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Downside Acceleration?

(March 20, 2005)

Dear Subscribers and Readers,

I hope all of our subscribers have had a good weekend.  I would first like to begin with an important note - a note that will affect both our subscribers and the operation of this website going forward.  Our market commentary website,, has been in full operation for over a year, and we would like to thank all our readers and subscribers for your support and advice during this "startup period".  During this period, we believe that we have offered good advice and knowledge when it comes to the stock market - along with keeping our heads cool during periods of turbulence in 2004.  We correctly "predicted" that the cyclical bull market will go on when times were tough, and I would like to think that we will continue to be successful in the future.  We will have this no other way.

Both my partner, Rex, and I have been putting a tremendous amount of time and effort into our commentaries during the last 12 months.  We would love to continue doing this, and also to assist our readers and to attract more members alike.  At the same time, we would also like to enhance our service offerings - to do more unique studies or create more technical indicators, and so forth.  In order to do this and in order to further justify the time that we are continually giving this website, we would like to transition to a subscription model sometime this year.  I understand this is a very important step and it may be a surprise to some of our readers.  However, my partner and I agree that this is most probably the best way to go going forward.

At the same time, we are also thinking of various ways to keep most of our current members, since I value every one of you who have subscribed.  As always, please email us if you have any questions or opinions (such as discounts or free subscriptions we can offer to guest commentators or to the most active posters on our discussion forum) about how we can do this in the best way.  Since we definitely value our subscribers' input, we will also conduct a survey about this sometime in the next few weeks.  Please stay tuned and please participate.

Okay, the hard part is now done.  Let's now get on with our commentary - starting with the preliminary results of our poll from last Thursday morning.  The question was: Are investors taking too much risk?  So far, we only have two votes (both of which voted "yes").  Please continue to let us know what you think by taking part in our poll!  Again, subscribers will need to register as a poster on our discussion forum before they can start voting.

It has certainly been an interesting week for the markets - both in terms of the news, the action, and in terms of what my technical indicators are telling me.  Early last week, there was a flight to safety as GM forecasted a weaker-than-expected first quarter earnings.  AIG and Fannie Mae (FNM) also continued the barrage of bad news.  When three of the most financially-leveraged and supposedly trustworthy companies in the world are behaving badly, investor confidence in the financial system will definitely be undermined.  This is very significant and important, as the modern financial system is very much dependent on investor and consumer confidence.  Frankly, I was surprised that the market didn't drop much further, although individual issues like DRL took a huge tumble last week (concurrent with downgrades on the stock).

So what does that mean?  I believe that the events of last week further reinforces the theme that I have been discussing over the last few months - that at some point this year, there will be a huge flight to safety not unlike the events that unfolded during the 1997 Asian Crisis and the 1998 Russian and LTCM crises.  The marginal user of credit and oil (think China) will be cut off - and any emerging market economies that depend significantly on the export of commodities will also suffer greatly.  With high yield and emerging market spreads near or at historic lows (correction: the 2004 default rate for high yield bonds is actually 1.249% - the lowest since 1996 - and not the 1.5% number that I mentioned - see my commentary from last Thursday morning), a lot of investors and/or hedge funds will be greatly surprised sometime this year.  In fact, I will not be surprised if a major hedge fund collapses sometime this year or in 2005.  Given the fact that many retail investors (and even Chinese peasants) are shifting out of the U.S. dollar and into other currencies such as the Chinese Renminbi and the Euro, I am also expecting a renaissance of the U.S. dollar sometime this year.  In order to buy U.S. Treasuries during a "flight to safety scenario," foreigners will need to purchase U.S. dollars.  The situation gets more interesting as I know for a fact that a significant number of hedge funds have also bought emerging market debt in the locally denominated currency.

Okay Henry, you also mentioned that it was an interesting week for your technical indicators - what was the deal with that?  I will elaborate further in the following paragraphs but this has been kind of a recurring theme for the last few weeks.  The fact of the matter is that some of my indicators are virtually screaming the market is oversold (such as the put-call ratio and the AAII survey) while other indicators that I also trust are not saying "oversold" at all.  In fact, some are still at moderately overbought levels such as the ARMS Index and the Market Vane's Bullish Consensus survey.

So much for words and opinions.  Let's now discuss the action of the Dow Jones Industrial Average vs. the Dow Jones Transportation Average by looking at the daily chart of those two indices updated to last Friday:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to March 18, 2005) - Both the Dow Industrials and the Dow Transports have surpassed their recent December 28, 2004 recovery highs on March 4th! The Dow Industrials declined a further 144 points (after declining by 166 points last week) while the Dow Transports declined 81 points this week - after rising by two points a week ago.  Based on the recent rise of both the DJIA and the DJTA since late October 2004, it looks like that the two major Dow Indices still have more downside to go.

