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Did the Retail Investor Just Show His Hand?

(November 6, 2005)

Dear Subscribers and Readers,

In last weekend's commentary, we discussed today's modern concept of risk assessment and how it is practiced and how it should be practiced in today's stock market.  In my conclusion, I stated: "Given the 5000-year recorded history of humankind, it is amazing to note that our understanding of modern finance and our concept of risk is still in its infancy.  Consider the fact that our modern perception of probability theory did not emerge until the 17th century, and that other theories such as the Modern Portfolio Theory did not begin to be studied until the early 1950s . This author has argued that today's most sophisticated tools are nowhere near adequate to measure the risks inherent in such financial instruments as equities, as many real-world risks are still impossible to quantify . As stock market participants, it is imperative that we are able to put the risks in perspective in each of our investments.  Like I have mentioned above, the ability to quantify risk is not totally dependent on one's IQ - even though there is somewhat of a correlation.  In a complex world and in today's information age, it is the ability to simplify each potential investment and filter out all the unimportant information - as well as minimize the number of real-world variables that we need to guard against.  Blind diversification by buying the S&P 500, for example, does not minimize your risks in any way if one has not done the necessary research."

Diversification in itself is not enough - just witness the many investors who preached the buy-and-hold concept and who bought the S&P 500 in March 2000.  Many of them had forgotten their intentions to buy and hold by late 2002.  In order to suppress one's emotions, minimize risks, and achieve above-average investment returns in the long-run, one must do the necessary research, as well as consistently review and research one's findings.  In addition, an investor must find the investments that suit one's temperament, as well as in areas where you possess an edge (see "The Mean Reversion Way of Making Money").  This is easier said than done - as you must also take the time to learn about yourself as well as to learn about your potential investments.   

Before this author makes an investment or takes a position in the financial markets, I always try to make sure that most, if not all, variables are lined up on my side.  In addition, I also try to buy undervalued assets or seek the mean reversion trade.  That is, even if things don't turn out the way I anticipate - the intention is to not to lose too much even if I had erred.  In Warren Buffett's words, having a "margin of safety" is imperative.

Let's now imagine a game of cards.  It really does not matter if one is a high roller or has the best card-playing skills out of every other player in the casino.  Once other players know your hand, you are pretty much "finished."  Readers can find many examples when it comes to playing cards, but let's discuss a couple of relevant examples in the financial markets:

  1. The demise of Long-Term Capital Management: When John Meriwether, the founder of LTCM, called Vinny Mattone (his first contact at Bear Sterns, which cleared trades for LTCM) and told him that the fund was down by 50% by the end of August 1998, Mattone replied: "When you're done by half, people figure you can go down all the way.  They're going to push the market against you.  They're not going to roll your trades.  You're finished."  In the midst of trying to raise capital, LTCM had also revealed bits and pieces of their highly secretive portfolio.  Sure enough, banks such as Goldman, Morgan, Salomon, and Merrill started closing out the same trades that LTCM had put on - not just to attack LTCM, but to save themselves.  Meanwhile, LTCM could not close out any of their trades.  With their huge positions, there is just no way the market could have taken their orders should they choose to sell.

  2. The near-collapse of Enron in October 1987, when a pair of rogue traders of Enron Oil put on a short position in crude oil in early 1986 - in a period of generally rising oil prices.  By the summer of 1986, oil was trading at nearly $10, but it proceeded to rise to over $20 a barrel in July 1987.  When Ken Lay and the Enron management team found out about the 84-million barrel short position, it was nearly too late, since Enron was approximately $1 billion down at that particular point in time.  Fortunately (or unfortunately, as the demise of Enron in 1987 could have saved a lot more tears and heartache down the road), Mike Muckleroy (the head of Enron's liquid-fuels division and an experienced commodities traders) and a small team of traders went to work and managed to ultimately salvage the situation.  Quoting "The Smartest Guys in the Room": His [Muckleroy's] only hope was to bluff his way out of his dilemma; if other traders knew what trouble Enron Oil was in, they were likely to bid the price of oil even higher, then demand payment.  To fool them, Muckleroy pretended that Enron had crude oil in hand; he even bought some to sell into the market.  The bluff bought him time.  Within a few days, oil prices began to decline.  Or at least they fell enough that Muckleroy and his team were able to close down Enron Oil's positions, reducing the damage to the company to around $140 million.  That still hurt, but it was no longer life-threatening.  "If the market moved up three more dollars Enron would have gone belly up.." Muckleroy later said.

