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This is Still Like Watching Paint Dry

(March 13, 2005)

Dear Subscribers and Readers,

As most of my readers should know, we have been conducting a buy-sell-or-hold poll for Coca-Cola (KO) over the last couple of weeks.  Both the company and its products are prevalent not only in American Society, but also in over 200 countries all over the world.  Coke's products are sold in more countries than the number of countries in the United Nations.  It is also the world's most recognized and most valuable brand - a brand that is worth over US$67 billion according to Interbrand.com.  Obviously, most of our readers and virtually everyone around the world must have an opinion about the company.  There are currently only seven votes conducted, but so far, there are no buys whatsoever.  Please vote or express your opinions (by posting or by emailing me at hto@marketthoughts.com) if you do not agree with our current results.

In terms of the volatility of the general market indices, it has been like watching paint dry over the last 24 months - ever since the major bottom back in March 2003.  The lack of volatility is also reflected in the return of the S&P 500 during 2004.  In Berkshire Hathaway's annual report, Warren Buffett stated: "In one respect, 2004 was a remarkable year for the stock market, a fact buried in the maze of numbers on page 2.  If you examine the 35 years since the 1960s ended, you will find that an investor's return, including dividends, from owning the S&P 500 has averaged 11.2% annually (well above what we expect future returns to be).  But if you look for years with returns anywhere close to that 11.2% - say, between 8% and 14% - you will find only one before 2004.  In other words, last year's "normal" return is anything but."  The significance of this statement has probably been ignored by 90% of all investors and stock market analysts but I believe that it sends a very subtle but important message (otherwise, Mr. Buffett wouldn't have put this statement in the first page of his address to his shareholders).  What is the message?  I believe the message is this: The fact that the market has not been nearly as volatile as past years over the last 24 months suggests that the chance of more volatile times ahead is high, not lower.  The situation we are currently in is analogous to a rubber band that is continuing to be stretched.  Sooner or later, a big move will come.  The question is (as always) - in which way will the direction be?

I have also examined the volatility of the Dow Jones Industrial Average over the last 15 years by calculating a running 10-day annualized volatility of the index (for a course on how to calculate volatility, please see this article by Ravi Kant Jain, President of eGAR Technology).  The results of this study pretty much confirmed what I suspected all along (and which has been confirmed by a declining VIX since this period) - that what we have been experiencing over the last two years has been the lowest volatility levels (in at least the Dow Jones Industrials) we have ever seen.  Following is a chart of the running 10-day annualized volatility of the Dow Jones Industrials vs. the actual daily closing levels of the Dow Jones Industrials from January 2003 to the present:

Running 10-Day Annualized Volatility of the DJIA vs. the DJIA (January 2003 to Present) - Since March 2003, the running 10 DAV has been consistently under the 20% line - even during the March, May, and July declines of last year.

As can be seen from the above chart, the running 10 DAV has been consistently below 20% since March 2003 - which represents one of the longest "low volatility" periods in stock market history.  The only other period over the last 15 years where we had experienced a similar period of "non volatility" was during the 1992 to 1994 period.  While volatility also remained low subsequent to 1994, the market ultimately blasted off to the upside starting in 1995:

Running 10-Day Annualized Volatility of the DJIA vs. the DJIA (January 1991 to December 1996) - With a few minor exceptions, the running 10 DAV has been consistently under the 20% line from the beginning of 1992 to the end of 1994 - coinciding with a period of very flat returns for the Dow Industrials overall.  The market ultimately took off on the upside starting in 1995.

The bulls would say that there may possibly be a repeat - with the market ultimately blasting off again to the upside even as volatility or the VIX stays at this relatively low level.  This may very well happen - but it is difficult for me to currently envision such a scenario given my beliefs that we are still in an ongoing secular bear market (and especially with the popular sentiment indicators near their bullish extremes).  One thing is for sure: The longer the market stays like this, the greater the up or down move will be when it ultimately does come along (which should happen by the end of this year).

