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Thoughts From the Author

(January 13, 2005)

Please note that we switched to a neutral position from a 100% long position in our DJIA Timing System yesterday morning at DJIA 10,530.  It looks like that we are somewhat early - but based on the fact that a lot of our indicators are still not close to being oversold, we are confident that the market will provide a better opportunity to establish a long position at some point during the next few weeks.  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 Subscribers and Readers,

The year 2005 started off with a significant decline in the major indices.  From their respective highs, the Dow Industrials has declined (on a closing basis) 2.2%, the Dow Transports 5.9%, the NASDAQ Composite 3.9%, the S&P 500 2.1%, the S&P 400 4.3%, the S&P 600 5.6%, and the SOX 7.3%.  As one can see, the decline has been broad, and rumors are now being circulated suggesting that this cyclical bull market is or is close to being over.

Readers, however, should know that I have made the case over and over again in my past commentaries justifying that this cyclical bull market is not over yet.  Moreover, a top does not appear until it is painfully obvious - such as a continued ascent in the stock market despite a zero or a negative spread between the long bond and the Fed Funds rate or a huge speculative "blowoff" such as what happened in the grand finale in late 1999 and early 2000 when the NASDAQ Composite doubled in less than six months.  It is 4am here local time and I am pondering with myself about these issues:

  • The spread between junk bonds and Treasury bonds is at a five-year low and near an all-time low, suggesting that investors' appetite for risk is very close to an all-time high.  This is reflected in the fact that there are no obviously undervalued assets out there.  The U.S. dollar has probably the most propensity to increase in value but I would not call the dollar undervalued either.
  • Readers may recall that tech insiders dumped stocks at a feverish pace in November - the most insider sales in tech stocks since August 2000.  Please also note the spikes in insider selling during Spring 2000, Fall 2000, Spring 2001, and Winder 2003.  As a rule, I have never thought of insider selling as a contrarian indicator.
  • On the flip (bullish) side, the spread between the long bond and the Fed Funds rate is still over 2.5% - a spread that definitely is not indicative of a recession or even an economic slowdown going forward. 
  • There is still a lack of IPOs and secondary offerings coming online.  Sure, corporate buying and insider buying are still muted, but this has also happened historically in the first ten trading days of the year.  The lack of supply being sold or getting unlocked going forward is a potentially bullish sign for the market going forward.
  • What about speculative sentiment during the last few months?  Sure, we did not have the speculation in nanotech stocks or Chinese stocks that were the hallmarks during the December 2003 to January 2004 period, but the continued speculation in transportation, homebuilding, commodity, and casino stocks during the August 2004 to December 2004 period were not that far behind (note that the Dow Transports rose a stunning 30% in four months during that period).  Mr. Mark Hulbert's proprietary sentiment indicator, the Hulbert Stock Newsletter Sentiment Index (HSNSI) stood at 56.1% at the end of 2004.  For comparison purposes, the HSNSI, while close, did not get over 50% during the December 2003 to January 2004 period.  Moreover, the Investors Intelligence data had four consecutive weeks where the Bulls-Bears% Differential was over 40%, something that did not happen even during the early parts of last year (when the Bulls-Bears% Differential was over 40% for three consecutive weeks).  During the latest week, the Bulls-Bears% Differential in the Investors Intelligence Survey declined from 42.3% to 36.5% but this number is still showing a high amount of optimism relative to past readings:

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 relaitvely high level of 36.5% (down from 42.3% from a week ago) - despite the decline of the markets during the last two weeks.  The Bulls-Bears% Differential readings in this survey has been over 40% for four of the last five weeks - an overly optimistic reading any way you look at it.

