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The Most Vulnerable Sector

(November 13, 2005)

Dear Subscribers and Readers,

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.  For now, we are completely neutral and in cash.  While the market has quickly become overbought since the bottom in late October, it should be noted here that the short-term uptrend continues to remain intact.  While this author does not recommend committing substantially on the long side based on our longer-term indicators (such as our MarketThoughts "Excess M" indicator), a couple of our short-term indicators are actually flashing bullish signals - the current overbought conditions in the market notwithstanding.  We will go into the necessary details later in this commentary.

In last week's commentary, we discussed the notion of whether the retail investor was "showing his hand" with regards to his bearish views on the U.S. Treasury long bond.  We concluded that based on retail investor sentiment and fundamentals (including the fact that any inflationary pressures in the economy was unfounded), the long bond was oversold and was due for at least a bounce, if not a resumption of its long-term uptrend.  This author stills stand by this view.  In the short-term, however, anything goes.  Should the yield of the 30-year Treasuries spike to a yield of over 5%, however, then this author would most likely be buying some Treasury bond futures for his own account.  As always, please note that this should not be construed as explicit investment advice.

Readers may ask why we haven't gone 100% long in our DJIA Timing System since the late October lows.  First reason: The market quickly got away from us and became very overbought very quickly, although that did not stop us from covering our 25% short position.  Second reason: Based on our longer-term monetary and overbought/oversold indicators, any bounce from the late October lows was most likely not going to be too sustainable, similar to many of the rallies we have witnessed over the last 22 months.  Final reason: Ever since January 2004, the "tape" has been very divergent in nature and that divergence has continued to hold true.  Just witness the action of WMT (the retailers), Dell, KO, IBM, the financials, and the recent action of the homebuilders and you will see what I mean.  The Dow Industrials - which is the index that forms the basis of our timing system - has been one of the weakest major market indices since January 2004.  Given the weak relative strength of the Dow Industrials since January 2004, this author believed that any subsequent bounce in this index should be subdued.  And so far, this has been the case.  As of Sunday, November 13, 2005, we are still completely neutral in our DJIA Timing System.

Like I mentioned, however, the short-term uptrend remains intact.  However, anyone who is choosing to invest or speculate on the long side should be very selective - both in individual stocks and individual sectors.  Okay Henry, so what you are saying?  Are you saying this is a good time to buy stocks?

I believe we are now in the late stages of the cyclical bull market that began in October 2002.  Moreover, our MarketThoughts "Excess M" (MEM) Indicator has been progressively getting more bearish - and continues to be more bearish by the week.  That means that anyone who is choosing to go long here is not only fighting the Fed, he/she is also getting on the bandwagon after many of his/her fellow investors have already gotten on the same bandwagon (on the long side).  That being said, a couple of relatively powerful short-term indicators (well, I guess at least one of them anyway, as you will soon see) are telling us that the current environment is still somewhat conducive to owning stocks - as least for the next couple of months anyway.  At the very least, I do not think anyone should be aggressively shorting the market here.

So what are those indicators?  Long-time readers should recall that I have utilized (on-and-off) the NYSE Specialist Short Ratio as a thorn on the bears' side over the past 12 months.  Subscribers who want a refresh can read about it in our November 7, 2004 commentary (which contains an illustration of the implications of a historically low NYSE Specialist Short Ratio) as well as in our May 15, 2005 commentary.   Here is an excerpt from the November 7, 2004 commentary just to make things simpler: "The specialist short-sale ratio is published each week and represents the percentage of all shares sold short during that week by the NYSE specialist firms - who are the brokers appointed by the NYSE to maintain orderly markets in individual stocks traded on the NYSE. The NYSE specialist short-sale ratio may not represent the bullishness or bearishness of professional traders, but it is definitely representative of the bullishness or bearishness of the public - as these specialists are generally forced to short-sell when the public is bullish (and thus buy stocks) and to buy when the public is bearish. The historically low readings we are currently experiencing in the specialist short-sale ratio represent huge bearish sentiment of the public - as this indicates that the specialists are not forced to do much short-selling in order to maintain the integrity of the stock market."  Moreover, the weekly NYSE Specialist Short Ratio has been a very good leading indicator of the total short interest on the NYSE.  The fact that this is still making all-time lows as we speak tells us that NYSE short interest ending November 15, 2005 (which should be released later this week or early next week) most probably made another record high - which has nearly been always bullish (since this bull market began in October 2002) from a contrarian standpoint:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to November 11, 2005) - 1) The 8-week moving average of the NYSE Specialist Short Ratio made another RECORD LOW READING in the latest week - now at a reading of 13.78%.  The fact that this indicator has continued to decline tells us that short-selling in the NYSE continues to be rampant - and most likely will result in another record high in short interest this month. 2) Reading also bottomed out a full three weeks after the significant early August 2004 bottom.  This used to be the lowest reading ever in the history of the NYSE, but this has been totally 'blown out of the water' by the readings since May 2005.

