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Our MarketThoughts “Excess M” Indicator

(October 23, 2005)

Dear Subscribers and Readers,

As of October 16th, our website has transitioned to a subscription model.  This is our first commentary catered to subscribers who have moved along with us to the "new" MarketThoughts family.  First of all, I want to say "thank you" for all your support.  Without all of you, we would not be here and certainly won't have the motivation to write a commentary going forward.  I am very optimistic going forward - optimistic on both the opportunity to learn from each other and the opportunity to reap big gains from the financial markets.  Again, as I have always emphasized: Most investors should focus on the big picture and invest for the long-run.  All one needs is to catch two to three secular trends or themes in his/her lifetimes, and one will be set.  As always, we will be watching.

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th.  On a 25% basis, this equates to a gain of 87.75 points.  This author is currently looking to initiate a 100% long position in our DJIA Timing System in short order - at least in terms of timeframe anyway.  Bulls and bears alike: The market is still very oversold and dangerous - and so we will keep you all updated on a day-to-day basis in our discussion forum.  Please login every night and we will discuss.  We will also restrict access in our discussion forum to subscribers only very shortly - most probably before the end of this year.

In the last two commentaries, two of the many things that I discussed include focusing on the secular view (three to five years out) as well as finding your "edge" when it comes to trading the market.  We discussed how Bill Gross gets his edge - an edge that is exclusive of his market knowledge (although that is definitely very valuable as well) - the idea of having a portfolio structural composition that is designed to generate positive alpha over the long-run.  Here at, we have always tried to maintain a longer-term view of things - as exemplified by our indicators such as the MarketThoughts Global Diffusion Index, foreign assets held in the custody of the Federal Reserve (which is a great indicator of the demand of U.S. dollars), the Philadelphia Bank Index, NYSE and NASDAQ short interest, the amount of margin debt, and so forth.  That is not to say, however, that we don't discuss the week-to-week action, and I think we do it fairly by consistently keeping track of our overbought/oversold indicators, as well as the action of the Dow Industrials vs. the Dow Transports, as well as our popular sentiment indicators.  Through it all, we have also always encouraged our subscribers to learn from our commentaries - since this is the true way to making and keeping wealth in the long-run.

In keeping up with tradition, we are going to introduce a new indicator in this weekend's commentary.  It is essentially a monetary indicator - an indicator which seeks to gauge the amount of speculative activity within the U.S. domestic economy.  We have labeled this the "MarketThoughts Excess M" indicator (the "MEM indicator").  Basically, it works like this: Whenever our MEM indicator declines below the zero line, there is a lack of "excess cash" in the domestic economy, and vice-versa.  The "lack of excess cash" indicates that the turnover of money is high (also known as velocity) - indicating that investors are "risk seeking" as opposed to being risk adverse.  This is important - as excess speculation in an economy makes it more prone to a slowdown or a recession, especially given that the bull cycles in commodities, real estate, and the stock market are now getting very mature.

Questions: What is velocity, and why do we use the MEM indicator as a proxy for velocity?  How is this MEM indicator calculated?

Although most stock market investors would remember Dr. Irving Fisher for his "Stock prices have reached what looks like a permanently high plateau" quote just days before the 1929 crash and the subsequent Great Depression, it is important to note that he was also one of the most influential economists of the 20th century.  He was a pioneer of what is today known as the Fisher Equation: M x V = P x T, or the Quantity of Money Theory, where:

M = money supply

V = velocity of money

P = general price level

T = volume of transactions of goods and services

Readers can read more about the Quantity Theory of Money at this Investopedia link.  For our purposes, it is only important to keep note that as the money supply decreases, it takes a higher turnover rate (velocity) of money to maintain the current activity in the domestic economy.  Just as with our overbought/oversold indicators, while a rising velocity indicator only tells us that investors and speculators are more risk-seeking, a velocity indicator that is on the high end of its range tells us that the market is on a dangerous footing.  A velocity reading that is on the low-end of its range tells us that a boom is inevitable.  Such was the case in late 2002 - just before the beginning of this cyclical bull market.