Another sentiment indicator which I have been tracking of is the Rydex Cash Flow Ratio (the ratio of cash flows into the Rydex bearish and money market funds over the cash flows into the Rydex bullish and sector funds).  While this indicator does not have too much of a history, it has worked well in the past.  During the late August period, this indicator was showing extreme bearishness on the part of the Rydex funds family speculators - leading me to believe at the time that any rally from the August lows were most probably sustainable.  From late August to late December, however, this ratio has gotten way ahead of itself, as shown by the following chart (courtesy of

Note that the very low (inverse) readings in the Rydex Cash Flow Ratio in late August 2004 were comparable to the low readings during March and August of 2004 - suggesting that a bottom was being firmly put in place.  However, the run-up in this ratio into late December was also equally swift - as this ratio quickly rose above levels that were significantly higher than what were seen during the January to February 2004 period.

So what does this mean?  My guess is that we should treat this current correction (and it is a correction until further notice) with respect - even though I believe that we are still in a cyclical bull market.  At this point, readers should not buy stocks (unless you are very nimble and always have stop losses under your purchases) until the market has gotten more oversold.  Judging by indicators such as the Rydex Cash Flow Ratio (currently at 0.76 which is still very high - again, please note the above chart has been inverted), the put-call ratios, the ARMS Index, and the McClellan Oscillators, the market is still not that oversold.  The major indices have also not corrected in a significant way - as exemplified by "only" a 5.9% fall in the Dow Transports after a 30% rally in four months.

So when can we reasonably expect a bottom?  First of all, I would like to see the Rydex Cash Flow Ratio breaking the 0.90 barrier again.  I would also like to see a Bulls-Bears% Differential reading in the Investors Intelligence Survey that is comparable to the readings during late May 2004 and late August 2004.  Let's also take a look at the 10-day and 21-day simple moving average of the ARMS Index, which has been very reliable in calling bottoms in the past:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - At these levels, neither the 10-day moving average (1.32) nor the 21-day moving average (1.12) of the NYSE ARMS Index are currently indicating an oversold market.

The current 10-day reading of 1.32 is still not at a level that I will associate with an oversold market.  Since trading the market is all about stacking the odds in your favor, I will not go long here until we see a good spike in the 10-day moving average of the ARMS Index - to at least 1.45 (which would be comparable with the late October reading) or even higher.  I would also like to see a corresponding increase in the 21-day moving average - to 1.30 or higher.  Right now, we are not even close at 1.12.

The author would also like to see a further correction in one of the more speculative major indices - the Dow Transports.  Following is a daily chart of the Dow Industrials vs. the Dow Transports which I have nearly always put in every one of my commentaries in the past:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to January 12, 2005) - The Dow Transports broke down in a significant way during the last couple of weeks (off 5.9% from an all-time high made on December 28th).  Potential support?  Probably around DJTA 3,300.  Both the Dow Industrials and the Dow Transports broke down from significant highs in the last couple of weeks - with the action of the Dow Transports looking particularly ominous (as it got very overbought mainly because of its relentless uptrend over the last five months.  We should see at least a ST rally during this week, but for now, the short to intermediate trend for both the Dow indices should remain down.

As I have mentioned before, the fact that the Dow Transports has only corrected 5.9% from its December 28th top (after rallying 30% in four months) makes me think that this correction is not over yet.  What would be a reasonable sustainable bounce point, you may ask?  Readers please note the uptrending line shown in the above chart which is connecting the March 2003, March 2004, May 2004, and August 2004 bottoms in the Dow Transports.  If this long uptrending line is to hold as support, then I would expect the Dow Transports to correct to approximately 3,300 before bouncing in a big way.  The 3,300 level also represents a retracement level of slightly over 60% from the August bottom to the December top - a retracement level which is very close to the Fibonacci ratio of 0.618 - a number which a lot of traders pay attention to.

Bottom line: Readers should keep in mind that I believe we are still in a cyclical bull market.  That being said, this does not mean we would not have a correction from time to time - even significant ones - all the more so since we did not have a very significant correction during the entire year of 2004.  We should actually welcome these corrections, since they usually provide good buying opportunities when all is said and done.  Readers should also be reminded that all one needs in order to make outsized returns during a given year is to be patient and wait for an oversold market before committing on the long side.  This strategy is usually the most successful for the majority of traders and it also involves the least amount of stress.

Signing off,

Henry K. To, CFA

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