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It is Still Too Early for a Top

(January 9, 2005)

Please note that we switched to a 100% long position from a 25% short position in our DJIA Timing System on December 14, 2004 at 10,640.  We are currently looking for an exit at above these levels since I believe the market should at least have a ST rally.  More details to follow in the following commentary.  The new section on our DJIA Timing System will be completed within the next few weeks.

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 now back in Houston from my trip in Hong Kong but am still not 100% - mostly because of jet lag and the fact that my total time in the air was nearly 20 hours long.  During my stay in HK, I managed to speak to numerous investment professionals, including the guys at GaveKal and an economics and finance professor at the very prestigious University of Hong Kong.  I will post my Q&A sessions with these guys on our website as soon as I can.  In the meantime, let's just say that China is definitely the real thing, and Hong Kong will be a major benefactor of the China economic revolution.  Despite the continued and consistent disappointments from the Chinese Empire since the latter period of the Ming Dynasty (1368 to 1644), I sincerely believe that the current economic revolution in China will not be deterred.  The only wildcard is Taiwan and her calls for Independence.  The Chinese leadership will not tolerate an independent Taiwan, and they are willing to risk war with the United States if it ultimately comes to that (of course, a lot of this hinges on how Hong Kong can be successfully integrated with the Chinese Mainland but I am not going to further discuss geopolitics since we are supposed to focus on the stock market in these commentaries).

As an aside, I believe at least the first half of the 21st century will still belong to America.  That being said, any Fortune 1000 company that ignores or fails to do business successfully in China going forward will ultimately be dismantled or acquired.  I believe this is a valid and common-sense prediction.  Corporate CEOs please take heed.

Okay, let's get on with a discussion of the markets.  On a short-term basis, the markets were definitely getting overbought in late December.  Sure, liquidity was still ample, but nothing goes straight up forever.  The correction that the major indices had last week should be viewed as a common occurrence within a cyclical bull market - and nothing else.  Perhaps we have already had a major top; perhaps not.  Even if we did experience a major top in late December, it is still too early to tell.

Like I have mentioned many times before, the market is all about playing the probabilities - and right now, the probabilities (to me) are not indicating a top here.  As Jesse Livermore often said: "Markets are never wrong-opinions often are."  There are numerous predictions out there predicting that the market has already topped and that the secular bear has already reasserted itself.  Where are the justifications?  Sure, the market has gotten overbought in late December.  Sure, short rates are rising and are due to rise further in the coming months.  Moreover, stocks are still overvalued (per the high P/E ratios and the low dividend yields), while earnings growth is due to slow down.

However, as I have shown in all my previous commentaries during the last six months, all the above reasons (even when combined together) do not make a convincing case for a top.  For example, margin debt in recent months (as of the end of November 2004) has not expanded in a very significant way - certainly not in a way that will indicate a significant top.  Cash in both cash and margin accounts as a percentage of total margin debt on the NYSE is still nearly twice the ratio to what was experienced during the first three months of the year 2000.  The following two charts showing the Wilshire 5000 vs. the increase in margin debt on the NYSE and along with the Wilshire 5000 vs. the various cash to margin debt ratios illustrate these arguments perfectly:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to November 2004) - As shown on this chart, while the rise in margin debt got slightly out of hand during the last three months as of the end of November 2004 (a rise of $23 billion by NYSE members), the longer-term trend (as shown by the increase of margin debt in the last six and twelve months) is still not showing a huge speculative increase in margin debt.

The above chart shows the increase in margin debt on the NYSE during the most recent three, six, and twelve months for the month ending November 2004.  While the increase in margin debt during the last three months (red line) has gotten slightly out of hand with an increase of $23 billion, the increase in margin debt during the last six and twelve months is still at a not-too-high number of $17 billion and $28 billion, respectively.  Over the short-run, we may see a little calming down in the increase of margin debt, but over the longer-run, there is still not too much cause for concern.  This notion is further reinforced by the following chart:

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

As I have illustrated in the above chart, cash levels as a ratio of margin debt is still nearly twice to what they were back in the year 2000.  The above two charts indicate that we do not have excessive leverage and risk-taking in the system.  Sure, the market continued to decline during most of the 2001 to 2002 period despite the "bullishness" as shown by the action of margin debt, but readers should keep in mind that we were in the midst of a cyclical bear market at that time.  Until further notice, we are still in a cyclical bull market, and cyclical bull markets do not usually end until we have seen an excessive amount of both speculation and optimism.  Right now, we are still not close.

As shown in my November 7, 2004 commentary, this cyclical bull market (if we are to follow the historical path of the two cyclical bull markets within the 1966 to 1974 secular bear market - which is the most pessimistic scenario possible in my humble opinion) will most likely not top out until the Fed Funds rate is at least 200 basis points from its trough - or until it has hit a rate of 3% or over.  My December 18, 2004 commentary also reinforces the continuation of this cyclical bull market.  In that commentary, I discussed the fact that the two cyclical bull markets within the 1966 to 1974 bear market did not top out until at least the level of the Fed Funds rate has risen over the rate of the 30-year Treasury bond.