The velocity of money is traditionally calculated using this question: V = GDP / money supply.  Unfortunately, preliminary GDP numbers are usually not available until a month after the quarter is over - which pretty much renders this equation useless from our perspective (that of the investor or speculator).  Somehow, we need to find an indicator that will give us an idea of the current velocity reading, and here is where our MEM indicator comes into play.  Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages).  The rationale is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve.  One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base.  By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity).  On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking.  If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing.

Such is the case we have today.  Following is a weekly chart showing the MEM (MarketThoughts Excess M) indicator vs. the St. Louis Adjusted Monetary Base vs. the Dow Industrials from February 1985 to the present:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. Dow Industrials (February 1985 to Present) - 1) Speculators continues to be aggressive in the face of the Fed reining in the monetary base.  This does not bode well for the markets going forward. 2) Markets did well during the 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade!  But now, the BoJ is tightening as well...

The drop in velocity during the period from 1990 to 1994 was a huge precursor to the late 1990s bull market.  This was further extended with the yen carry trade, when the Bank of Japan actually helped "subsidized" the boom in the U.S. stock markets from 1995 to 1998.  Once the yen carry trade ended, we had the Russian Crisis, and LTCM, etc - until the final blowoff just subsequent to the St. Louis Adjusted Monetary Base started exploding in late 1999.  As one can see, our MEM indicator is currently negative and has been trending downward for some time.  This means velocity has been increasing - and combined with a tightening Fed (see green line) and a tightening Bank of Japan (the Japanese monetary base is now hugging the flat line), I believe the markets (especially the commodity markets and real estate) are sitting on the edge right here.  We will continue to do work on our velocity indicator going forward, but for now, our MEM indicator will suffice - as the indicator has done a pretty good in gauging the velocity of money in the past.

Of course, similar to the story of our MarketThoughts Global Diffusion Index, this does mean that the markets will fall tomorrow.  What it does mean, however, is that until the Fed and the Bank of Japan "play loose" with the monetary base again, any further rallies in the commodity, real estate, and the stock markets will be extremely limited.  On the contrary, the downside is potentially huge - even though the market is currently very oversold.

This continuing decline in liquidity is also reflected in our weekly chart showing the relative strength of the Philadelphia Bank Index vs. the S&P 500:

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 eight months ago and and has stayed down since - with the exception of a back-kiss off the same line 25 weeks ago.  While the relative strength of the Bank Index has recently bounced, it is important to note that it is still on a downtrend. And thus, the threat of a liquidity crunch is still very high - especially given the monetary tightening around the world and given continuing high energy prices.

Again, given the inherent nature of the above chart, it is difficult to see when the financial markets will exactly break down - but the above chart is definitely telling us that something continues to be wrong with the financial markets.

This continuing increase in velocity (risk seeking) is also reflected in the latest margin debt numbers as of the end of September 2005:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to September 2005) - As shown on this chart, the rise in margin debt got slightly out of hand in late 2003 but it has certainly been dying down since then (with the exception of November and December of last  year).  However, this author would still like to see both the three-month and the six-month change hug the flat line (it is currently at $16.3 billion and $13.6 billion, respectively) before I would call for a sustainble uptrend here.  The solution?  A significant correction along the lines of the July to August 2004 correction.

Last month, I had discussed that I had wanted to see the 3-month and 6-month change in margin debt hug the flat line (i.e. zero growth) before I would think about committing on the long side.  At that time, the increase was $11.9 billion and $8.2 billion, respectively.  Interestingly, not only has the change in margin debt not gone down, it had actually gone up!  As the above chart mentioned, the 3-month and 6-month change in margin debt is now $16.3 billion and $13.6 billion, respectively.  While it is perfectly logical to assume margin debt has decreased over the last three weeks, my guess is that the 3-month and 6-month change in margin debt is still nowhere near hugging the flat line.  Moreover, the 12-month change in margin debt just made another 16-month high - suggesting that speculation is still well and alive.  While bears should be careful of the current oversold condition in the stock market, bulls should definitely not rest on their laurels either.  In fact, my guess is that 2006 will be a down year, although right now, we will take it one week at a time.

