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Watch Out - Bank Index Now Breaking Down

(January 17, 2005)

Please note that we switched to a neutral position from a 100% long position in our DJIA Timing System on the morning of January 12th at DJIA 10,530.  No new signals as of now although we are planning to establish a 50% short position in our DJIA Timing System within the next few trading days.  The new section on our DJIA Timing System will be completed within the next few weeks.

Dear Subscribers and Readers,

After reading the first paragraph of this commentary, you may wonder the change of position this author have regarding the stock market.  At this point last week, I was still planning to look for a bottom in the next couple of weeks to establish a long position, but recent events have caused me to revise my position.  As the title implies, the main reason is the recent breakdown in the Bank Index, but of course, there are other reasons which I will illustrate later in this commentary.  We are now planning to establish a 50% short position in our DJIA Timing System within the next few days - which is the maximum allowable short position in our DJIA Timing System.  Let's start off in classic Dow Theory terms with a comparison of the DJIA vs. the DJTA from January 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to January 14, 2005) - 1) The Dow Transports continue to break down in a significant way during the last three weeks (off 6.4% from an all-time high made on December 28th).  Potential support?  Still around DJTA 3,300. 2) Both the Dow Industrials and the Dow Transports broke down from significant highs during the last few 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.  The Dow Transports has also tended to lead the Dow Industrials over the last two years - this breakdown is definitely very ominous especially coming in the face of a major non-confirmation by the Dow Industrials.

The breakdown of both the Dow Industrials and the Dow Transports during the last three weeks is particularly ominous, especially given the huge 30% rise in the Dow Transports from late August to late December and in the face of a MAJOR Dow Transports non-confirmation by the Dow Industrials (the Dow Transports making an all-time high while the Dow Industrials failed to confirm on the upside - in fact, it was approximately 900 points away from confirming).  It should also be kept in mind that the Dow Transports has tended to lead the Dow Industrials over the last two years - and thus the recent 6.4% decline in the Dow Transports probably does not bode well for the Dow Industrials going forward.  The potential support area for the Dow Transports is still a print of DJTA 3,300, but I would not be surprised if the Dow Transports eventually break below that level.

Now, let's cut to the chase and discuss the breakdown of the Philadelphia Bank Index and put everything into perspective.  I will first start off with a discussion of the following weekly chart - a chart that I have posted on this website in previous commentaries.  Following is the weekly relative strength chart of the Bank Index vs. the S&P 500:

 Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1) The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards. 2) 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. 3) Relative strength of the Bank Index has marginally broken below support -- suggesting the cyclical bull market is now in danger.

As shown in the above chart, the relative strength of the Bank Index vs. the S&P 500 has broken below its support line - a support line which dates back to May 2003.  This breakdown is all the more authoritative given the fact that the spread between short-dated and long-dated bonds continues to narrow while credit spreads are now close to an all-time low.  The carry trade is nearly over, and the market is discounting that fact.  The fact that the relative strength of the Bank Index is declining from such a high level (from a level that is even higher than the 1997 to 1998 levels) tells me that the coming decline could be pretty vicious, indeed.

The Bank Index has always acted as a very good leading indicator for the stock market, and this latest decline will have to be respected.  While this cyclical bull market does not have to be over in the face of a weak Bank Index (and this is what happened during the mid 1998 to early 2000 period when the major indices continued to rise in the midst of a weak Bank Index), it does not mean that we will not have a significant correction here.  In fact, this is what I am currently betting on, as a weaker Bank Index is most probably discounting the fact that some marginal borrower (whether it is a country or a big corporation) out there is about to go belly up.  Holders of cyclical stocks please take heed.

Now, let's take a look at the state of corporate profits.  Following is a chart showing the level of corporate profits and the level of corporate profits as a percentage of GDP from the first quarter of 1980 to the third quarter of 2004 (which was released in late December 2004).  According to the Bureau of Economic Analysis, total domestic corporate profits actually declined $59.3 billion in the third quarter from the second quarter of 2004:

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 3Q 2004) - Both corporate profits and corporate profits as a % of GDP took a plunge in the third quarter of 2004.  The former declined from $988.6 billion $929.3 billion while the latter declined from 8.5% to 7.9%.  Such a plunge in profits (in both absolute and percentage terms) has not been seen since the decline of coporate profits from the first quarter to second quarter of 1998.

This latest decline in corporate profits has not been seen since the second quarter of 1998, when corporate profits declined from $772.8 billion to $703.1 billion from the first quarter to the second quarter of 1998.  Diving deeper into the press release, it is interesting to note that the latest decline in corporate profits can be attributed to the decrease in corporate profits in the financial sector, as corporate profits in the financial sector declined $68.7 billion in the third quarter (in other words, accounting for more than 100% of the total decline).  In fact, corporate profits in the financial sector also experienced a decline in the second quarter - a $7.9 billion decline even as total corporate profits increased $28.3 billion!  The last time that corporate profits in America experienced such a dive was the second quarter of 1998, and we all know what happened in late 1998, as the world went through the Brazilian, Russian, and LTCM crises.  The million-dollar question is: Who is the next marginal borrower that is going to go belly up (or close to it, anyway)? 

The next logical question is: What can we do to make money off of this next crisis, if it is going to happen?  My quick answer is: Go to cash and sit on it (the next alternative is to buy Treasuries as credit spreads will widen in the event of a financial crisis).  When a financial crisis hits somewhere in the world, the US$ usually goes up, as the US$ is still the world's reserve currency and is thus regarded as a safe haven.  The fact that the US$ is still so oversold (along with the fact that everyone and his dog is still betting the US$ will go down) makes holding cash in a U.S. bank account a doubly attractive option.  If one is not satisfied with this "safe" route, then one could go ahead and short sell financial stocks - preferably banks that lend money to developing countries.

