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Market is Now Oversold – Can It Get more Oversold?

(October 13, 2005)

Dear Subscribers and Readers,

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 last night at the close, the Dow Industrials stood at 10,216.91 - giving us a respectable gain of 399.09 points.  The market is now oversold - and anyone that is still short the market indices should be very careful here.  If, on the other hand, you have an open short position in an individual stock and a major theme to go by (such as a collapse of copper prices, a dramatic cooling down in real estate speculation, etc.), then this author would be candid with you: The oversold signals that we are getting now is very short-term in nature, and with earnings expectations relatively high and with earnings season upon us, this author is looking for more downside in the next several weeks.  As of Wednesday evening, this author will continue to remain 25% short in our DJIA Timing System, but given that we are now pretty oversold, this author is now keeping a very close eye on the markets - just so we can make a "graceful" exit when the right time comes along.

In our commentaries over the last couple of weeks, I have consistently harped on the need for an oversold condition before the market can enjoy a sustainable rally going forward.  I argued that the oversold conditions that we had witnessed (such as April 2005) over the last 12 months were not sufficient - and that given the tightening liquidity and the continued high willingness to speculate despite decreasing liquidity (i.e. higher velocity) - this author is looking for more downside ahead.  In other words, the bulls are still fighting with the Fed, and virtually all the time, the Fed will win - especially in a structurally deflationary environment.

Looking at the bright side, many more of our longer-term indicators are now falling into place for the bulls.  There is a bunch of contrarian indicators I am currently looking at - such as the amount of equities and mutual funds held by households as a percentage of total financial assets, as well as the biggest monthly plunge in the Conference Board's Consumer Confidence Index since October 1990.  On October 5th, we also witnessed a Lowry's 90% downside day - which may or may not be a prelude to a series of 90% downside days just up ahead (if it is, it will be very painful for bulls in the short-run but will be very bullish in the longer-run).  On the liquidity side, this author is also looking for the imminent end to the Fed rate hikes by the beginning to middle of next year - provided that the commodity markets will cooperate (which I think they will).

But enough - the purpose of this mid-week commentary is to update our readers with the overbought/oversold indicators that this author is currently keeping track of - and how they could be used to determine a buying point going forward.  To sum up, yes, we are in a ST oversold condition right now but some of my other indicators are still not confirming.  Moreover, we are still witnessing a significant amount of speculation all over the world, including speculation in countries such as Indonesia (this author would not touch that country with a ten-foot pole) and other international markets such as Japan (which I will go into a little bit more detail later in this commentary).  Finally, earnings season has not begun yet.  Taking all these in stride, there is very good reason to believe that we still have not seen a sustainable bottom in the major market indices just yet.

We will begin our first look of our overbought/oversold indicators by taking a look at the daily high-low differential ratio of the NASDAQ.  This indicator is constructed by taking the difference of the daily new highs and the daily new lows within the NASDAQ, and then dividing this difference by the total number of issues on the NASDAQ.  Since the beginning of this bull market, the most oversold reading we obtained was a reading of negative 7.81% registered on August 6, 2004.  A similar oversold reading was registered on April 15, 2005 - when this ratio hit negative 6.69%.  As of Wednesday at the close, this reading was at negative 6.04% - a very oversold reading relative to the readings we have been witnessing since this cyclical bull market began.  Following is a daily chart showing the high-low differential ratio of the NASDAQ vs. the NASDAQ Composite from January 2003 to October 12, 2005):

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 2003 to October 12, 2005) - The Nasdaq High-Low Differential Ratio is now at negative 6.04% - just a little bit less oversold than the reading of negative 6.69% on April 15, 2005.  For reference purposes, the most oversold reading we have received so far in this cyclical bull market was the negative 7.81% on August 6, 2004.   Looking at the record of the late 1990s bull market, however, the High-Low Differential Ratio ususally does not get fully oversold until it is sitting within the negative 8% to negative 14% range. Conclusion: The Nasdaq is now very oversold, but it looks like there is still some downside to go.

While the negative 6.04% reading at the close last night does seem very oversold, it is important to note that there is usually two spikes down before the market forms a relatively sustainable bottom.  So far, we have had only one spike.  Moreover, the experience of the 1990s bull market has shown that historically, only a reading between the negative 8% to negative 14% range will bring about a sustainable rally (multi-month rally) going forward.  For comparison purposes, this ratio actually crashed to a hugely oversold reading of below negative 20% in the wake of the Russian, Brazilian, and LTCM crises in the Fall of 1998 - and we were still officially in a bull market.  While this author is not looking for such a drastic decline, it is important to note that a reading of negative 6.04% - in the grand scheme of things - is not really that oversold, especially since we haven't had our second spike down yet.