Okay, let's take another look at the long-term picture.  From a long-term perspective, this author has previously stated that he will not commit on the long side in a substantial way until the market becomes more oversold.  While the S&P 500 does not need to decline to a P/E of 10 (or even 6) in order to qualify, we certainly have not witnessed the ideal oversold condition that this author has been looking for over the last couple of years.  I have mentioned them before - but now let me summarize what they are.  My idea oversold condition is a market that satisfies all the following conditions:

  1. A 10-day moving average of the NYSE ARMS Index over 1.5

  2. A 10-day moving average of the equity put/call ratio over 0.80

  3. A NASDAQ high-low differential ratio (difference of highs and lows divided by total issues in the NASDAQ) in the range of negative 8% to 14%

  4. The Percentage of NYSE stocks above their 200-day EMAs at approximately the 30% level

  5. A Market Vane's Bullish Consensus at approximately the 50% level

Finally, I would like to show our readers the following VERY long-term chart of the ratio-adjusted NYSE McClellan Summation Ratio, courtesy of  This chart has ratio adjusted since we nee to accurately compare the readings over a very long time period:

Ratio-adjusted NYSE McClellan Summation Ratio

Excuse the "mess" on the above chart, but I feel this is a very important chart - a chart that gives a very good perspective as to just how oversold the current stock market is relative to past declines (and buying opportunities) in U.S. stock market history.  As of today, the NYSE Summation Index (ratio adjusted) is at negative 560.67 - oversold yes, but definitely not as oversold as prior oversold readings.  For example, the decline during May 2004 was more oversold using this reading.  The last hugely oversold reading was during July 2002, when the NYSE Summation Index (ratio adjusted) declined to negative 1000.

It is interesting to note that Don Hays of has been comparing the current scenario to the 1994 scenario - arguing for one more potential decline before we embark on a 1995 to 1996 style rally.   However, please note that during 1994, there were two spikes down in the NYSE Summation Index to approximately negative 1000.  We have had no such spike downs to the negative 1000 level this year.  Moreover, the period during 1994 was preceded by an extended period of low money velocity - something that we also do not enjoy today.  We may very well get our 1994 scenario, but changes are that it won't be this year.  If the 1994 scenario is to occur, then my guess is for next year, at the earliest.

In the last two years, we have not witnessed an oversold market that has satisfied all the above conditions.  This author is still waiting, but when it does come, the opportunity for profits will be huge going forward.  Please note, however, that the absence of the above oversold readings do not preclude us from going 100% long the DJIA Timing System, since our goal for our DJIA Timing System is to outperform our benchmark (the Dow Jones Industrial Average) as well as do it with much less volatility (risk).  By "committing on the long side in a substantial way" this author means buying the more speculative stocks, and perhaps even use a little bit of margin, as long as one is "diversified" in at least four to five stocks.

Let's now discuss the day-to-day action of the market, along with popular sentiment indicators, and why we had gone flat (0% position) in our DJIA Timing System from a 25% short position.  Let me first answer the last question.  In last weekend's commentary, I had stated: "Can the market bottom here?  Of course, anything can happen - especially in the financial markets (for readers who don't believe this, just look at the collapse of Refco in a period of less than a week).  The market could very well take off here without a major sell-off in the major market indices of a higher NYSE ARMS reading, but history suggests that it won't be a sustainable one."  While our gain from our short position on July 14th was not mind-blowing by any means, it was a respectable gain nonetheless, and since the market was so oversold, it would have been foolish not to take it.  Like we had mentioned, anything can happen.  The stubborn refusal of the Dow Transports and the continuing decline in oil prices helped make our covering decision that much easier.  As a rule, we at MarketThoughts do not bet on major crashes - and definitely not in the 30 companies in the Dow Jones Industrial Average.

