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No Man's Land

(February 21, 2005)

Dear Subscribers and Readers,

I hope everyone has had a good President's Day here in the U.S. I surely did - it is always nice to take a break from the market - especially on a Monday! This is just my personal opinion but the idea of extended hours trading and 24/7 around-the-clock trading sounds lousy to me - as it diverts time away from good old research and fundamental analysis. Actually, from a Warren Buffett and from a somewhat selfish standpoint, we should all encourage that - as a setup like this will encourage more speculation, more emotions, and thus ultimately more inefficiencies in the stock markets around the world. More inefficiencies and six-sigma events mean more opportunities for people like us to profit. Remember, one of my trading rules is this: Buy on extreme pessimism and sell on extreme optimism.

Unfortunately, we do not have such a scenario today. As the title implies, I believe we are currently in "No Man's Land" - and this is reflected in the neutral position that we have established in our DJIA Timing System since January 12th. More specifically, too many of our indicators are now in conflict with each other. I will discuss them in more detail in the following paragraphs but for now this much is true - times are certainly very confusing. That being said, however, I still don't think the cyclical bull market has topped out yet, as I have outlined many times before in our previous commentaries. I do believe, however (and ironically), that in order to have a blowoff rally which will cap out one of the greatest cyclical bull markets in history, we will need to have a more severe correction in the stock first - possibly and most probably triggered by some kind of liquidity crunch or some external event (such as another terrorist strike). Does this sound confusing enough? Now, I don't claim to know a lot about the stock market but hopefully, I will be able to help our subscribers and readers navigate this market successfully as we finally do trace out that top - possibly sometime this year or even early next year.

The first sign of indecisiveness in the stock market comes from looking at our familiar chart - that of the daily chart showing the action of the Dow Jones Industrial Average vs. the Dow Jones Transportation Average:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to February 18, 2005) - 1) The Dow Industrials is now only 69 points away from surpassing a new recovery high.  Will it be able to hang on or will this latest rally attempt fizzle out?  2) Watching the action of both the Dow Industrials and the Dow Transports were similar to watching paint dry last week - as the former declined 0.10% while the latter rose 0.19% for the week.  The DJIA looks set to challenge its most recent high, but the DJTA is still lagging - suggesting a totally indecisive market.

While the Dow Jones Industrial Average is only 69 points away from challenging its most recent high, the Dow Jones Transportation Average is still lagging - or more accurately, 191 points away from its December 28th all-time closing high of 3,811.62. While the action of the stock market still looks good today, a non-confirmation (especially a PRIMARY non-confirmation which involves the Dow Industrials not confirming the Dow Transports when the latter made an all-time high on December 28, 2004) of one of the primary Dow Indices by the other is cause for concern. More importantly, the Dow Transports has also been leading the Dow Industrials since the bottom of the last cyclical bear market in October 2002. Is it still continuing to lead or has the Dow Industrials taken over? We will soon find out.

As our subscribers know, one of the things that have been troubling this author has been the action of the Bank Index - or more specifically, the relative strength of the Bank Index vs. the S&P 500. As I have discussed before, the relative strength of the Bank Index vs. the S&P 500 has traditionally been a very good leading indicator of the broad market. What is the chart saying now? Well, let's just say that subscribers who are invested in bank stocks or in mortgage financing stocks or who believe that the current market is still being driven by liquidity will not like what they see:

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 finally broke through support convincingly in the latest week - suggesting that the cyclical bull market is now in danger.  In the more intermediate term, this most probably suggests a developing liquidity crunch (perhaps in a marginal country like China or in a marginal industry like the mortgage financing companies) sooner rather than later.

As I discussed in the above chart, relative strength of the Bank Index vs. the S&P 500 has convincingly broken below the support line that has been in place for the last 20 months. What does this suggest? Like I said, this most probably suggests the beginning of a credit crunch somewhere in the world or somewhere in a certain sector of the U.S. economy. The greatest sufferers will be the marginal users of this credit - whether you're talking about domestic Chinese companies (who are also marginal users of oil and natural gas) or the mortgage financers. The end of easy credit also suggests that the cyclical bull market is in danger, although like all bull markets in the past, this cyclical bull market will only die in exhaustion - something that we have not seen yet and which we will probably not see until we have witnessed a liquidity-induced correction in the stock market (as what happened during the 1997 to 1998 period). Speaking of mortgage financers, how about Fannie Mae? The stock is now trading at its March 2003 low, and while it looks cheap here, the underperformance of Fannie Mae over the last few months may signal more than the uncertainty surrounding mere accounting restatements.