Another indicator that is calling for a very oversold short-term condition is the percentage of NYSE stocks above their 200, 50, and 20-day exponential moving averages (EMAs).  Following is a chart courtesy of Decisionpoint.com showing these EMAs vs. the NYSE Composite during the last three years:

Note that both the % of NYSE stocks below their 20 and 50-EMAs are at oversold levels comparable to the March 2003 bottom.  However, the % of NYSE stocks below their 200-EMAs (a long-term indicator) is still nowhere close.

The percentage of NYSE stocks below their 20-day and 50-day EMAs, is at their most oversold since April 15, 2005 - and interestingly, is at an oversold condition comparable to where it was back in February to March 2003.  However, what is more important to this author at this point is the fact that the percentage of NYSE stocks below their 200-day EMAs (a longer-term indicator) is still at a relatively high level.  That is, it is still at a level comparable to the May 2004, August 2004, and April 2005 bottoms - which, in retrospect, did not provide much of a buying point for most stocks and for a sustainable market rally.  Unless this indicator hits the 30% to 40% level in the coming days, this author will not be committing too much to the long side, especially with the flood of earnings reports due starting early next week.

At this time, other technical indicators that are flashing hugely oversold readings include the average price of the S&P 500 relative to its 52-week low and 52-week high (a chart also courtesy of Decisionpoint.com which I showed you in last weekend's commentary), along with the Rydex Cash Flow Ratio - which is surely over 1.0 at this point (the data will be released Thursday morning).  Please note, however, that the former is a relatively short-term indicator (a 46% reading in today's environment is significantly different to a 46% reading in March 2003 given that stock prices were so low two and a half years ago), while the Rydex Cash Flow Ratio does not have too much of a historical record.  Sure, a reading of 1.0 will be very oversold relative to the readings of the last three years, but please note that this reading actually hit a level over 1.50 during October 1999 - not to mention an insanely high level of over 2.00 during October 1998!  Since we are now so late in the current cyclical bull cycle, readers can never be too careful.

In contrast to the technical indicators that I have just mentioned, I now want to mention some of my other indicators that are really not signaling anything close to a "fully oversold" condition in the stock market.  One such popular overbought/oversold indicator of mine is the NYSE ARMS Index.  Following is a chart showing the 10-day and 21-day of the NYSE ARMS Index vs. the daily closes of the Dow Industrials from January 2003 to the present:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - The 10-day MA of the ARMS Index is still only at 1.19 - a somewhat oversold reading but not enough to signal an impending bottom.  The most oversold reading in recent months was the 1.28 reading we obtained on August 26th - definitely not low enough to act as a base for a sustainable rally going forward either.  This author would like to see this reading surpass the 1.5 level at some point before he will be willing to committ in a huge way on the long side.

Readers who are familiar with my many commentaries regarding the NYSE ARMS Index should know that my "optimal" oversold reading is a ten-day reading above 1.5.  We have not had one that is close to it since late October of last year (fully a year ago).  The most recent "oversold" reading in the NYSE ARMS Index was the 1.28 reading that we obtained on August 26th - and such a reading on a stand-alone basis is merely an indication of a short-term bottom, at best.  The current ten-day reading of 1.19 is nothing short of comical - in that a sustainable market rally has NEVER emerged out of such a low reading from the ten-day NYSE ARMS Index.  This author would at least like to see the August 26th surpassed before I will commit on the long side in a substantial way.

Another indicator that is not sending out hugely oversold signals is the deviation of the Dow Industrials, the Dow Transports, and the NASDAQ from its 50-day and 200-day simple moving averages.  For readers who are interested (and we all should be, as it presents a very simple analysis of overbought/oversold conditions and as it is not a very popular indicator among newsletter writers) you can find the three relevant charts in the charts section of our website.  These three charts are interactive (you can adjust the time periods on them) and are updated every Wednesday and Saturday evenings.

From looking at the charts, it is obvious that the only "oversold indication" is the fact that the NASDAQ Composite is 4.79% below its 50-day moving average - which is comparable to the April 15, 2005 bottom but still far away from the readings that we witnessed in early August 2004.  Moreover, the NASDAQ Composite is only 1.82% below its 200-day moving average, a far cry from the reading that got on April 15, 2005 (when the NASDAQ Composite was close to 5% below its 200-day moving average).  The Dow Industrials, meanwhile, is only 2.73% and 2.88% below its respective 50-day and 200-day moving averages, respectively, hardly an indication of a sustainable bottom even relative to its oversold reading in April 2005.  As for the Dow Transports - well, we are the furthest from achieving an oversold reading on that index.

