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We Will Remain 25% Short, For Now

(September 29, 2005)

Dear Subscribers and Readers,

It is nice to be back!  I would like to thank you for all the kind messages that were sent to me in the midst of our evacuation from Houston.  I have read them all the emails and messages - and I am truly touched and humbled by them.  I am continued to be amazed at how life can change very quickly and suddenly (just like in the markets).  One cannot anticipate these kinds of events, but at least one can prepare for them.  Forgive the comparison, but this is not unsimilar to having a stop loss in your positions should you choose to speculate in the financial markets.  Again, thank you.

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616.  As of Wednesday at the close, the Dow Industrials stood at 10,473.09 - giving us a slight gain of 142.91 points.  I am still not 100% caught up with the markets and in my daytime job, so forgive the relatively short commentary.  The market currently remains in limbo - with huge divergences in most sectors (with financials, homebuilding, and retail underperforming while energies, international, and semiconductors overperforming) and no obvious trades (at least from the perspective of this author) in play.  Global liquidity continues to disappoint, and while Hurricane Rita did not cause too much damage on land (Houston effectively escaped unscathed), it did cause a significant amount of damage to offshore oil and natural gas drilling rigs.  Estimates are still very sketchy at the moment but in terms of rig damage, Hurricane Rita could have been the costliest hurricane in history.  Like I have mentioned numerous times before, all these do not add up to an equity-friendly scenario, especially if we experience a colder-than-expected winter a couple of months from now (it is amazing to see how exogenous events can sometimes impact your investment portfolio in a significant way - even those without long-term consequences).

To add to the bearish sentiment, the technical condition of the market has been very weak and is now probably the weakest since this bull market began in October 2002.  Even though the major indices have failed to decline, we are witnessing deteriorating conditions in indicators such as the McClellan Oscillator and Summation Index, new highs vs. new lows, and in the action of the Lowry's Buying Power vs. the Lowry's Selling Pressure indices.  One can also witness such a deterioration in the Philadelphia Bank Index, as the relative strength of the Bank Index vs. the S&P 500 is now at its lowest in over three years:

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 approximately seven months ago and and has stayed down since - with the exception of a back-kiss off the same line 22 weeks ago.  More importantly, the relative strength of the Bank Index made another new low last week - the lowest level since March 2002.  The threat of a liquidity crunch is now very high - given the monetary tightening around the world and given continuing high energy prices.  The change of a significant decline in equity prices is now very high.

I have been discussing the implications of a breakdown in the relative strength of the Bank Index since the beginning of this year.  One obvious implication is a tightening of liquidity, which we have been and are still witnessing throughout the developed world.  This "liquidity crunch" is being witnessed in the monetary aggregates of the United States and Japan, as well as individual events such as the bankruptcies of Delta and Northwest Airlines.  To further compound the matter, the minimum payment threshold for credit cards is also set to change next month - with an increase from 2% to 4% of the balance.  Considering that 35 million credit card accounts in the United States are being serviced with just the minimum payment, it is not difficult to see a continuing adverse impact of liquidity going forward.

As an aside, readers may be surprised that the Nikkei 225 has risen so much in the last four months, even in light of the surprisingly convincing reelection of the current PM of Japan, Prime Minister Junichiro Koizum (who brings along with him a mandate to reform the Japanese Postal System and economy).  From late May to today, the Nikkei has basically rallied from just under 11,000 to the current level of approximately 13,500 - a rally of 22% in a mere four months.  Please keep in mind, however, that virtually all the recent purchases of Japanese equities have been foreign purchases - not domestic purchases.  Without a significant amount of domestic buying, it is difficult to envision how the Nikkei can continue its current ascent (it is also extremely overbought at this stage) - and chances are that domestic purchases will not rush in anytime soon, given the dismal growth in the Japanese monetary base and overbearing energy prices.  The latter is especially important given that Japan has no natural resources of her own, and has to import virtually all her coal, oil, and natural gas needs.

Finally for the bears, the breakdown of Fannie Mae (an over 10% decline in the stock today - not witnessed since the 1987 Crash - to just $41.71 per share) today is extremely ominous, given the charges of overvaluation in assets and underreported credit losses.  Combined with a $1 trillion asset base and huge complacency in the performance of the stock since the initial scandals were uncovered (as a matter of fact, it is a pick on the Motley Fool Inside Value newsletter) - there is definitely a lot of room for continuing disappointments going forward - not just for Fannie Mae investors but for all investors who invest in financial services companies in general.  Make no mistake; Fannie Mae is a huge deal.  If any one stock can move the market, then Fannie Mae will definitely rank up there along with GE, Microsoft, Intel, AIG, Citigroup, and possibly Wal-Mart.

Okay Henry, all the things that you have just discussed sound bearish to me, so why aren't you going 50% short in your DJIA Timing System, as you have hinted you may in your last full commentary ten days ago?