Such scenarios had been played out many times in history, such as when Arthur Cutten tried to corner the corn markets knowing that Jesse Livermore had an illiquid short position of ten million bushels (Jesse Livermore ultimately came up with an ingenious way of getting out of his short position).  In early 2001, J.P. Morgan Chase, one of Enron's largest bankers, already had a short position in Enron stock to the tune of approximately $300 million - which was one of the five largest short positions the firm had in North America.  Morgan subsequently continued to add to its short positions on the way down.

In other words, revealing one's hand in the markets is usually a death sentence - especially if one usually does not have the ability to ride out those positions.  Such is the case usually with the positions of retail investors - who are inherently emotional and who usually has the least ability to hold on to a position - which leads to the heart of today's commentary.

In various posts on our discussion forum, I had discussed the prevailing bearishness on the homebuilders.  In scanning various message boards around the web, one cannot help but notice that many retail and amateur "investors" are now shorting the homebuilders - fully convinced that the housing bubble will collapse with the increase in the both the Fed Funds rate and the 30-year Treasury rates.  Before I go on, however, I want to emphasize this: This author is not advocating our readers to go long the homebuilders.  There is no question that the best (and the least risky) gains in the homebuilders are now behind us.  Sure, some of the better homebuilders may double from here, but the downside risks definitely outweigh the upside risks.

No, this author is actually more interested in the direction of the long bond going forward.  In going short the homebuilders, many of the amateur "investors" are fully convinced that long rates can only head higher from here, citing the latest upticks in the ECRI's Future Inflation Gauge, the CPI readings, and the scheduled 2006 cost-of-living increase for Social Security payments (the highest since the 1991 increase).  No doubt, these concerns are legitimate, but this author feels that too many retail investors are now in the high inflation camp for comfort, and given that the Fed has shown no signs of slowing down the Fed funds rate hike, it is time for bond bears to be cautious here.  This is highly obvious when one takes a look at the Commitment of Traders (futures) report for the 30-year Treasury bond:

Commitment of Traders (futures) report for the 30-year Treasury bond

The above chart is courtesy of Software North LLC.  As one can see, the commercial traders currently have a 12-month record net long position in the long bond.  At the same time, the small speculators (retail investors who trade futures "for fun") are now short the U.S. Treasury bond in a major way.  Throughout the history of futures trading, commercial traders have been mostly correct over time, and my guess is that this time will not be any different.

As I have also mentioned before, it is also interesting to note that the last time the ECRI Future Inflation Gauge was this high (June 2000), the Fed precisely stopped its interest rate hikes during that month and inflationary pressures quickly went away soon afterwards.  Moreover, the last time the Social Security COLA was this high was the scheduled increase in 1991, and inflationary pressures also quickly ebbed afterwards.  Unless one believes that a new secular trend of high inflation has now dawned upon us (which this author has argued is not happening in last week's commentary), this author believes that the U.S. Treasury Bond will be a buy at some point over the next several weeks.

Mr. Mark Hulbert, from, has done some excellent work on newsletter sentiment.  More specifically, Hulbert has a proprietary indicator, called the Hulbert Bond Newsletter Sentiment Index (HBNSI), which tracks the bullish sentiment of short-term bond timing newsletter - and historically, as Hulbert has argued, it is a very good contrarian indicator.  In his most recent commentary, Hulbert states that the HBNSI closed at a negative 67.4% last Thursday evening, and that "There has been only one other time when the HBNSI dropped to as low a level as where it was Thursday night. That was early last April, very close to its low for the year. The 30-year Treasury bond proceeded to rally by nearly 7% between then and late June, which in the staid world of government bonds is a big deal."  While this does not mean that bond prices will immediately begin a huge rise starting tomorrow (in fact, bond prices again dipped lower last Friday), it most probably means that the bond outlook over the intermediate term looks good.

Okay Henry, you have just shown us two sentiment indicators which seem to confirm each other and that look very bullish.  Should we go long U.S. Treasuries here?  Are there any other sentiment indicators you are tracking?