Also, don't forget about the equity put/call ratio (which also acts as a contrarian and an overbought/oversold indicator).  As of Wednesday evening, the ten-day moving average stands at 0.65 - still significantly far away from the 0.73 reading that we got in April 2005, not to mention the 0.79 reading in late October 2004.  At this point, the equity option traders are not bearish enough.

Finally, it is interesting to note that while many people are calling for a crash here, there are also many traders who are complacent - chiefly because similar declines in August 2004, October 2004, and April 2005 have produced good buying points.  However, if I have learned anything about the markets over the years, it is this: The more times an indicator or a set of indicators are depended upon, the less useful they will be going forward.  A corollary is this: The more times a trader has been correct in calling the markets, the higher the chance his or her next call will fail.  Whether it is complacency or because of the fact that other traders have caught up with him, this is phenomenon that has been clearly observed over time, and one which makes intuitive sense.  While we could very well have a buying point right here, this author is highly doubtful, for the following reasons:

1) The sectors and industries that have been leading the market for the last two years are now in the midst of breaking down.  This is a "strange" phenomenon which we have not witnessed before - just take a look at the homebuilding, the steel, and the transportation sectors.  While I would not call the end of the cyclical bull market right here, this most probably indicates a more serious correction going forward - a correction which will be more serious than those we have witnessed over the last two years.

2) Per Richard Russell, the trigger of a Lowry's Intermediate Sell Signal - which has a great historical record dating back to the 1930s.  Interestingly, the last intermediate sell signal was triggered in May 2004, and it turned out to be a headfake.  The history of the Lowry's intermediate signals basically says this: The more whipsaw that the intermediate signals experience, the higher the chance the next signal will be a genuine one.  We had a false one back in May 2004.  This one could be a more authoritative one.  Just because the cyclical bull market isn't over yet, it doesn't mean we cannot experience a Fall 1997 or Fall 1998 style decline in the major indices.

3) The continuing hike in the Fed Funds rate - which is expected to rise to 4.25% by the end of this year.  Unless the stock market or the commodity market experiences a substantial decline in the next few months, chances are that the Federal Reserve will continue hiking until December of this year.  For now, it is the bulls against the Fed.  And usually, it is not good to bet on the former, especially in a structurally deflationary environment.

And finally, the fact that many of the world's major markets are still holding up relatively well suggests that the decline in the U.S. stock market isn't over yet.  Usually, the most marginal countries go out first - such as Indonesia, Thailand, South Korea (relative to the U.S.), then Europe and Japan, etc.  But this time, we are witnessing a different phenomenon - in that global markets are rallying while the U.S. stock market is underperforming.  Such is the fate of the Japanese stock market, which has been making four-year highs despite the continuing dismal growth in its monetary base:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to September 2005) - 1) Note that Japanese money growth has been plunging since the end of 2003 and has thus far shown no signs of letting down.  In fact, the YoY growth is now at 1.73% - one of the slowest growth rate in 4 years! 2) Note that the second derivative (the rate of growth of the Japanese monetary base) is still in negative territory - although it turned up quite a bit since February. 3) Momentum of the Nikkei diverging from monetary growth...

Historically, the second derivative of the Japanese monetary base correlates relatively well with the year-over-year appreciation in the Nikkei 225.  Recently, there has been a significant divergence.  This author believes that the divergence will be closed in due time.  For now there is still a lot of speculative fever in the global stock and bond markets, and until this somewhat dissipates, this author is still not optimistic on committing to a sustainable uptrend in the U.S. stock market.

Conclusion: While some of our short-term indicators are already flashy hugely oversold signals, some of our more intermediate and longer-term signals are still holding out - such as the NYSE ARMS Index, the deviation of the major market indices from their 50-day and 200-day moving averages, the equity put/call ratio, and the percentage of NYSE stocks below their 200-day EMAs.  Moreover, a plausible argument can be made against this current decline being similar to the "run-of-the-mill" declines that we have witnessed over the past two years - in that both the technical action of the market and the liquidity conditions are truly different this time.  The cautious trader should wait here - and see what the earnings reports have to say and what the subsequent reaction will be.  For now, we will remain 25% short in our DJIA Timing System, but will continue to be vigilant and watch for any signs of a short-term bottom in the next couple of weeks - to either cover our short position or even go long for a temporary trade.

Signing off,

Henry K. To, CFA

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