Now, let's discuss the Flow of Funds report released by the Federal Reserve on Thursday.  I haven't had much time to study this report - however, I have updated a chart which should provide some clues as to when this cyclical bull may top out.  Like I have mentioned before, I am not willing to call a top just yet (even as the Bank Index has continued to underperform) until virtually all my "top-calling indicators" have confirmed with each other.  One such indicator is the amount of equities and mutual funds as a percentage of total financial assets held by households.  The idea is that as households hold more of their assets in equities and mutual funds on a percentage basis, the more likely it is for the market to top out.  Following is chart which I have posted before and which shows this indicator from the first quarter of 1962 to the fourth quarter of 1974 - which includes the 1966 to 1974 secular bear market period:

Equities and Mutual Funds as a Percentage of Total Household Financial Assets (1Q 1962 to 4Q 1974) - More importantly, in both the final quarters of the 1967 to 1968 and the May 1970 to 1972 cyclical bull markets, the equities and mutual funds as a percentage of total household financial assets ratio experienced a huge increase of approximately 2% - suggesting a classic 'blowoff phase.'

Assuming that we are currently in a secular bear market that is not unsimilar to the 1966 to 1974 secular bear market, the current cyclical bull market will most likely not top out until the amount of equities and mutual funds as a percentage of total household financial assets has increased approximately 6% from its trough levels in October 2002.  Furthermore, the end of this cyclical bull market will most likely be preceded by a "blow off" quarter characterized by this percentage rising approximately two percentage points.  Let's now look at the most updated chart of this indicator, which includes data until the end of the fourth quarter of 2004:

Equities and Mutual Funds as a Percentage of Total Household Financial Assets (1Q 1992 to 4Q 2004) - Equities and mutual funds as a percentage of total household financial assets bottomed at 23.79% in the third quarter of 2002 in the recent 2000 to 2002 cyclical bear market.  The current bounce of slightly less than 4% in this percentage is mediocre (at least on an absolute basis) - suggesting that the current rally in the equity markets is not over yet - especially given the fact that we have not had a final 'blowoff phase' so far - a phase which has historically meant an increase of at least 2% in this percentage in just one quarter.

This percentage currently stands at 27.45% (which is always subject to revision by the Federal Reserve but which ultimately shouldn't change much) - 3.66% above the trough level of 23.79% which we saw in October 2002.  A "blowoff" on the upside which kills the bears and sucks in the remaining cash on the sidelines within the next six months and which ultimately takes this percentage to around the 30% level would be consistent of a top of this cyclical bull market.  Please note that part of this can also be accomplished by a fall in bond prices (although historically this has not been the case).  Corollary: A potential speculator who wants to "play" in this final blowoff phase on the long side (not unsimilar to the October 1999 to March 2000 blowoff phase) would be advised to buy stocks that have a high short interest and/or which have been regularly a "featured" stock on Investors' Business Daily over the last 12 months.  That is, you want to find stocks with the qualities that will attract your average investor and/or which has the potential to kill the people who shorted those stocks.  Stocks like TASR, TZOO, SINA, SNDA, RIMM, AAPL, GOOG, etc., all come to mind.  Do not buy "value stocks" during this final blowoff phase.

Since I have not had time to study the Flow of Funds report, I will seek to provide more interesting statistics from that report in next week's commentary.  I will now conclude this week's commentary by providing a weekly update of the regular charts that we usually keep track of.  Let's start off with the daily chart showing the action of the Dow Jones Industrials vs. the Dow Jones Transports from January 2003 to March 11, 2005:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to March 11, 2005) - 1) Both the Dow Industrials and the Dow Transports have surpassed their recent recovery highs on March 4th! 2) The Dow Industrials declined 166 points last week while the Dow Transports was essentially flat - up a mere two points.  It is still too early to tell what this entails, especially since it is normal for the indices to consolidate here after they both made new highs a week ago.

As shown on the above chart (even though it may not be obvious), both the Dow Industrials and the Dow Transports surpassed their recent highs (the latter its all-time high) a little bit over a week ago - suggesting that the life of this cyclical bull market has just been extended.  During the latest week, the Dow Industrials declined 166 points while the Dow Transports rose a mere two points.  At this point, it is still too early to try to make anything out of last week's action - given that the market is neither extremely overbought nor oversold, it is most probably wise to just sit it out on the sidelines if you are not already committed.

Before I go on, I would just like to express one additional thought.  I believe there is a very high chance of a blowoff before the top of this cyclical bull market is reached.  There has always been one before the top and there will be another one yet again.  Prior to every blowoff, however, there has always been a significant decline - a decline that will make our popular sentiment indicators tilt to the bearish side.  Prior periods that I have studied include the October 1972, May to June 1987, and the October 1999 periods.  Right now, sentiment is still not dark enough in order to set up a good-enough-base for such a blowoff.  This may sound contradictory (I have also mentioned this in last week's commentary) but basically the idea is this: Before the market will top out, there will be a final phase where the market will "blow off" to the upside.  However, in order to set up the conditions for such a "blowoff," there will need to be a substantial decline beforehand.  This may sound ridiculous to the novice trader but this has always happened in the past and will most likely happen again this time around.