Indeed, I do.  Another sentiment indicator of government bond prices I have been keeping track is the Rydex Bond Ratio - which I have previously discussed in our commentaries on an on-and-off basis (including in last week's commentary).  In last week's commentary, I stated: "Moreover, the Rydex Bond Ratio (Rydex bearish assets on government bonds divided by Rydex bond assets) is at a point where bond yields have topped out in the past - with the exception of early 2004."  Again, following is a chart showing the yields for the 30-year Treasuries vs. the Rydex Bond Ratio over the last two years:

Rydex Bond Ratio

The current reading of 41.03 on the Rydex Bond Ratio (bearish assets divided by bullish assets) is the most bullish reading (in terms of sentiment) since June 2004 - and is consistent with readings that we witnessed in the many tops in yields over the last year, such as December 2004, March 2005, and August 2005.  There is just one thing I am worried about here.  Note that the Rydex Bond Ratio readings have been very volatile since early October - something which we have not witnessed before.  Another strike against the Rydex indicators is its relative lack of history.  That is, I would not be surprised if we see a Rydex Bond Ratio reading similar to the one which we got during May 2004 (which reached a reading of 120) before we see a top in yields.  Because of the fact that the Rydex Bond Ratio has been exhibiting such a volatile trend in recent weeks, this author would most probably not go long the long bond until we at least see a Rydex Bond Ratio of over 50 or even 60.  Only a high reading in the 50 to 60 range at this point would convince me that any spike in the Rydex Bond Ratio is not temporary.

In terms of sentiment, another strike against the long bond can be seen in the Market Vane's Bullish Sentiment in U.S. Treasury bonds.  The most recently weekly reading stands at 59% - still not rampantly bullish from a contrarian standpoint.  For comparison purposes, the Market Vane's Bullish Consensus readings came in at 39% in May 2004, 53% in December 2004, 57% in March 2005, and 64% in August 2005.  Just like the Market Vane's Bullish Consensus readings we have been getting for the stock market, this author would like to see the Market Vane's Bullish Consensus for bonds settle at the 50% to 55% level before committing on the long side in a substantial way.

Let's now take a look at the most recent action in the stock market.  From a Dow Theory standpoint, the biggest news was the topping of the all-time high on the Dow Transports at the close last Thursday - when the Dow Transports closed near the 4,000 level at 3,973.44.  However, it is interesting to note that despite the Dow Transports making an all-time high, not only did the Dow Industrials fail to make an all-time high, it also failed to surpass its March 4, 2005 high of 10,940.55 - the high for this cyclical bull market.  Such a confirmation is ominous.  Moreover, as can be seen in the following chart of the Dow Industrials vs. the Dow Transports, the Dow Transports is now severely overbought, as it has already rallied a whopping 8.6% over the last two weeks!

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to November 4, 2005) - This is the first time we had to adjust our scales for awhile.  As can be seen in the above chart, the  the Dow Transports broke to a new all-time high (surpassing the previous high of 3,786.13 made on March 7, 2005), closing at 3,935.22 for the week.  However, not only did the Dow Industrials not confirm by bettering its all-time high, it also failed to surpass its March 4, 2005 high of 10,940.55.  For the week, the Dow Industrials rose 128 points while the Dow Transports rose a whopping  193 points, or 5.2%, on top of the 3.3% rise from the week before.  This divergence in the Dow Industrials is the most flagrant divergence we have witnessed in the two Dow indices since 2004, and serves as a warning as to how strong the market really is.  We will continue to stay neutral and not chase any rallies from current levels.

Moreover, some of our short-term technical indicators are quickly becoming overbought.  For example, the ten-day moving average of the NYSE ARMS Index is now at 0.90 - the lowest reading since mid September.  Meanwhile, the equity put/call ratio is now at 0.58 - declining from a 0.72 reading just from a couple of weeks ago.  For readers who are looking to go long, it is most probably better to wait until the market works off its current overbought condition.  As always, however, please keep in mind that we are now in the very late stages of this cyclical bull market.  While the Philadelphia Bank Index has been overperforming recently, it should still be noted that for much of the last nine months, the Bank Index has severely underperformed, and remains so to this day.  The fact that the Federal Reserve has signaled that it will continue to tighten (there is now a 90% change of the Fed Funds rate moving to 4.50% by January of next year) will also not bode well for financial stocks going forward.  As for the darling of the current cyclical bull market - the homebuilders - they are still woefully underperforming as a group - even with the latest bounce.

Subscribers that are true students of the stock market will note that both the NYSE and the Total Market A/D line topped out in early August.  The bulls would argue that in the last bull market, the Dow Industrials did not top out until January 2000, and the S&P 500 until March 2000 - DESPITE the NYSE A/D line topping out back in April 1998.  At the very least, this should give us close to a two-year timeframe, right?  This author will object to this view, as the character of every bull market is unique.  Readers should note that in this bull market, both the mid caps and the small caps have been leading (as opposed to the last bull market when large caps outperformed everything else in a notable way) and as a result, any warning will not show up in the A/D line, since by definition, any upcoming declines in both the small caps and the mid caps will be accompanied by a comparable decline in the A/D line (since small and mid caps represent the majority of the market in terms of number).  This was the case with the 1936 to 1937 cyclical bull market, as well as the case with the 1976 to 1977 bull market - when both small caps and mid caps led the way.  There was hardly an advance warning, and this author does not believe we will receive any advance warning from the A/D line this time either.