Given the steepness of the rise of both the DJIA and the DJTA since late October 2004, it "looks like" that both the two major Dow Indices still have more room to go on the downside assuming that this is only a "normal correction" within an ongoing cyclical bull market.  Furthermore, assuming that the market is only undergoing a normal correction (which may be a correct assumption in the short-term but probably not so in the intermediate term, such as the next nine months), a logical support level would be a DJIA print of 10,250 and a DJTA print of 3,500 - which represents the support level on the trend line (for the DJTA - the one for the DJIA is not shown) drawn from the bottom in March 2003 to the bottoms in May and August of 2004.

Now, readers may recall my quick discussion of the Federal Reserve Flow of Funds report in last week's commentary.  In that commentary, I outlined the fact that equities (which includes mutual funds) as a percentage of total household financial assets increased 0.73% during the fourth quarter of 2004 - and which represents an increase of 3.66% from the trough of 23.79% that was reached in the third quarter of 2002.  I "concluded" that based on historical precedent, this percentage will need to rise to approximately the 30% level before I will even think about calling the end of this cyclical bull market.  The Flow of Funds report contains many little "gems" and I would now like to discuss another statistic which I have been keeping track for the last few months.

Frequent readers of my commentary should know that I have always contended that we have a housing bubble in various parts of the country.  The first time I discussed the following chart was in my December 12, 2004 commentary - when I compared the value of real estate assets held by households as a percentage of total assets with the quarterly increases in the OFHEO HPI - a "measure designed to capture changes in the value of single-family homes in the U.S. as a whole, in various regions of the country, and in the individual states and the District of Columbia."  During the third quarter of 2004, both of these statistics set an all-time high (!) - something worth noting especially in light of the continued break down of Fannie Mae (FNM) and the technical underperformance of Countrywide Financial (CFC).  The discussion of real estate and housing is especially timely this week given the continued collapse in mortgage financing stocks last week (check out DRL which provides mortgage financing in Puerto Rico).  A poster on our discussion forum, pcoulter, has also asked whether this is now a good time to short the homebuilding stocks.  His personal "favorite" is Toll Brothers (TOLL).  Readers who are knowledgeable in the homebuilding industry and certain homebuilding stocks may want to help him out with some ideas and opinions!

The following chart shows the value of real estate assets held by households as a percentage of total household assets vs. the quarterly percentage changes in the Office of Federal Housing Enterprise Oversight (OFHEO) House Price Index from the second quarter of 1975 to the fourth quarter of 2004:

Real Estate held by Households and Nonprofits as a Percentage of Total Assets vs. the Quarter-to-Quarter Change in the OFHEO House Price Index (2Q 1975 to 4Q 2004) - Previous record quarterly increase - which was surpassed by the increase during the third quarter of 2004! The latest increase in housing prices (1.96%) decelerated per the OFHEO HPI) from the third quarter to the fourth quarter of 2004 - after rising by a spectacular 4.61% during the third quarter of 2004.  Real estate as a % of household assets, however, is still at its second highest level ever, after reaching a record high in the last quarter.

As a percentage of total household assets, the value real estate assets declined slightly in the fourth quarter - after rising substantially in the third quarter of 2004.  In terms of relative value, the value of real estate assets in the United States is still at its second highest level ever - after reaching a record high in the third quarter of 2004.  Please also keep in mind that we are also talking about an environment in which every other asset class is overvalued - including all types of bonds (from short-dated to long-dated U.S. Treasuries to domestic high yield debt to emerging market debt) all types of equities (from the Dow Industrials to the S&P 500 to the S&P 600 to Utilities to international stocks) and virtually all kinds of commodities.  Is there a housing bubble in at least parts of the United States today?  Dear readers, you make the choice.

Speaking of "extraordinary events," the latest NYSE margin debt data was just released last Friday.  Total margin debt declined by approximately $5 billion during February - not much of a movement and certainly not a surprise.  What is surprising, however, is the huge decline of cash in both cash accounts and margin accounts - with a combined total decline of approximately $31 billion!  Following is the chart showing the Wilshire 5000 vs. cash in margin and all accounts to margin debt ratio vs. cash in all accounts to Wilshire 5000 ratio:

Wilshire 5000 vs. Cash and Margin Debt Ratios (January 1997 to February 2005) - While margin debt decreased slightly during February, cash levels in both cash and margin accounts plunged $10 and $21 billion, respectively!  Cash levels as a ratio of margin and the Wilshire 5000 are now at lows not seen since Nov. 2000 and Jan. 2001, respectively.

As one can see, cash levels are now at very ominous levels.  Cash levels as a percentage of total margin debt is now at a low not seen since November 2000 and cash levels as a ratio of the Wilshire 5000 is now at a low not seen since January 2001.  The combination of this and the fact that some of my technical indicators are actually at moderately overbought levels brings forward the possibility that we may actually see a more severe decline ahead - a decline that will be more severe than any of the declines that we have seen since March 2003).  Readers please stay tuned.

