likely (given the experience of the two cyclical bull markets in the 1966 to 1974 secular bear market) somewhere in the neighborhood of 1,250 to 1,350. I still stand by this range although I would not be surprised if the S&P 500 actually exceeds 1,350 before forming a significant (probably another multi-year given that I still believe we are in a secular bear market) top.

The percentage deviation from the 200-day moving average in both the Dow Industrials and the NASDAQ Composite is still nowhere near highly overbought, as evident from the following charts:

Daily DJIA Closing Values vs. its % Deviation from its 50 and 200 DMAs (January 2003 to December 23, 2004) - Much, much higher deviations from the 200 DMA during most of 2003!

Daily NASDAQ Closing Values vs. its % Deviation from its 50 and 200 DMAs (January 2003 to December 23, 2004) - Again, much higher deviations from the 200 DMA during most of 2003!

Again, the % deviation from the 200 DMA of the DJIA is currently at 5.68% and for the NASDAQ Composite at 10.04%. The % deviations for both the DJIA and the NASDAQ were at much higher levels during most of 2003 – and they also most recently topped out at 14% and 25% in January 2004 and September 2003, respectively. As shown by this longer-term indicators, we are still very far away before the bears can start calling for a significant top in the major indices.

As shown in my commentary last week (and updated this week), the spread between the long bond and the Fed Funds Rate (while getting narrower) is still nowhere near a point where a reversal of the market is inevitable, as shown 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 spread between the long bond and the Fed Funds rate narrowed by a mere two basis points in the previous week – effectively an insignificant decline. While the Long Bonds and Fed Funds Differential has definitely narrowed quite a bit over the last six months, we are still nowhere near a level (effectively the zero line if we apply the 1966 to 1974 experience to the current market) where a decline in the stock market is inevitable.

This bullish view is reinforced by the relative strength of the Bank Index vs. the S&P 500, as it is still holding above its support level – indicating that this cyclical bull market is solidly intact:

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 is still above support -- suggesting the cyclical bull market is still solidly intact.  In fact, relative strength of the Bank Index actually had a slight uptick during the latest week.

The most recent short interest data for the New York Stock Exchange has also been released. While the latest month (settlement date of December 15, 2004) shows a further decline of 112 million shares in short interest, we are still only 490 million shares less than the all-time high in the number of shares shorted on October 15, 2002 (right at the bottom of the last cyclical bear market):

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to December 15, 2004) - For the month ending December 15, 2004, total short interest on the NYSE decreased by 112 million shares. Short interest on the NYSE is still very close to the all-time high (490 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.

Moreover, it is interesting to note that short interest declined approximately 779 million shares (approximately 10% of the entire short interest on the NYSE) in the six months leading up to January 15, 2004 – a date which was very close to the last significant top in the major stock market indices. In the six months leading up to December 15, 2004, however, short interest actually increased 156 million shares – suggesting that there is still ample “fuel” to sustain a further uptrend in the months ahead.

Bottom line: Tops are still inherently difficult to call. A lot of my ST indicators are getting highly overbought but this does not mean the market cannot get even more overextended, especially since there is still ample liquidity in the stock market – at least until the second week of January anyway. The fact that my longer-term indicators are currently not indicating a highly overbought situation is not a good sign for the bears. Readers should focus on the bigger and longer-term picture, and that picture is currently saying that the bull market is still solidly intact.

Signing off,

Henry K. To, CFA

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