We now turn to the chart showing the most recent daily action of the Dow Industrials vs. the Dow Transports.  For the third week in a row, the most significant news of last week from a Dow Theory point of view is this: The refusal of the Dow Transports to decline below its September 20th low is again a bullish non-confirmation of the Dow Industrials.  The million-dollar question is: Does this non-confirmation signal an inevitable rise in the Dow Industrials?  No one knows, but with the Dow Transports only 42 points above its September 20th low, who knows - it may very well confirm tomorrow (Monday).  If it does, then we will sit back and wait for the inevitable oversold situation:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to October 21, 2005) - 1) During the latest week, the Dow Industrials declined 72 points to close at 10,215.22 - the lowest close since May 13th.  Meanwhile, the Dow Transports declined 15 points to close at 3,623.72 - still 42.27 points above its September 20th closing low of 3,581.45.  The stubborn refusal of the Dow Transports to close below its September 20th low, along with a very oversold condition in the markets - despite the weak action of the Dow Industrials - are the main reasons why we closed out our 25% short position in our DJIA Timing System.  Our next signal will most likely be a long signal.  Once we are reasonably sure we have a ST bottom in place, we would not hesistate to go 100% long in our DJIA Timing System. 2) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials!

As the above chart mentioned, even though the Dow Industrials made its lowest close since May 13th, the Dow Transports has still refused to confirm by declining below its September 20th closing low.  Our next signal will most likely be a 100% long signal.  Even if the Dow Transports is to confirm on the downside in the next few days, the prudent thing to do is to sit back and wait and buy on the inevitable oversold situation.  It is no time to be a hero here and try to anticipate a crash.

Before we go on and discuss our popular sentiment indicators, it is important to first point out the following article by Mark Hulbert of the Hulbert Financial Digest.  As the article points out, the HSNSI (Hulbert Stock Newsletter Sentiment Index) is now at a reading of negative 30.1% (effectively a six-year low) - definitely not something to trivial with.  However, it is also important to keep in mind that we saw much more negative readings during the late 1990s bull market, with this reading making an all-time record low of negative 81.82% in October 1999. My point is that in the short history of this sentiment indicator, there have been several times where this indicator has been more oversold - and given the fact that this sentiment indicator does not have a long history, it is imperative that we take any oversold reading here with a grain of salt, since we do not have a large sample size.  That being said, this will be a very important indicator to keep track of going forward.

Let's now discuss our most popular sentiment indicators - starting with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials.  The latest weekly reading actually increased from negative 9% to positive 7%.  On the contrary, the ten-week moving average edged down from 4.4% to 4.0% signaling in the more intermediate term, this indicator is become quite oversold - although anything can happen in the long-run:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey increased from negative 9% to positive 7% in the latest week. The ten-week moving average edged down from 4.4% to 4.0%.  Again, the question is: Is this ten-week moving average of 4.0% oversold enough?  For comparison purposes, the ten-week moving average hit a low of negative 9.8% in May earlier this year, and a hugely oversold reading of negative 15.8% in March 2003.  This author would like to see this reading decline below the 0% level before committing on the long side, and this could happen as soon as this week - provided the market experiences another decline.

Same message from last week: "Both the weekly and the 10-week readings are now becoming very oversold, but please keep in mind that we have seen much more oversold readings earlier this year in April, as well as back in March 2003.  We did not really get a sustainable rally after the oversold conditions in April.  My guess is that the current bullish sentiment in the AAII survey would need to get more oversold before we will see a sustainable bottom.  At the minimum, this author would like to see the 10-week reading sell off to below the 0% level before committing on the long side".  Please keep in mind that since this AAII survey can become more oversold even as the market bottoms, this author has chosen to cover our 25% short position in our DJIA Timing System last Friday - just to be on the safe side.  We will continue to keep watch of the AAII survey - and most probably go long once we receive confirmation that this indicator is becoming more oversold.

