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One more chance, Mr. Market?

(February 10, 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. My partner, Rex Hui, is currently in Hong Kong and so the new section on our DJIA Timing System won't be finished until he gets back from Hong Kong (middle of next month).

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!

Note: Going forward, our charts section will be updated on Wednesday and Sunday evenings - concurrent with the updating of our regular twice-a-week commentaries. I personally feel these charts are invaluable. One can also do historical studies on them - as well as to see how the DJIA and the NASDAQ are currently doing relative to their 50 DMAs and 200 DMAs.

Dear Subscribers and Readers,

Okay, I have stated (as one of my New Year's Resolutions) that I will focus more on industry and individual stocks analyses (the recent article on the airlines industry from the CFO magazine is a must-read, I believe) this year and to adopt a more buy-and-hold attitude as I thought there will be more of a trend this year. The weakness of the stock market over the last few days (and especially the Dow Transports) is making this very difficult indeed. Every time the market goes up a little bit, insider selling, IPOs, and secondary offerings will flood the market. At the same time, corporate buying has been strong and critical buying has always occurred every time the market peered over the edge for the last 12 months. The strongest trend we've had in 2004 had been the strong uptrend of the transportation stocks, the commodity stocks, the casino stocks, the homebuilding stocks, and various internet stocks during the August to December 2004 period. The Dow Industrials, meanwhile, pretty much only traded within a 1,000 point range for the entire 2004 - and it has continued this way in 2005.

A lack of a broad market trend is okay as long as there is some semblance of value in the market. Today, however, I still do not see any compelling values. At some point, the market will resolve to either the downside or the upside, but with the lack of a trend and the lack of values, I prefer to stay out of the market for a little bit until we at least get a decently oversold situation in the markets - such as the situation back in early to mid-August. I would not buy here (even though I believe we are still in a cyclical bull market) unless I get a oversold situation. I am in essence asking "Mr. Market" to give me one more chance to make money on the long side before (I believe) the secular bear market will take over again. Will it bite? I don't know but I certainly will give it a shot. Buying stocks in a highly oversold situation is always a high-probability bet. And should stocks immediately crash after that? Well, I'd always have my stop losses. Stock markets don't crash over night, you know (with the exception of the October 19th, 1987 22% one-day decline in the DJIA).

First of all, the reason why I believe we are still in a ST downtrend is the fact that the market has not rallied more strongly, despite a semi-oversold condition back in late January and a resurgence of corporate buying and mutual fund inflows over the last couple of weeks. Since a few days ago, however, corporate buying has dropped, and new and secondary offerings have ramped up considerably. The second concern is: What kind of indicators should we keep track of in order to call an oversold situation, you may ask? And what are those indicators saying now? Besides the most popular indicators that I have used in the past, are there any other indicators out there?

Let me first answer the last question. Generally, the weakest stocks (or the stocks that were the most unpopular at the time) perform the worst in a general market decline. An example is the airlines industry. Following is the weekly chart (updated as of last weekend) of the American Exchange Airlines Index vs. the S&P 500 Index from January 1995 to the present. Please note that the Airlines Index have historically underperformed the S&P 500 whenever the market has turned down and has nearly always led the market in general declines:

Relative Strength (Weekly Chart) of the Airline Index vs. the S&P 500 (January 1995 to Present)

Note that relative strength is approaching a level not seen since October of last year - after hitting resistance and turning down in December of last year. The question is: Are we at a sustainable support level in terms of the relative strength of the Airline Index? It certainly seems so from this chart, but the bounce of the Airlines stocks over the last few weeks or so has been weak. Moreover, I still have not been able to detect any panic selling of the airline stocks in general over the last six weeks - something that has nearly always happened in the last few sustainable bottoms we have had in the stock market. Finally, I have stated in the past (in our Discussion Forum) that we will need to see some liquidation and reduction in capacity in the airlines industry before we can see a bottom in this industry (which is being reinforced by the latest CFO Magazine article on the airlines). I stand by this view and therefore I will make a bold prediction here: The next sustainable bottom in the stock market will arrive when one (or more) of the legacy airlines files for bankruptcy. This will cause a panic and subsequent stampede out of airlines stocks - and should hopefully create a buying opportunity in both the airlines industry and in the broad stock market.

Here is another example where I am not seeing any panic yet: Even though Krispy Kremes Donuts (KKD) is officially in a cash crunch and has no flexibility to maneuver in the short-run, the stock "only" declined 10% today and it is still trading above its book value - hardly suggestive of a panic. I think the brand could be and should be saved in the long-run but as of right now, I do not see a long opportunity in this stock just yet. Perhaps another few weeks from now?

Okay, let's get on with the most popular sentiment indicators. The Bulls-Bears% Differential readings in the AAII survey will not be released until sometime tomorrow. I will post those readings in our discussion forum as soon as I get them. In the meantime, the Bulls-Bears% Differential reading in the Investors Intelligence Survey is out. For the latest week ending Wednesday afternoon, the reading actually increased from 29.2% to 31.4% - not suggestive of a solid bottom if we believe (as I do) then we are now in the midst of at least a short-term downtrend. The bullish sentiment in this reading did not confirm with the bearish sentiment in the AAII readings that we saw over the last few weeks.

The lack of bearish sentiment is also confirmed by the latest Rydex Cash Flow Ratio readings. While this reading increased from 0.70 to 0.74 after Wednesday's decline, the latest reading is still relatively low (please note that the y-axis has been inverted on the below chart) compared to readings that were experienced during the many lows in 2004. At this point, I am not going to consider buying stocks until we have at least reached the 0.90 level. Following is the relevant chart courtesy of http://www.decisionpoint.com:

Rydex Cash Flow Ratio

A description of an oversold or potentially oversold condition will not be complete without a discussion of the ARMS Index. Following is an updated daily chart of the 10-day and the 21-day moving averages of the ARMS Index vs. the Dow Industrials from January 2003 to the present:

As can been seen on the chart, the current 10-day reading of the ARMS Index is only at 1.103 - after coming off a peak of "only" 1.339 on January 13th. We are nowhere near an oversold level, especially considering the many overbought readings that we got from right after the election up to late December. I believe we will need to see another spike in the 10-day ARMS Index before we will get a sustainable bottom again.

Finally, I would refer our readers to the updated charts in our Charts Section of our MarketThoughts.com website. As one can see, the DJIA is still 3.66% above its 200-day moving average while the NASDAQ is still 3.77% above its 200-day moving average. For me to consider buying stocks here, I would want these two major indices to at least test support at their 200-day moving averages. Right now, we are still not close.

Bottom line: I believe we are now in a defined downtrend - however short-term it may be. Given the lack of compelling values and the lack of an oversold situation in the stock market, I am going to wait for awhile before initiating any new positions on the long side. I will let me readers know once I have changed my mind. There is also a high chance we will establish a 100% long position in our DJIA Timing System once we believe a firm bottom has been put in place.

Signing off,

Henry K. To, CFA

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