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 increased a whopping 29% from a highly oversold weekly reading of negative 14% to positive 15%.  Meanwhile the ten-week moving average edged up from 3.7% to 4.7%, suggesting that the downtrend in this survey may be over for now.

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey jumped from negative 14% to positive 15% in the latest week - suggesting that the downtrend of this survey may have reversed. The ten-week moving average, meanwhile, rose slightly from 3.7% to 4.7%. 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.  That is, this author does not think the most recent low in this survey was indicative of a major bottom, and thus any rally going forward should not be sustained.  For now, we will remain neutral in our DJIA Timing System.

However, as noted on the above chart, the ten-week moving average of 3.7% that we obtained last week was most probably not oversold enough to give us a sustainable uptrend going forward.  While the market should at least hold well for the next several weeks, this author is still very cautious.  Instead of looking to establish a 100% long position in our DJIA Timing System that I had discussed last week, we are now adopting a wait-and-see attitude.  Even with the relatively bearish sentiment, this author still does not like the market at all.  We will sit back and continue to reevaluate over the next couple of weeks.

The Bulls-Bears% Differential in the Investors Intelligence Survey, bounced up four percentage points this week - with the latest weekly reading rising from 15.6% to 19.6.  The four-week moving average declined from 17.4% to 16.9%:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey jumped from 15.6% to 19.6% in the latest week - suggesting that in the short-run, the downtrend of this survey may have reversed.  The four-week moving average edged down from 17.4% to 16.9% - the lowest reading since late May and is now at our 'optimal oversold reading' of 20% or below.  Since this latest rally has taken off without us and since the market is now ST overbought, we will not try to chase anything here.

Unless the market embarks on a watershed decline in the next few weeks, the four-week moving average of the bulls-bears% differential in the Investors Intelligence Survey has most probably put in a ST bottom - suggesting that the market should at least hold well over a short-term basis.  You want to speculate?  Please go right ahead - but please keep in mind that one should be cautious here and be always on the lookout for any indications that the market may resume its decline.  For now, we will remain completely neutral in our DJIA Timing System until further notice.

As for the Market Vane's Bullish Consensus, the most recent weekly reading edged up slightly from 60% to 61%. The four-week moving average is now at 59.0%, and again, unless the market declines substantially over the next few days, it now looks like this survey has now reversed to the upside:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus edged up slightly from 60% to 61% in the latest week -  with the four-week moving average now at 59.0% - the lowest reading since late August 2004.  In retrospect, this was good enough for a trade on the long side, but given that many of our indicators did not become 'fully oversold' in the latest decline, this author does not believe any uptrend from a couple of weeks ago is sustainble for buy-and-hold purposes.  Moreover, this author would still like to see a weekly reading at the 50% to 55% level (which we have not seen since November 2003) before he is willing to commit on the long side.  For now, we will remain completely neutral in our DJIA Timing System.

Even though the current four-week moving average is only one percentage point away from the readings that we obtained during August 2004, this author is still very wary about committing on the long side in a substantial way - all the more so given that the Fed is continuing to tighten and given that we are now very late in the cycle of this cyclical bull market.  Our message from last week remains the same: "That being said, if the market resumes its decline here and if the upcoming decline renders the market more oversold than we have seen over the past two years, then this author would not hesitant going long at that point."  For now, we will, again, remain completely neutral in our DJIA Timing System.

Conclusion: Unless the world is now experiencing the beginning of a new secular bull market in inflation, this author believes that the most recent decline in the long bond will end over the next several weeks - which should hopefully create a significant buying opportunity.  For now, most of our sentiment indicators are lining up - with the lone holdout being the Market Vane's Bullish Consensus for Treasury bonds.  As I have previously mentioned, this author does not currently believe we are in such a cycle, and that any spikes in consumer good inflation should only be temporary.  We have had similar experiences in 1990 as well as 2000.  The retail investor has just shown more than half of his hand - and the market, being the stern master that it is, will not let him get away with only a slap of the hand.

For now, the market should hold well over the next couple of weeks, even though in the short-term, it is pretty overbought.  Investors or traders who want to go long here should be very selective with their positions - and given that this cyclical bull market is now very mature, one should always continue to be vigilant.  For now, we will continue to remain neutral in our DJIA Timing System, especially since it has been the weaker index for the last two years.

Signing off,

Henry K. To, CFA

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