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Short Term Outlook for the Stock Market

(January 23, 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. We were planning to establish a 50% short position in our DJIA Timing System early last week but the market got away from us before we could establish the trade. Oh well - there will be other opportunities. The new section on our DJIA Timing System will be completed within the next few weeks.

Dear Subscribers and Readers,

As we mentioned in the first paragraph, our intention to initiate a short position in our DJIA Timing System was scuttled as the market very quickly got away from us last Wednesday afternoon.  We had expected more of a rally but that did not materialize.  The late afternoon decline on Friday also surprised us - and I am sure it surprised quite a few people as well.  This could've been worse - at least we were not on the long side trying to find a way out of our positions.  For now, we will stay neutral.

Besides the "surprise declines" last Wednesday and last Friday, there is really nothing new to report.  As we outlined in our market commentary last week, it was time to be careful as the Bank Index (among other things) was breaking down.  I also believed that the market was in a defined downtrend, and that we would not hit a sustainable bottom until the market got more oversold.  I still stand by this view (ST bearish) as of now.  I will back up my view in the following commentary.

Let's cut right to the chase and take a look at the daily chart of the Dow Jones Industrials vs. the Dow Jones Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to January 21, 2005) - The Dow Transports continue to break down in a significant way during the last three weeks (off 8.9% from an all-time high made on December 28th).  Potential support?  Still around DJTA 3,300. Both the Dow Industrials and the Dow Transports continue their descent during the last week as they lost 1.6% and 2.8%, respectively for the week.  This represent the third consecutive down week to start off the year - something which has not occured since 1982.  For the year, the two Dow indices are down 3.6% and 8.6%, respectively.

As I mentioned in the above chart, the market (as measured by the DJIA and the DJTA) declined three consecutive weeks to begin the year, something which it has not done since 1982.  Is this a significant statistic?  Probably not, but it is definitely interesting.  Like I mentioned last week, this author does not believe we will see solid support here at least until the Dow Transports has declined to approximately the 3,300 level.  As of right now, we are looking to be "on track." 

In last week's commentary, I discussed the breakdown of the Philadelphia Bank Index and the possible implications.  Since then, the Bank Index has risen above its support line again but the damage is done - especially given the continued tightening by the Federal Reserve and the continuing narrowing of the spread between short term rates and the yield of the long bond.  The fact that the Bank Index pierced support from such a high level also makes this breakdown more authoritative.  Following is the updated weekly chart of the relative strength 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 marginally broke below support last week -- suggesting the cyclical bull market is now in danger.  It has bounced somewhat in the latest week, but the damage is already done. The BKX definitely bears watching going forward.

As shown in the above chart, the relative strength of the Bank Index vs. the S&P 500 marginally broke below its support line last week - a support line which dates back to May 2003.  As I said last week, the carry trade is nearly over, and the market is discounting that fact.  However, it is to be kept in mind that the breakdown of the Bank Index does not necessarily mean the imminent end of the cyclical bull market (similar to the mid 1998 to the early 2000 experience when the DJIA rose to new highs in early 2000).  Rather, the breakdown of the Bank Index represents a danger signal - a danger signal that all investors should take heed.  This was brought home (in spades) during the late 1998 period, when the Brazilian, Russian, and the LTCM crises all hit at around the same time.  Where will the crisis hit this time?  I am not going to bet on anything here but my guess would be China (which I outlined why in last week's commentary, “Bank Index Now Breaking Down” ).

Okay, now that I have gotten this out of the way, where are we heading in the short-run, you may ask?  At which point can we expect a tradable bottom?  Good questions, and I will try to answer them in the following paragraphs.

No doubt, the market has declined in a substantial way during the last three weeks, but according to most of the technical indicators that I have been keeping track of, the market is still not oversold - at least not at a point at which I will initiate any long positions.  I have said this before and I will say this again: The market is all about playing the probabilities and keeping risks to a minimum.  This is how one can extract profits from the market in the long-run.  If this means only buying stocks once or twice during any given year, then so be it.  I will definitely not initiate any long positions here, even at the risk of the market getting away from me on the long side.  I have previously mentioned a 3,300 support level for the Dow Transports (which we are definitely not there yet).  I will now follow with more analyses.

I will begin the "whether we are oversold" analysis by looking at the 10-day and the 21-day simple moving average of the NYSE ARMS Index.  Following is a daily chart of the two moving averages vs. the DJIA during the period from January 2003 to the present:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - The 10-day moving average of the NYSE ARMS Index (currently at 1.29) bounced off the 21-day moving average (currently at 1.22) last Wednesday and is now heading back up again.  This is a bearish event, and it will continue to be bearish until the 10 DMA manages to rise to a more oversold level.

As of right now, the 10 DMA of the ARMS Index sits at 1.29 - still not a traditionally oversold level.  Please keep in mind that the March, July and August bottoms sold the reading at 1.89, 1.74, and 1.66, respectively.  Even the late October decline saw the 10 DMA of the ARMS Index at 1.45.  We are still far away from such a reading (unless we get a reading of > 3 tomorrow).