The fact that the eight-week moving average of the NYSE Specialist Short Ratio is at 13.78% is nothing short of amazing.  For comparison purposes, the eight-week moving average of the NYSE Specialist Short Ratio touched a low of 29.95% on November 10, 1944 - which preceded a rise of 30% in the Dow Industrials over the next 12 months, and a rise of 43% over the next 18 months.  Such a low reading did not occur for another 38 years - when on July 16, 1982, the eight-week moving average Specialist Short Ratio touched 30.75%.  What followed was even more explosive - as not only did the DJIA surged 30% over the next six months, it ultimately rose a staggering 54% before an intermediate top was registered. The only instance when this indicator erred was on January 6, 1984 (when the 8-week moving average of the Specialist Short Ratio touched a low of 30.92%) - the Dow Industrials proceeded to decline nearly 20% in the next two months (however, the Dow Industrials traded at the top of its 52-week range immediately before we got this reading). Readers should note, however, that the DJIA had recovered this loss by the beginning of 1985, and that over the next 18 months, the DJIA rallied another 110% before finally surrendering to the October 1987 crash. Again, the two other low readings (32.21% on July 27, 1984 and 31.65% on July 5, 1996) that occurred had hugely bullish implications.

Based on the current readings of the NYSE Specialist Short Ratio and assuming that historical precedents hold true, there could be some explosive action in the NYSE in the short-run, even as our monetary and valuation indicators continue to be flashing bearish signals.  That being said, it is very difficult to argue that the NYSE Specialist Short Ratio has not outlived its usefulness, primarily because of the following three reasons:

  1. In today's environment, short-sellers are not constrained to retail investors anymore - all the more given the huge amount of assets that have poured into hedge funds over the last few years.  Hedge funds are generally more sophisticated and not subject to emotional swings.  Moreover, a significant amount of short positions are for hedging, and not for outright speculative purposes.

  2. A significant amount of trading being done on the New York Stock Exchange is now done electronically, and not through specialists any longer.  This has a direct effect of decreasing the numerator in the NYSE Specialist Short Ratio, and subsequently the absolute level of the NYSE Specialist Short Ratio, since the denominator of the Ratio is not affected.  This is the number one reason why the NYSE Specialist Short Ratio has relentlessly decreased over the last few years.

  3. The total amount of short interest on the NYSE is still only at 2.5% of all outstanding shares on the NYSE - hardly a precursor to a general short squeeze.

This will most probably be the final time that we will cover the NYSE Specialist Short Ratio on the MarketThoughts website (since it is now very close to having outlived its usefulness), although this is definitely something for bears to be careful about given historical precedents.  This author would just like to "lay it out" for our subscribers, so to speak, given that this ratio has been bothering me (given that our indicators have been flashing bearish signals) for the last few months.

Another short-term indicator and that makes much more logical sense is the number and amount of buybacks and cash acquisitions vs. the number of primary and secondary offerings that the stock market is currently experiencing.  Going into the January to March 2000 period, this indicator was immensely bearish, as TrimTabs could have testified.  Today, this indicator is flashing the most bullish signal since September 2001.  I will now quote from the latest daily report of TrimTabs: "$46.0 Billion in New Stock Buybacks Announced 1st 8 Days of November. At This Rate Dollar Amount of New Stock Buybacks in November Would Easily Smash Previous Record of $53.6 Billion set September 2001. Whopping 141 New Stock Buybacks Totaling $81.7 Billion Announced Last Four Weeks; Equal to 53% of All Buybacks Announced During Entire 2003 & 26% of all in 2004."  Moreover, according to TrimTabs, virtually all companies in the Russell 1000 have completed their announced buybacks over the last few years - including the period spanning the first two quarters of 2005.  At the same time, cash takeovers in the latest week totaled near $6 billion - a four-week high, while the number of IPOs being done continues to be dismal.  Just as I am typing this, Koch announced it is buying Georgia Pacific for $13.2 billion in cash and taking it private - which represents a premium of 38.5% over the current stock price.  This will add tremendously to stock market liquidity in the coming days.