The final chart in my November 21, 2004 commentary shows a very interest phenomenon.  It showed that both the pre-2003 total absolute earnings and total earnings as a percentage of GDP for public companies reached a peak in the third quarter of 1997, and yet the major indices continued to rise for more than two years until the first quarter of 2000.  The second quarter of 2004 (I will update the third quarter numbers as soon as I can) shows a new high in absolute earnings and a reading of 8.5% for total earnings as a percentage of GDP.  If we are to follow historical precedent - even assuming a decrease in total earnings going forward both on an absolute and relative basis - than the major indices still have room to grow.

I have not shown the following chart for three months but the following weekly chart shows the performance of the Dow Jones Industrials vs. the level of M-3 for the period from January 1999 to December 27, 2004.  It is interesting to note that every time M-3 growth has flattened over the last few years, the market (as represented by the DJIA) has underperformed (either concurrently or on a slightly lagging basis):

Weekly M-3 vs. Dow Industrials (January 1, 1999 to December 27, 2004) - Readers - please look carefully at the six circled areas.  Every time M-3 growth has been flat over the last few years, the market has either stayed flat or experienced a significant correction.  Hopefully, the recent flattish trend of M-3 growth has abated, as M-3 increased a whopping $56.6 billion for the week ending December 27, 2004.

For the latest week ending December 27, 2004, however, M-3 rose a whopping $56.6 billion.  While one week does not make a trend, the continued increase in M-3 will have very bullish implications going forward, especially if the major indices reach a very oversold status during the next few weeks.

That being said, the action of the last couple of weeks looks short-term to intermediate-term bearish.  While some of my very short-term indicators have gotten very oversold (such as the NYSE, NASDAQ, S&P 400, and S&P 600 McClellan Oscillators and the percentage of stocks below its 20-EMA on the NYSE and on the very speculative Dow Transports), my more intermediate term indicators are telling me otherwise.  For example, both the 10-day and the 21-day moving average of the NYSE ARMS Index are still not close to oversold status as the former is currently only at 1.23 while the latter is at 1.09.  Moreover, we only got one >2 reading (2.5 to be exact) in this decline so far.  This 2.5 reading was obtained on January 4th, the first >2 reading since October 8th:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - At these levels, neither the 10-day moving average nor the 21-day moving average of the NYSE ARMS Index are currently indicating an oversold market.

As shown in the above chart, the current readings of both the 10-day and the 21-day moving average cannot be regarded as indicating an oversold market, especially when compared to some of the higher readings that we have gotten over the last twelve months.

The sentiment surveys are also not indicating an oversold market.  The best example is the Bulls-Bears% Differential reading 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 is still at a very high level of 42.3% - despite the heavy decline of the markets during last Monday to Wednesday (this survey is taken at the close on Wednesday evening).  The Bulls-Bears% Differential readings in this survey has been over 40% for the last four weeks - a way too optimistic reading any way you look at it.

As I outlined in the above chart, the latest reading in the Investors Intelligence Survey is still not showing an oversold market - the major reason being that the latest reading of 42.3 is on the very high side, along with the fact that this reading has been over 40% for the last four weeks.  Not only is this reading not oversold, but it is pretty heavily overbought given the recent action of the stock market.

Meanwhile, the latest Bulls-Bears% Differential in the American Association of Individual Investors Survey is what I will have expected, as the latest reading declined from a relatively high 42% to only 3% as of last week:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey dived from 42% to only 3% in the latest week, suggesting that investors have taken a 180-degree turn in their investment decisions.  While this is longer-term bullish, it does not mean that the market cannot decline further from here. In fact, the decline of this reading has acted as a leading indicator in the past for the stock market (on the downside) during both the late July to August and the late September to October period.

However, it is interesting to note that this not necessarily mean that a bottom is already here.  In fact, the decline of this reading has acted as a leading indicator for the stock market on the downside during the late July to August and the late September to October period, when the Bulls-Bears% Differential declined from 12% to negative 2% for the week ending July 30, 2004, and from 24% to 2% for the week ending October 1, 2004 (in fact, this has acted as a lead of approximately three weeks during those two occasions).

Bottom line: While there is nearly no doubt that we now have a ST to intermediate term downtrend on our hands, the fact that the market is very oversold on a very short-term basis indicates that we should at least have a decent rally during parts of this week.  Any further rally, however, should be sold until we can get a clearer perspective on whether the market will need a longer consolidation period before it can enjoy a more sustainable uptrend again.  The longer the consolidation period, however, the higher the ultimate gains will be as this cyclical bull market matures.  I will be looking for an exit point in our DJIA Timing System at some level above our entry point of 10,640 and at this point, will probably not get long again until the market reaches a more oversold level.  I will provide more bottom-fishing targets during Wednesday's or next week's commentary.

Signing off,

Henry K. To, CFA


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