I am now going to go ahead and discuss the technical indicators which I have said provide conflicting views.  First up is the NYSE ARMS Index.  Following is a chart I have shown many times before - that of the 10-day and 21-day moving average of the NYSE ARMS Index vs. the Dow Jones Industrials:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - It is interesting to see that despite the 'confidence undermining' news coming out of GM, AIG, and FNM, the market is actually at overbought levels per the 10-day and 21-day MA of the NYSE ARMS Index.  Please note that we have always seen a spike in both the 10-day and 21-day MA whenever the market has gotten oversold and ready for a bounce during the last two years.  In the author's opinion, we will need to see another spike yet again before we can be more confident in initiating long positions.

Please note that not only are the 10 DMA and the 21 DMA of the ARMS Index not oversold, they are actually at overbought levels - with the former at 0.968 and the latter at 0.997.  During the most recent January correction, the former actually hit a peak of 1.339 while the latter hit a peak of 1.270.  Based on this index, I would definitely like to see a much more oversold reading in the NY ARMS Index before I would be confident in initiating long positions.

One of our popular sentiment indicators, the Market Vane's Bullish Consensus Survey, is also showing a moderately overbought market, as evident from the following weekly chart of the Market Vane's Bullish Consensus readings vs. the Dow Jones Industrials:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading decreased from 68% last week to 66% this week.  Please keep in mind that the 68% reading of last week represents a high not seen since November 19, 2004.  Since this reading is still 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 again for this week: Do not initiate new long positions here if you haven't already done so.

As indicated by the Market Vane's Bullish Consensus readings, we are still nowhere near oversold territory.  The readings which accompanied an oversold market have been in the 58% to 61% range in 2004.  Before this correction is over, I expect lower readings.  One thing's for sure.  I will not be comfortable in initiating any long positions here unless we get a reading that has at least declined to the 50% to 55% range.

On the other hand, I have mentioned that the put-call ratio is now oversold.  The following chart (courtesy of shows both the equity and the CBOE put-call ratios vs. the S&P 100 Index:

The 10 DMA CBOE P/C ratio is now at a low not seen since August 2004. However, the 10 DMA equity P/C ratio is still not at an extremely oversold level.

Note that the 10-day moving average of the CBOE P/C ratio is now at an extremely oversold level - a level which we have not seen since August of last year.  However, the equity P/C ratio is still not as oversold as we would like it to be, as it is now at a level which is only comparable to the late January low.  That being said, the P/C ratio is generally indicating a market that is oversold.

The message of the P/C ratio is confirmed by the Bulls-Bears% Differential reading in the American Association of Individual Investors survey, as the latest readings indicate an equal percentage of bulls vs. bears - thus giving us a Bulls-Bears% Differential reading of 0%:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey decreased from 25% to 0% this week - suggesting the public is getting nervous yet again.  Under 'normal circumstances,' this would be good enough for a buy, but since a lot of my other indicators I am currently looking at did are not at oversold levels, I would not depend solely on this survey in justifying any buy decisions here.

Finally, the latest Bulls-Bears% Differential reading in the Investors Intelligence Survey is, at best, at a neutral level:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey decreased from 34.1% to 30.2% in the latest week. Please keep in mind that the lowest reading over the last seven weeks that we have witnessed is 29.2% in early February.  Both the 29.2% reading and the current reading of 30.2% are definitely not low enough to indicate a sustainable low.

A shown on the above chart, the latest reading is a print of 30.2%, just slightly over the 29.2% that we got in early February (just subsequent to the late January lows).  Like I mentioned in the above chart, neither of these readings are low enough to indicate a sustainable low going forward.  For comparison purposes, the Bulls-Bears% Differential in the Investors Intelligence Survey declined to as low as 21.0%, 15.1%, and 9.4% during the March, May, and August 2004 lows.  As of right now, I would not initiate any long positions here until this reading declines to at least the 15% to 20% range.  A note from last week: "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."  For most investors who have not initiated any long positions, it is probably a good idea to wait for such a reading before buying with both hands.

Conclusion: I would not take this current situation lightly.  I believe the conflicting readings that I am seeing in my technical indicators is ominous.  Please keep in mind that declines tend to accelerate while the market is in an oversold situation.  We are seeing an oversold situation in some of my indicators, but neutral to even moderately overbought in other indicators.  What does this mean?  I am only guessing here, but it probably means that the market is vulnerable to a further acceleration on the downside from last week (since some of my indicators are oversold) - but that we may be seeing a more substantial decline than usual (since some of my indicators are at neutral to -overbought levels).  This conjecture is all the more authoritative given the market's under-reaction (IMHO) to the potentially market-moving news from GM, AIG, and FNM last week.  Coupled with a potential surprise from the Fed meeting this week, the market is definitely poised to further accelerate its decline.  Obviously, this may not pan out, but when it doubt, it is usually best to stay out of the market.  This is definitely one of those times.

Signing off,

Henry K. To, CFA

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