Good question.  First of all, I am inherently a cautious person, and it shows in my commentaries.  Significant declines or crashes are indeed rare - even though conditions are now ripe for a significant decline.  By going 50% short, one better be right on the timing, as an oversold rally out of left field could quickly vaporize any gains one already has.  This author usually likes to go short when the market is ST overbought, not the other way around.  Trend following only works in a market with a clearly defined trend, and now is not the time to double down on our 25% short position in our DJIA Timing System.

More importantly - there has been one important thing that has bothering this author for the last few weeks.  This first emerged in the form of a persistently oversold Rydex Cash Flow Ratio - a historically very reliable contrarian indicator and one which indicates what the retail investor is doing on a day-to-day basis (a very valid assumption given professional investors would use futures and options instead of paying the hefty commissions imposed by Rydex Funds).  Following is a chart courtesy of www.decisionpoint.com showing the daily Rydex Cash Flow Ration from October 2004 to September 27, 2005:

The Rydex Cash Flow Ratio is very oversold any way you look at it – comparable to the lows we witnessed during May 2004, August 2004, April 2005, and late August 2005.

As indicated by the extremely oversold condition in the Rydex Cash Flow Ratio, retail investors have been particularly bearish and remain so - which has been historically a bullish development.  The persistent oversold condition in the Rydex Cash Flow Ratio during late August and now caused me to think about this more and to do a little bit more research.  I have now come up with a possibly valid conjecture, as I will further explain below.

The conjecture: If one looks at the action of retail investors in the domestic stock market, then one is already witnessing a very oversold situation - although the popular indicators like the ARMS Index, the new highs vs. new lows, etc., don't show such an oversold condition.  As it turned out, the Rydex Cash Flow Ratio represents only one data point in a world full of data points.  The extremely oversold condition in retail investor's interest is also evident when one looks at the action of the survey as conducted by the American Association of Individual Investors (the AAII survey) - which is a survey that tracks the sentiment of individual investors.  During late May, the ten-week moving average of the bulls-bears% differential in the AAII survey declined to negative 9.8% - a reading which we have not witnessed since April 2003.  Another data point is a "dilemma" that has been raised by TrimTabs on an intermittent basis for the last 12 months: That if the buying patterns of retail investors today represented the typical buying pattern during the 1980s and 1990s bull market, the S&P 500 should be approximately 30% higher than it is now - given today's record insider purchases, stock buybacks, cash acquisitions, and the lack of primary and secondary offerings.  Make no mistake: The retail investor or speculator is generally not buying domestic equities, as there are much "better" things to invest in than technology or retail stocks - such as real estate, commodities, and emerging market equities.

To further expand this conjecture, and in the tradition of "nothing is obvious," we now take a look at the record plunge in the Conference Board's Consumer Confidence Index for September.  As indicated by the official press release from the Conference Board, Consumer Confidence plunged from a revised 105.5 reading in August to a 86.6 reading in September - the lowest reading since October 2003 and the largest monthly decline since the decline from September to October 1990.  At first glance, this looks bearish, but please keep in mind that the Consumer Confidence Index has been historically relatively reliable as a contrarian indicator.  Moreover, the Consumer Confidence Index is a direct reflection of the potential behavior of the average U.S. consumer, and indirectly, his or her outlook on the general U.S. economy.  If the average U.S. consumer is bearish on the economy, then it is not a stretch to conclude that the average retail investor is also bearish on the U.S. stock market.   Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to September 2005:

Monthly Chart of Consumer Confidence vs. DJIA (January 1981 to September 2005) - In our last commentary regarding the Consumer Confidence Index, I stated: 'This author is looking for a reading below the November 2004 reading of 90.5 before we can most probably enjoy a more sustainble uptrend going forward - especially given the maturity of this cyclical bull market.'  Well, we now gotten such a reading - as the Consumer Confidence Index registed the largest monthly decline since October 1990.  But what next?

As I have consistently mentioned for the last 12 months, any rally in the markets will not be sustainable unless it is preceded by a sub-90 reading in the Consumer Confidence Index, and for the first time since March 2004, we have gotten such a reading.  More importantly, it is interesting to note that the 3-month, 6-month, and 12-month returns of the Dow Industrials subsequent to the October 1990 plunge were approximately 12%, 18%, and 25%, respectively.  As I have warned in our discussion forum, bears should be careful here and be willing to cover his or her short positions at a moment's notice.

Conclusion: At this point, however, this author is not going to commit any huge positions in this market - as there are currently no "obvious" trades that I am relatively confident about.  While retail investors' interest in the stock market may be very oversold, this author is still not willing to commit on the long side substantially just yet - preferring to see more oversold readings in our traditional technical indicators.  For now, we will remain 25% short in our DJIA Timing System - preferring to give our bearish scenario more time to work out - but at the same time, not going overboard with a 50% short position.  We will re-evaluate in this weekend's commentary.

Signing off,

Henry K. To, CFA

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