The Bulls-Bears% Differential in the Investors Intelligence Survey, meanwhile, also got more oversold - as the weekly reading declined from 16.6% to a still more oversold reading of 15.8% in the latest week - again, the most oversold reading since early May of this year.  The four-week moving average declined from 23.4% to 20.2%:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey edged down from 16.6% to 15.8% in the latest week - the lowest weekly reading since early May of this year.  The four-week moving average declined from 23.4% to 20.2% - the lowest reading since June earlier this year and getting close to our 'optimal' oversold reading (a four-week moving average below the 20% level).  I anticipate going 100% long in our DJIA Timing System within the next couple of weeks - even for just a ST rally.

The four-week moving average of the bulls-bears% differential in the Investors Intelligence Survey is now just a tad north of the 20% oversold level that we have been looking for - a good development even though this is just one of the many puzzles we are currently looking at.  While I also mentioned that we may go 100% long in our DJIA Timing System within the next couple of weeks, it is not certain that we will, especially given the unpredictable nature of the stock market.  We will just have to see.

As for the Market Vane's Bullish Consensus, it is encouraging to see a further decline in the bullish sentiment in this indicator, even though the Market Vane's Bullish Consensus only declined from a reading of 58% to 57%.  Nonetheless, this weekly reading is only one percentage point away from the oversold reading in mid-August 2004.  The four-week moving average also declined from 61.8% to 60.0%, although it is still two percentage points higher than the 58.0% reading we received in late August 2004:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus decreased significantly in the latest week - from a reading of 62% to 58%, the most oversold reading since late August 2004.  The four-week moving average is at 61.8% - the lowest reading since late May earlier this year.  Sure, both these readings are signaling an oversold market, but keep in mind that they continue to be mired in significant downtrends.  Again, however, this author would like to see a weekly reading at the 50% to 55% level (which we have not seen since November 2003) and a four-week moving average below 60% before he is willing to commit on the long side.

Again, from last week: "Recent history has shown that the market cannot enjoy a sustainable rally without the Market Vane's Bullish Consensus declining to at least a reading at 50% or lower - no matter how oversold the AAII or the Investors Intelligence Survey became.  Therefore, this author would like to see the Market Vane's Bullish Consensus declined to precisely that level before committing on the long side.  A 50% reading would make it the most oversold reading since August 2003."  As of right now, we're still waiting, but if we see some panic selling sometime this week (for example, a daily NYSE ARMS reading of over 2.0) then this author would not hesitate going 100% long in our DJIA Timing System.

Conclusion: Our long-term monetary and velocity indicators are still calling for lower prices ahead - especially for the commodity and real estate markets, since they have received bulk of the attention (liquidity and speculation) in the last few years.  On the contrary, the least vulnerable is, ironically, actually the Dow Jones Industrials, although this author is still looking for lower prices in the Dow Industrials in the months ahead as well.  Again, this author will not commit on the long side in a substantial way until all our oversold conditions have been satisfied, although this does not preclude us from entering a 100% long position in our DJIA Timing System (just for a ST rally) should the market become more oversold in the short-run.  We will continue to remain neutral here, but will definitely inform our readers via our "special alerts" emails once we change our minds. 

Subscribers who have not done so should read our prior two commentaries regarding the "reversion to the mean" strategy as well as "The Bill Gross' way to making money."  Both of them should offer insights as to how you can find your "edge" in investing or trading, as this is imperative for "beating the market" in the long-run.  (One simple strategy to find your edge is just to quit your day job and focus on the markets on a full-time basis.)

Signing off,

Henry K. To, CFA

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