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Richard Russell now Bullish

(March 6, 2005)

Dear Subscribers and Readers,

First of all, let's ask the following question: Why has Richard Russell turned bullish?  Main reason: Not only has the Dow Jones Industrials and the Dow Jones Transports confirmed each other on the upside by making a four-year high and an all-time high, respectively, the Dow Jones Utilities has also confirmed on the upside on Friday at the close.  The fact that all three major Dow Indices closed at a high last Friday is a bullish signal, he argues, and for those people who want to speculate on the long side, then Mr. Russell thinks that he or she can buy ETFs such as the DIA, QQQQ, or SPX (with a tight stop, of course).  Readers who have followed Russell for the past few years may think that he is now out of his mind.  However, from a purely mechanical interpretation of the Dow Theory, this is not totally irrational, as a bull market is, by definition, extended (and has usually been proven this is the case) when all three of the major Dow Indices have made major recovery highs - especially on the same day.

The following chart depicting the daily closes of the Dow Industrials vs. the Dow Transports shows how far and how fast we have come over the last couple of years:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to March 4, 2005) - 1) Both the Dow Industrials and the Dow Transports have surpassed their recent recovery highs! 2) The big news last week: All the three major Dow Indices (the Dow Industrials, the Transports, and the Utilities) confirmed each other on the upside last Friday at the close with the Industrials and the Utilities closing at a four-year high, while the Dow Transports closed at an all-time high by bettering its December 28th close of 3,811.62.

No doubt, the bullish action on Friday has extended the life of the cyclical bull market, but the logical question is: How far away are we from the top of this cyclical bull market?  Before we seek to answer that question (and I don't profess to have a good answer to that question, by the way), let's consider a few things:

  • Assuming that the current cyclical bull market began in October 2002, we are now nearly 29 months into this cyclical bull market.  Please note that the two cyclical bull markets of the 1966 to 1974 bear market lasted 26 months and 31 months, respectively.  Readers who are interested in a history of bull and bear markets (as compiled by Global Financial Data, Inc.) can go back and find it in our March 1, 2004 commentary.  In that particular commentary, I stated that if the current cyclical bull market is to follow the timelines of the two cyclical bull markets within the 1966 to 1974 secular bear market in terms of duration and percentage gained, then: ". If the author has to make a guess here, my most conservative forecast would be for a top in the S&P 500 somewhere in the range of 1,250 and 1,350, and ending around September 2004 to May 2005.  Note that this is my most conservative forecast, as I would not be surprised if the S&P 500 makes an all-time high."  Twelve months since that statement, I still stand by it.  In terms of timeframe and points gained, we are certainly now at or near that range.

  • Please remember that "values" forms the basis of all Dow Theory.  The second most important concept under the Dow Theory is the concept of the primary trend.  The P/E of the S&P 500 is currently 21 while the dividend yield is 2.1%.  On a historical basis, the stock market is still very much overvalued.  I also believe we are still in the midst of a secular bear market - a secular bear market which will correct the excesses (things such as outrageous CEO compensations, a willingness to take a lot of risks and speculate, and a "make money at all costs" mentality, etc.) of the 1980s and 1990s.  We are currently still very far away from the finish line.

  • Readers may also recall the Fed Funds rate study that we did in our November 7, 2004 commentary.  The charts and commentary accompanying that study is clear: If we are to follow historical precedent (that is, the action of the two cyclical bull markets within the 1966 to 1974 bear market), then this market will not top out until the Fed Funds rate has risen 200 basis points from the trough - at the earliest.  The Fed Funds rate most recently bottomed in June 2004 when it hit a trough of 1.0%.  Today, the Fed Funds rate is at 2.5% and is currently projected to rise to 2.75% at the next Fed meeting on March 22nd.  Barring a huge financial disaster, the Fed Funds rate should rise to 3.0% by May 3rd.  However, this author believes that a 3.0% Fed Funds rate is still too low to break this cyclical bull market (Here's a thought: a potential breaking point may be 3.5% since this is the current yield of the Dow Utilities.  Once the Fed Funds rate gets over 3.5%, why would investors continue to hold overvalued stocks - even utility stocks?).  Nonetheless, I personally believe that the Federal Reserve will continue to raise rates until we have seen a huge correction in the stock market.

  • Referring to the same Fed Funds study, the October 1966 to November 1968 cyclical bull market topped out 16 months after the trough of the Fed Funds rate in July 1967.  Meanwhile, the May 1970 to 1972 cyclical bull market topped out 10 months after the trough of the Fed Funds rate in February 1972.  If we are to follow historical precedent based on this study, then the current cyclical bull market would top out sometime in April to October of this year.  Following is a chart from that I have posted before in our commentary.  As one can see, 16 months is already a bit of a stretch.

Months to S&P 500 Peak after a Fed Funds Trough. Major troughs in the Fed Funds Rate have typically preceded major stock market peaks by several months.

Readers should be very familiar with the calendar of the FOMC meetings that I posted earlier.  The mantra of "Don't fight the Fed" still applies - no matter how technically bullish the market currently looks.  Based on the first study and the Fed Funds rate study, there is a very strong chance that this cyclical bull market will end sometime in April to October of this year.