There is another alternative - this may not sit well with some of my subscribers since I know for a fact that a significant number of my subscribers still have long positions in stocks of this industry.  Before I go on, let me say this: In future commentaries, I intend to dedicate more time and space to industry analysis, as I believe tactical allocation among different industries is probably more important (and which makes more money) than being able to time the S&P 500 on a weekly basis.  The sector I am talking about?  It is the steel industry.

Why?  First of all, it is important to keep in mind that the steel industry is a very cyclical industry - as investors who have invested in steel stocks in the past can attest to.  Moreover, it should be noted here that 70% of the growth in demand for steel during the last six years has been because of the growth in Chinese demand.  There is no doubt about it.  If you are invested in steel stocks, you are essentially betting on the continued construction/real estate and car manufacturing boom in China.  However, there are signs that the construction/real estate and car manufacturing boom is probably going to slow going forward - as investments have continued to rise in recent years and is now at approximately 45% of GDP (compared to approximately 16.5% of GDP here in the United States).  This is also happening in the midst of a continued tightening of credit by the Chinese Central Bank.  It is also interesting to note that there is currently a huge overcapacity in the car manufacturing in China.  As the guys at GaveKal has pointed out, there are now over 300 car manufacturers in China and the supply of cars is projected to nearly double that of demand in 2006!  Talk about overcapacity - cars are literally rotting in the dealers' lots in China.  The shortage in steel was mainly driven by this huge buildup in capacity and production - and I do not believe this will last going forward.

On the other side of the equation, tons of companies are now actively building steel furnaces due to this perceived shortage going forward.  However, as this article pointed out, the Chinese is expected to become a net exporter this year, and more production is on the way for 2006.  Even the companies that are worried about overcapacity going forward are building more steel furnaces themselves, as other companies are also trying to take advantage of the two-year rise in steel prices.  Therefore, if you are long in steel stocks - not only are you betting on a continued boom in China going forward, you are also making a bet that the production side would not be able to keep pace with demand.  I have a different view on both accounts - and if my view holds true, then I think there will be a drastic reversion to the mean for steel stocks in the next six months, especially since the speculative favor in steel stocks has gotten pretty high over the last 18 months.

I am going to conclude this weekly commentary with an update of the popular sentiment indicators, including the Rydex Cash Flow Ratio indicator.  To sum up, virtually all these indicators (except for the Bulls-Bears% Differential in the American Association of Individual Investors) still do not indicate a sustainable bottom.  I will begin with the chart of the DJIA vs. the Bulls-Bears% Differential in the AAII Survey (the corresponding chart for the Investors Intelligence Survey can be viewed in last Wednesday's commentary):

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey continued to decline from a lowly 3% to (6%) in the latest week, suggesting that retail investors continue to be bearish in their investment decisions.  While this is longer-term bullish, it does not mean that the market cannot decline further from here.  Again, 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.  If last year's experience is to hold, then we may get a significant bottom in the next two weeks.

As outlined in the above chart, the Bulls-Bears% Differential in the AAII survey has declined to a negative 6%, suggesting that individual investors are now more bearish than bullish.  This indicator has typically had a lead time of two to three weeks - suggesting that a tradable bottom may be in place for the stock market as early as this week or the week after.  However, in the author's opinion, any bottom here should only be viewed as a temporary bottom - as I believe that the weakness of the Bank Index triumphs over everything else.

Following is the weekly chart of the Market Vane's Bullish Consensus vs. the DJIA.  I have shown this chart before.  The latest reading of 63% suggests that we most probably do not have even a tradable bottom yet:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading currently stands at 63% - still at a relatively high level which most probably does not indicate a bottom here anytime soon.  For comparison purposes, this reading was at  61%, 59%, 56%, and 60%, respectively at the March, May, August, and October bottoms.  I believe we should see a reading below those readings before we can have a stronger rally going into 2005.  My preference and target?  Most probably a reading of 50% or so - the readings that we consistently got during the July to September 2003 consolidation period (also circled above).

Like I mentioned in the above chart, my "ideal" reading of this survey is for a reading of 50% before I can be confident in going long stocks again on a longer-term basis.  Please note that the 50% reading is what we got during the July to September 2003 consolidation period.  Any rally that begins from the 50% level (or lower) should most probably be sustainable going forward.

This statement is repeated from Wednesday's commentary: "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 Decisionpoint.com)."  Following is an update on the Rydex Cash Flow Ratio.  Please note that this ratio is now at 0.79, an increase of 0.03 from last Wednesday evening and close to the bottom of the Bollinger Band.  In the short-term, I believe that there is a good chance this ratio will at least return to the 20-day EMA (or the mid-range of the Bollinger Band) of 0.70, but right now, this ratio is still not close enough to being oversold on a longer-term basis:

Rydex Cash Flow Ratio - 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.

Like I said before in my previous commentaries, I would like to see this ratio break above the 0.90 again before I can be confident in calling a sustainable bottom.  Optimally, I would like to see this ratio reach the 1.00 to 1.05 range again, which would be similar to the readings that we got during the March 2003, August 2003, and August 2004 periods (or even the 1.75 level which was reached during October 1999).  I will update the 10-day and 21-day moving average of the ARMS Index in Wednesday's commentary.

Bottom line: Readers should understand this.  While I still believe that we are in a cyclical bull market, it does not mean that we will not have a significant correction going forward.  In fact, the recent breakdown of the Bank Index is precisely giving us advance warning of this possibility.  Readers who are invested in financial stocks or in very cyclical stocks (in particular, the steel industry) should take heed.  This author will most probably be taking a 50% short position in our DJIA Timing System within the next few trading days.

Signing off,

Henry K. To, CFA

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