That being said, let's again take a look at what our major sentiment indicators are saying.  To put it briefly, all three of our major sentiment indicators basically exhibit more bullish readings than last week.  Looking at these readings, our position on the stock market does not change - I believe that we need to see more bearish readings here before the market can "blow off" to the upside and give us a final top in this cyclical bull market.  Let's first take a look at the Bulls-Bears% Differential reading of 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 increased slightly from 32.6% to 34.1% in the latest week. The lowest reading over the last six weeks that we have witnessed is the reading of 29.2% in early February.  Again, 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.  My guess is that the market will need to decline in a substantial way here before there will be a 'blow off' to the upside.

Again, the recent low reading of 29.2% is most probably not low enough to act as a "base" for a blow off to the upside.  During October 1972, this reading got to as low as 7.1%, June 1987, 8.7%, and October 1999, 1.7%.  Please note that the lowest reading that we saw in this survey in 2004 was a reading of 9.4% made during September - we will most probably need to see a comparable (or even lower) reading before we can experience a "blow off" on the upside in the major stock market indices.

Now, let's look at the Market Vane's Bullish Consensus readings.  Following is the chart of the Market Vane's Bullish Consensus vs. the DJIA for the period January 2002 to the present:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading increased from 67% last week to 68% this week - a high which we have not seen since November 19, 2004.  This reading is definitely 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%).  My advice: Do not initiate new long positions here if you haven't already done so.

A reading of 68% in the Market Vane's Bullish Consensus Survey is on the high side any way you look at it.  Moreover, the 61% reading that we got in late January is nowhere close to low enough to act as a "base" for a "blow off" to the upside either.  For comparison purposes, this reading was at 43% during May 1987 (the Market Vane's Bullish Consensus data that I have only goes back to April 1982) and 26% during October 1999.  From looking at these two historical precedents, the "ideal reading" of 50% that I have been looking for before a "blow off" may be a little bit on the high side.

Finally, let's take a look at the survey that has been confusing the heck out of me and that has been conflicting the readings of both the Investors Intelligence Survey and the Market Vane's Bullish Consensus over the last couple of months.  Following is the weekly chart showing the AAII Bulls-Bears% Differential readings vs. the DJIA from January 2003 to the present:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey increased from 13% to 25% this week - suggesting a nervous public is again committing to long positions.  While the readings of this survey is STILL 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.  At the same time, however, I would not be shorting stocks given that we have not seen an overly bullish reading in this survey yet.

Okay, Bulls-Bears% Differential in this survey increased from 13% to 25% in the latest week - sort of confirming the more bullish readings in the previous two surveys.  However, the readings in this survey over the last two months have definitely been on the low side.  This is especially interesting when you consider the fact that this reading "only" got to as low as 6% during October 1999 (the data on the AAII survey only goes back to July 1987) - which is actually 16% higher than the negative 10% reading which we got in late January earlier this year.

I had also wanted to discuss a little bit about the Rydex Cash Flow Ratio as well but since this indicator does not have too much of a history (and Rydex assets have literally exploded since 1999) I don't think you can reasonably compare the current readings to the reading that we got during October 1999.  I do want to mention, however, that during the October 1999 period, the Rydex Cash Flow Ratio was over 2.25 - a reading that literally dwarves the 0.80 reading that we are currently seeing.

Conclusion: As the title suggests, watching the action of the major indices over the last 24 months has been literally like watching paint dry.  History had shown, however, that the longer that this situation lasts, the more explosive the subsequent action will be - thus presenting more opportunities (and dangers) for investors and traders alike.  The most likely scenario that I currently see is a substantial decline within the next couple of months - followed by a 'blow off" to the upside within the next six to eight months will be finally mark the top of this cyclical bull market.  For now, I believe readers should sit this one out if you haven't committed in the market already.

Please participate in our new poll: Is Berkshire Hathaway a buy, sell, or hold?  Again, you will need to register as a poster on our discussion forum in order to be able to cast your vote.  Thank you for participating!

Signing off,

Henry K. To, CFA

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