The ARMS Index readings are further confirmed by the action of the equity put-call ratio.  As shown by this put-call ratio chart from vtoreport, the 21-day moving average of the equity put-call ratio is an uptrend.  This is bearish.  What makes this doubly bearish is the fact that this reading (currently at 0.64) is still not at an oversold level yet.  What will constitute an oversold reading, you may ask?  Please note that this reading reached a level of 0.72 during March of last year and 0.80 during May of last year.  The author would like to see similar readings before I would like to call for at least a tradable bottom here.  Speaking of indicators available on the website, it should also be noted (as shown by the Commitment of Traders Report) that small traders were net short 35,000 Nasdaq 100 futures contract late last year, but has since completely reversed their positions and are now net long nearly 24,000 contracts!  Again, this is bearish - especially given the recent decline of the NASDAQ and of the stock market.

The latest NYSE short interest (as of January 14th) has also just been released.  Short interest on the NYSE now totals 7.73 billion shares, an increase of 20 million shares from December 15th:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to January 14, 2005) - For the month ending January 14, 2005, total short interest on the NYSE increased 20 million shares - pretty much an insignificant number.  Nothing to new to report at this point although the author would definitely like to see a higher jump in short interest before he is comfortable in calling for a tradable bottom.

After a 242 million-share decline from October 15th to December 15th, a rise of 20 million shares in short interest hardly calls for an oversold situation here.  While a rise in short interest does not necessarily mean a sustainable bottom (as witnessed by the persistent rise of short interest during the late 2000 to late 2002 period as shown in the above chart), a significant rise in short interest is definitely a requirement for a sustainable bottom.  We currently do have not this as per the NYSE short interest.  If I was to guess, I would like to see a short interest of over 8 billion shares before I can comfortably call for a sustainable bottom and initiate any long positions here.

The Rydex Cash Flow Ratio is actually now at a more oversold level than most of the other indicators that I am currently watching.  The ratio is now at a reading of 0.83, a jump of 0.04 from last week's reading:

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.

Given the huge run-up in this ratio (keep in mind that y-axis has been inverted) towards the latter part of last year, I therefore expect the Rydex Cash Flow Ratio to reach a more oversold level (at least a reading of 0.90 which will be the same level reached during the late March 2004 bottom) before turning in a tradable bottom.  Last week, I have thought that this reading would retrace and touch the mid-range of its Bollinger Band (at the time, 0.70) before selling off again, but it has thus far continued to go down (with only a small bounce last Tuesday).  I again expect some bounce this coming week, but will it able to touch retrace and touch the mid-range of its Bollinger Band (currently at 0.73) again?  I do not pretend to know, and it also probably not a bet that I will want to make at this point.  Better to let the market sell off and then go in on the long side once the market has reached a more oversold level.

The popular sentiment indicators that I keep track of every week also reinforces this view, with the possible exception of the Bulls-Bears% Differential in the AAII survey.  Let's start off with the weekly chart of the Bulls-Bears% Differential in the Investors Intelligence Survey vs. the DJIA:

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey declined from 36.5% to 31.2% this week.  While this reading is relatively low compard to the readings since  November of last year, it is still relatively high compared to the readings during the bottoms in March, May, and August of last year.  Moreover, the Bulls-Bears% Differential readings were over 40% for four consecutive weeks in late December to early January, suggesting that there should be more correction room up ahead.

As I stated in the above chart, the current reading of 31.2% in the Investors Intelligence Survey is nowhere close to being oversold.  That being said, there is approximately a one to two-week lag in this reading - so we will find out more about the latest sentiment per this survey come Wednesday evening.  Let's now take a look at the same ratio but from the AAII survey:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey continued to experience low readings.  The 0% reading of the latest week, continue to suggest that retail investors are bearish in their investment decisions.  While this is longer-term bullish, it does not mean that the market cannot decline further from here.  However, this reading has been below 10% for three consecutive weeks, suggesting that we may be close to a tradable bottom here - at least in terms of time anyway.

This current 0% reading in the Bulls-Bears% Differential in the AAII survey shows that individual investors (at least those that are surveyed by the AAII) are currently not buying any new positions.  This survey is more bearish than most - therefore, the survey is saying that we should be looking to buy soon - although it is always good to get confirmation from my other technical indicators.  That being said, the latest Market Vane's Bullish Consensus data is not confirming this AAII reading, as the Market Vane's Bullish Consensus actually rose from 63% to 65% in the latest week:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading actually rose from 63% last week to 65% this week (not a good sign for the bulls) - suggesting that we definitely have not seen a bottom yet.  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.  Again, my preference and target?  Most probably a reading of 50% or preferably below - the readings that we consistently got during the July to September 2003 consolidation period (also circled above).

This latest reading of 65% again suggests that we have not put in a tradable bottom yet.  Like I have mentioned before, 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.

Bottom line: We are still in a defined downtrend - with most of my technical indicators still not at an oversold situation.  This indicates to me that any long positions initiated here would most likely not be profitable.  Support for the Dow Transports is 3,300 - which is also very close to its current 200-day moving average.  The support for the NASDAQ Composite is also at the 200-day moving average (currently 1,976).  Support for the Dow Industrials, however, is probably slightly lower than the 200-day moving average.  I would be very careful from here if the Dow Industrials is to close below the 10,150 level, and I would probably declare the cyclical bull market to be over should the Dow Industrials close below the October 25th low of 9,749.99 in the coming months.

Signing off,

Henry K. To, CFA

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