Now that we have our short-term bullish indicators out of the way, we would again like to remind our subscribers that we are now in the late stages of the game - along with the fact that the market is now technically overbought.  However, if one does choose to speculate here, I would not actively discourage it.  In fact, there are still many long opportunities out there.  The trick is to avoid the losers, since more than of our time should be about managing risks and avoiding losers, as opposed to spending your time trying to "hit that home run."  This is actually the heart of this commentary, appropriately entitled "The Most Vulnerable Sector."

So Henry, which sector do you think is the most vulnerable to a decline, and that you will avoid for the foreseeable future?

Readers who have read some of my past articles regarding my view of the next three to five years may be surprised, but I believe both crude oil and natural gas are now very vulnerable to a decline over the next three to six months, unless we obtain some extremely cold weather in both the United States and in Western Europe during the winter season in the next few months.  The fact that crude oil and natural gas prices failed to make significantly higher highs in the wake of Hurricane Katrina and Rita was a bearish signal, and given that the shut-in production of both crude oil and natural gas is now gradually coming back online, and given that crude oil imports in China has effectively been flat over the last few months, it is reasonable to assume that crude oil and natural gas will continue to decline throughout the winter.  Following is a chart from the EIA showing the decline of shut-in production since the landfalls of Hurricanes Katrina, Rita, and Wilma:

Chart from the EIA showing the decline of shut-in production since the landfalls of Hurricanes Katrina, Rita, and Wilma

Moreover, based on the latest readings of our MarketThoughts Global Diffusion Index (MGDI) - which has historically done a very good job of leading or tracking the CRB Index and energy prices, there is still much further room for energy prices to correct.  For newer readers, I will begin with a direct quote from our May 30th commentary outlining how we constructed this index and how useful this has been as a leading indicator.  Quote: "Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages."

Following is the monthly chart showing the YoY% change in the MGDI and the rate of change in the MGDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Energy Index from March 1990 to September 2005. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to the end of October (the October OECD leading indicators won't be released until December 9th). In addition, all four of these indicators have been smoothed using their three-month moving averages:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the Dow Industrials & the CRB Energy Index (March 1990 to September 2005) - 1) Historically, the rate of change in the GDI has also led or tracked the YoY% change in the CRB Energy Index very closely.  Again, note the recent divergence - they should converge in due time - which will mean much lower energy prices ahead. 3) Barring a cooler-than-expected winter, energy prices still have more room to fall.

As I mentioned in many of our commentaries since May 30, 2005 and on the above chart, the rate of change (second derivative) in the MGDI has historically led or tracked the YoY% change in the CRB Energy Index very closely.  The recent divergence has been going on for an unusually long period - primarily because of energy demand coming from China - but combined with declining global liquidity and a "blow off" in prices of certain commodities, I fully expect "hard commodities" to be significantly lower in price by the end of this year.  Make no mistake: The "worst case scenario" has already occurred with Hurricane Katrina and Hurricane Rita - and the verdict was decidedly against the bulls (since energy prices fail to make new highs after the landfall of Hurricane Rita).  Moreover, the Chinese import of crude oil has been flat over the last few months - and this is also not projected to rise substantially over the next six months. Barring a colder-than-expected winter in both the United States and in Continental Europe over the next few months, the 2nd derivative of the MGDI and the year-over-year % change in the CRB Index should continue to converge (and thus, giving us lower oil and energy prices).

Finally, both the domestic crude oil and natural gas inventories - as well as gasoline inventories (surprising given that this was still below the five-year range in October) are now close to or even above the top end of their five-year historical ranges.  Following are the relevant charts from the EIA, starting with U.S. crude oil stocks:

U.S. crude oil stocks

While U.S. crude oil stocks have been above its five-year range since April earlier this year, it is interesting to note that the latest inventory number is the highest it has ever been outside of its five-year range - in both absolute and percentage terms.  Back in April, Chinese demand growth was projected to rise to the stratosphere, and combined with the fact that "spare production capacity" was projected to be less than two million barrels (per day) on a worldwide basis, one has the perfect recipe for an upsurge in crude oil prices.  Now that Chinese demand is projected to be flat, and now that the "worse case scenario" has occurred without a worldwide shortage of crude oil, my guess is that crude oil will continue to trend lower in the coming weeks.