At the same time, readers may recall the email that I sent out on Thursday evening.  Quote: ". Readers who are interested can read the original posting from BCA here, but basically, the BCA is arguing for a scenario where the U.S. pension funds may allocate more money to bonds away from stocks over the next five to eight years - or a shift of approximately $600 billion (this is equal to about three years of mutual fund inflows during a bull market) primarily because of pension accounting changes.  This has also recently been published on the CFO magazine."  The FASB is expected to adopt IAS 19 in place of FAS 87 accounting - which does not allow smoothing of assets in calculating defined benefits pension fund expense.  In such a scenario, pension funds will be forced to allocate more of their assets to bonds, as this will ensure their pension expense will be more predictable and which will also allow them to "match" their cash outflows better with the inflows coming in from their bond portfolios.  This is expected to be adopted next year, but you can be sure that pension funds will try to be one step ahead and will start to shift some of their funds from stocks to bonds beginning later this year.  This is truly significant, as $600 billion is nearly three years of mutual fund inflows IN A BULL MARKET.  In a bear market, an additional $600 billion of outflows from the stock market will TOTALLY CRUSH equities.  This is still an ongoing issue, and I will definitely keep my readers updated.

Now, let's go onto something else which I have emphasized over and over again - that of the relative strength of the Bank Index vs. the S&P 500.  The results are in, folks, and the performance of the Bank Index is still dismal.  Following is the relevant chart:

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 two weeks again and it has continued to underperform since that time. This suggests that the cyclical bull market is now in danger.  Again, 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).

It is already two weeks since the relative strength of the Bank Index vs. the S&P 500 broke support, and it has continued to stay that way ever since.  Moreover, the absolute performance of the Bank Index is nothing to write home about either, as evident by the following daily candlesticks chart:

Bank Index - Philadelphia ($BKX) - The Bank Index is still currently below its 50 DMA despite the strength of the market last week.

It is difficult to see how the Bank Index can start to outperform again, in light of how strong it got since early 2000 and in light of a higher Fed Funds rate just up ahead.  Moreover, since an all-time in late December, the Bank Index has formed a series of three lower highs (if the 50-day moving average is to hold).  To negate this bearish pattern and for the bull market to continue to hold, the Bank Index will need to surpass its all-time high of 104.77 in the coming weeks.

In terms of the popular sentiment indicators, this author has not seen any readings in the recent past which will convince me that any upcoming rally will be a strong rally (despite the three major Dow Indices all making new highs last Friday).  Why?  Because not one of the sentiment indicators that I keep track of really got that oversold in recent weeks.  Let's first 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 decreased slightly from 32.7% to 32.6% in the latest week. The lowest reading over the last five weeks that we have witnessed is the reading of 29.2% in early February.  If the market is to 'blow off' to the upside here, I do not believe that the reading of 29.2% would act as a good enough base for the DJIA or the major indices to go up much further.

The latest Investors Intelligence data just published last Wednesday suggests a Bulls-Bears% Differential of 32.6% - a slight decline from 32.7% last week.  The lowest reading during the last three months was a reading of 29.2% - definitely not low enough for me to be convinced that a strong, sustainable rally will be up ahead.  For comparison purposes, this reading got to as low as 9.4% in late August of last year.

The Market Vane's Bullish Consensus is pretty much telling me the same story:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading increased from 63% last week to 67% this week - a high which we have not seen since two weeks ago and prior to that, late November of last year.  This reading is now 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%).  However, I would not dare to call a top here until this reading has reached at least the 69% to 70% in the coming weeks.

The lowest reading that we have gotten over the last few months has been a reading of 61% set in late January - definitely not an oversold reading on a historical basis.  Moreover, the current reading is already a high 67%.  While I am definitely not courageous enough to call a top here (because chances are that it is not) I will probably get more courageous as this readings rises towards the 69% to 70% levels (or even higher).

The only sentiment survey which would be of comfort to me if I was a bull is the Bulls-Bears% Differential in the American Association of Individual Investors Survey:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey increased from 0% to 13% this week - suggesting a nervous public is again committing to long positions.  While the readings of this survey is telling us to buy again, they are not confirming the readings of my other sentiment indicators - as all the other indicators I am currently looking at did not get that oversold during the recent January decline.

The Bulls-Bears% Differential in the AAII survey sank to as low as negative 10% during late January (the lowest reading since mid May of last year) and is currently sitting at only (positive) 13%.  Based on this reading along, the bull definitely still has more room to run.  At this stage, I will give the bulls the benefit of the doubt and not try to call a top here until this reading has at least reached a more overbought level (such as the >40% readings that we got during December of last year).

Bottom line: While the market looks technically bullish here based on a purely mechanical interpretation of the Dow Theory, it should be noted here that the basis of all Dow Theory is values, and we definitely do not see any values right now.  Moreover, the counter-secular, secondary trend is now getting very old, and the higher the market goes, the more logically closer it is to the top of this 29-month cyclical bull market.  Judging by my past studies and history, the most likely area for a top here is an S&P 500 print of approximately 1,250 to 1,350, and a timeframe of May to October of this year.  Until then, this author will advice his readers to do nothing, as the market is getting more and more narrow everyday - that is, even if the market is to blow off to the upside, the stocks that will be participating on this final rally will not be easy to pick.  If only I can go into hibernation for the next six months, I would - but it could be fun watching the action of the stock market unfold over the next several months anyway.  We expect to be short in our DJIA Timing System sometime during the next six months.  For now, we remain neutral.

Signing off,

Henry K. To, CFA

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