The latest margin debt numbers for January 2005 have also been released from the NYSE - which to me indicates another potential red flag. Margin debt held by NYSE members rose $6.8 billion during December, and despite the stock market correction during the first three weeks of January, it has only declined by $470 million during January. Moreover, the total margin debt (which includes numbers reported to the NASD and which included estimated January NASD numbers since they won't be released until a couple of months from now) to Wilshire 5000 ratio is now at a high not seen since November 2000 - suggesting that the appetite for risk-taking is now at a very relatively high level:

Wilshire 5000 vs. Margin Debt (January 1997 to January 2005) - Still on an uptrend and most probably more room to run before the market tops out.  Margin debt would need to rise another 50% to surpass its all-time high.  However, this ratio is now at a high not seen since  November 2000.

Moreover, cash levels in cash and margin accounts relative to margin debt are also at a low not seen since February 2004 (even though they are still around twice the levels of the 1999 to 2000 period) - which, as many of you may remember, preceded the huge March 2004 correction in nearly all issues on the NYSE:

Wilshire 5000 vs. Cash and Margin Debt Ratios (January 1997 to January 2005) - While current 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, this ratio has consistently declined since July 2004.  Cash levels as a ratio of margin is now at a low not seen since Feb. 2004.

With margin debt at such a high level relative to the Wilshire 5000, and with cash levels relatively low, I will be hard-pressed to initiate any long positions here. At the same time, however, the trend of the stock market still looks healthy, and the sentiment of the public is not overly bullish (which is good from a contrarian standpoint). That being said, I am also seeing some conflicting data from my popular sentiment indicators - which I will outline in the following paragraphs.

I will first discuss the Bulls-Bears% Differential readings in the American Association of Individual Investors Survey. This survey is conducted every Wednesday evening at the close, and has been the most accurate so far in calling ST tops and bottoms over the last 12 months. Following is the latest weekly chart of the readings in this survey compared to the weekly closes of the Dow Jones Industrial Average:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey declined from 21% to only 6% this week - suggesting a nervous public in committing to long positions.  The four-week moving average is now at 8.5%, while the ten-week moving average is at 14.9% - which represents the lowest 10-week reading since early October.  Given the bearish outlook of my other indicators, I expect much lower readings in this survey before I could reasonably commit to long positions in this market.

While the latest reading of this survey indicates a reluctant public to buy stocks (suggesting that it's a good time to buy from a contrarian standpoint) I would still be very careful in initiating long positions here given the bearish indicators I am getting from other indicators that have also been reliable in the past. As I have also pointed out before, I am also getting conflicting data from other sentiment surveys. Let's now take a look at the Bulls-Bears% Differential 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 actually increased again - from 31.4% to 35.4% in the latest week.  The lowest reading over the last few weeks that we have witnessed is the reading of 29.2% in early February - is this low enough for a sustainable bottom?  Most probably not.

The Bulls-Bears% Differential in the Investors Intelligence Survey has actually increased - a direct conflict of the reading in the AAII survey. Moreover, this reading only got as low as 29.2% a few weeks ago, suggesting that the market still has not gotten as oversold in order to sustain a good rally going forward. Incidentally, the Market Vane's Bullish Consensus reading is showing the same thing. Following is the weekly chart of the Market Vane's Bullish Consensus reading vs. the Dow Jones Industrials:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading increased from 66% last week to 67% this week - a high which we have not seen since late November of last year.  This reading is now actually on the high side, and given that the 61% reading that we got in late January was not overly low, this is definitely cause for concern (again our 'ideal' reading that should indicate a sustainble low is 50%).  Given that there is a direct conflict with the readings from the AAII survey, I would say that the current trend of the market is murky, at best.

As I indicate in the above chart, the latest reading of 67% (an increase from a 66% reading last week) from the Marker Vane's Bullish Consensus is not confirming the low readings from the AAII survey - suggesting that we should be careful with initiating long positions here. Given the bearishness as exhibited by the relative strength of the Bank Index and the high amount of margin debt, then the current trend and outlook is murky, at best.

Bottom line: I am going to reiterate this: There is no reason in going long right now except in individual stocks that one believes exhibit good risk/reward ratios, such as if one had gone long on Friday in PFE and MRK, etc. We are currently in "No Man's Land." However, given the lousy action of the Bank Index and the high amount of margin debt outstanding (and relatively low cash levels), I would be betting on a down market in the next couple of months if I was forced to make the bet. Readers may cite the strength of the SOX, but after making a high of 445.14 early last week on an intraday basis, the SOX ultimately closed at 427.73 last Friday - a decline of approximately 3.9% from its high. Like I have said before, for the SOX argument to gain more strength, it will need to surpass its last intraday high of 453.95 hit in early December of last year before I could make any judgement.

Signing off,

Henry K. To, CFA

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