Following is the relevant EIA chart on natural gas inventories.  Again, please note that natural gas inventories are now very close to the top-end of its five-year range.  Moreover, given the fact that the spread between the current spot price ($9.50/MMBtu) and the December contract price ($11.75/MMBtu) is at or near historical highs, it now makes much more sense to inject as much natural gas as possible for storage purposes - and save it for future delivery.  That is, there is a good chance that natural gas inventories may even surpass the top-end of its five-year range in the coming weeks, unless the cash price and the nearby contract price converge relatively quickly:

EIA chart on natural gas inventories

The following chart showing gasoline inventories (again, courtesy of the EIA) is actually the most surprising of all:

Chart showing gasoline inventories

It was only ten weeks ago when gasoline prices were projected to be $3.50 or $4.00 at the pump, but since the landfall of Hurricane Rita, gasoline demand has contracted.  That is, despite the shutting down of nearly five million barrels of refining capacity, gasoline inventories have actually managed to climb to near the high-end of its five-year range.  As the amount of shut-in crude oil production continues to decline and as refining capacity comes back online, there is a good chance that gasoline inventories may even surpass the top-end of its five-range in the coming weeks.

Finally, there is no accompanying chart showing propane inventories, but sharp-eyed investors may notice this on the EIA website: "U.S. inventories of propane continued to build, with a 1.0-million-barrel gain that positioned the nation's primary supply of propane at an estimated 70.4 million barrels as of November 4, 2005. The weekly build pushed inventories to their highest level in nearly four years, just slightly below the level reached on December 7, 2001, that totaled nearly 70.8 million barrels."  In the short-run, the U.S. is awash with energy - most probably enough to put us through a cooler-than-expected winter and certainly more than enough to bring down energy prices if we do not have a cooler-than-expected winter.  Anyone that is thinking of going long the stock market at this point should avoid energy stocks, at all costs.  In the longer-run (three to five years), however, this author is still bullish on energy prices, but in the short-run, its recent uptrend is now most probably over.  At this point, this author is very reluctant to give target prices, but I would not be surprised to see an oil price close to $45 a barrel and a natural gas price back down to $8 per MMBtu in the coming months.

Let's now take a look at the most recent action in the stock market.  From a Dow Theory standpoint, this author would like to mention two notable things - both of which had already been mentioned last week.  The biggest news was, again, the topping of another all-time high on the Dow Transports at the close last Friday - when the Dow Transports closed at 4,073.25 for the week.  Since the October 21st low, the Dow Transports has rallied 12.4%.  However, it is again 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.  While such a non-confirmation is ominous, my guess is that the Dow Industrials will surpass its March 4, 2005 high of 10,940.55 over the next few weeks.  This is purely a conjecture, but such a "confirmation" should lure more investors to the bullish side - thus finally setting us up for a significant top.

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to November 11, 2005) - For the second time in two weeks, we have had to adjust our scales for the Dow Jones Transportation Average.  The Dow Transports again broke out to a new all-time high last week, closing at a high of 4,073.25 for the week.  For the week, the Dow Industrials rose 155 points while the Dow Transports raked in another huge gain of 138 points.  Ever since its low three weeks ago, the Dow Transports has appreciated an astounding 12.4%.  At the same time, however, the Dow Industrials has only appreciated 4.6%, severely lagging the Dow Transports.  Again, 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.

If what I have conjectured turns out to be true, then it would be one for the Dow Theory history books.  Not because anyone will be made famous by this "call," but because under Dow Theory terms, such a top would be a case of a "textbook top."  For now, we should take this one day at a time, but given that the market is now very overbought on a short-term basis, this author will most likely stay in cash unless we experience a significant correction over the next few trading days.

Before we go ahead and discuss our most popular sentiment indicators, let's again turn to one of his latest articles about stock market sentiment by Mr. Mark Hulbert of  In that article, Hulbert laments the fact that according to his HSNSI - a sentiment for measuring market-timers among stock market newsletters - sentiment has gotten bullish too quickly ever since mid-October.  Quoting Hulbert: "As of Monday night, the HSNSI stood at 39.2%. As recently as mid October, it stood at minus 30.1%, which means that at that time the average newsletter editor that is part of this index was recommending that his clients allocate nearly a third of his equity portfolio to the short side of the market . In just 17 trading sessions, in other words, the average short-term market timer has increased his recommended exposure by 69.3 percentage points . This is hardly the stuff of which walls of worry are constructed."  For a more detailed read on the HSNSI, please read Hulbert's latest article on stock market newsletter sentiment, but needless to say, the market has quickly became very short-term overbought over the last three weeks. 

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 experienced another huge increase in the latest week - rising a whopping 21 percentage points from a moderately oversold reading of 15% to a highly overbought reading of 36%.  Meanwhile the ten-week moving average jumped from 4.7% to 8.9%, suggesting that the downtrend is over, for now:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey experienced another huge jump in the latest week - rising from 15%  to 36%, on top of the 29 percentage point rise from the week before.  Over the short-run, this survey has gotten very overbought.  The ten-week moving average, meanwhile, rose from 4.7% to 8.9% - which most probably mean that this rally has further to rally, notwithstanding any short-term consolidation.  For now, we will remain neutral in our DJIA Timing System, unless the market experiences a sharp-enough correction which will allow us to jump in.

While this indicator is very overbought on a short-term basis, the fact that the ten-week moving average is still only at 8.9% suggests more upside in the coming weeks, even though the market "should" correct or at the very least, consolidate over the next five to ten trading days.  Unless the market experiences a sharp and quick correction, however, this author will sit on the sidelines, for now.  While this author may not hesitate going long some individual stocks that I like, I am at this point very reluctant to go long an index (the Dow Industrials in our DJIA Timing System) that has been one of the weakest indices ever since January 2004.

The Bulls-Bears% Differential in the Investors Intelligence Survey, bounced up 6.3% in the latest week - with the latest weekly reading rising from 19.6% to 25.9%.  Meanwhile, the four-week moving average increased from 16.9% to 19.2% - again, suggesting that the downtrend in this survey is now over for the time being:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - 1) The Bulls-Bears% Differential in the Investors Intelligence Survey jumped from 19.6% to 25.9% in the latest week - suggesting that this survey is now in a short-term uptrend.  The four-week moving average, meanwhile, also reversed on the upside - increasing from a reading of 16.9% to 19.2%.  This survey is implying now implying more upside, although this does not mean there won't be any corrections or consolidation in the short-run.

In last week's commentary, I mentioned: "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, I still continue to stand by this statement.  For subscribers who choose not to go long, this author would not recommend going short either - unless you really know what you're doing.  Better to sit back and enjoy your upcoming Holiday time.

As for the Market Vane's Bullish Consensus, the most recent weekly reading increased from 61% to 63%. The four-week moving average increased from 59.0% to 60.3%, and again, it 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 rose from 61% to 63% in the latest week.  Meanwhile, the four-week moving average increased from 59.0% (the lowest reading since late August 2004) to 60.3% - which still represents an oversold reading relative to the readings since January 2004.  The most likely scenario is for this survey to trend higher in the coming weeks.  Like I have been mentioning over the last 15 months, however, 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 substantially on the long side.  For now, we will remain completely neutral in our DJIA Timing System.

Over the last 18 months, this survey has persistently been unwilling to decline to the 50% to 55% level - and as a result, never gave us a satisfactorily oversold condition for us to commit substantially on the long side.  While this survey definitely has more room to run on the upside - and perhaps enough even to give us an all-time high on the S&P 400 and S&P 600, for example, this author still does not feel it will give us any substantial gains on the upside over the next few months unless one is a very good individual stock picker.  For now, we will, again, remain completely neutral in our DJIA Timing System.

Conclusion: When it comes to successfully investing or trading in the financial markets, it is more important to manage and control risks as opposed to trying to pick winners or "home runs" on a consistent basis.  While a couple of our short-term indicators (with the TrimTabs short-term demand/supply indicators being more important than the NYSE Specialist Short Ratio) may argue for higher stock prices over the next few months, it is still very important to know what you're doing - given the divergence "tape" we have been witnessing since January 2004.  For now, this author will contend that one of the sectors to avoid is the oil and gas sector - given that energy supply is ample and given that bullish sentiment is still prevalent in the sector.  Unless the U.S. and Western Europe experience a cooler-than-expected winter in the next few months, energy prices should continue to trend down in the weeks ahead - especially since the growth of Chinese import of crude oil is still projected to be relatively flat for the foreseeable future.

For now, the market should hold well over the few months, even though in the short-term, it is still very 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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