Market Overbought But Not Out
(December 11, 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. Even though the market is still overbought at this point, this author does not believe the top has been achieved yet. This author may be far more convinced once he has seen the new NYSE margin debt numbers (due to be out in the next week or so), as well as the short interest numbers (due to be out a couple of weeks from now). My longer-term views of the market, however, have not changed over the last week. I still believe the market is in the midst of tracing out a top - given the declining global liquidity in the midst of huge speculation in the stock and commodity markets, the continued underperformance of the Philadelphia Bank Index, the relatively long life of this current cyclical bull market, the significant divergence of the NYSE A/D line and the Dow Jones Utility Index. For now, we are still completely neutral and in cash and urge our readers to do the same in general - unless one is very familiar with a certain sector or individual stock. At the same time, this author does not believe a top is complete without the Dow Industrials overtaking the 11,000 level and luring many of the "sideline investors" back into the stock market - thus completing this last "blow off" phase of this cyclical bull market.
From a trading volume standpoint, the next three weeks should be a non-event for the stock market, as many traders and fund managers take off early for the Christmas Holidays. That being said - whenever trading volume has been low - the market has tended to be on the volatile side. For any subscriber who currently has a position in the markets, I would like to ask you to "be careful." Going forward in the next three weeks and into 2006, this author believes that increasing volatility will be the order of the day, as global liquidity continues to decline amid the recent "euphoria" in the commodity markets and international markets, such as the recent rise in precious and base metals prices, natural gas prices, as well as Japanese equities and the continued rise in U.S. mid caps and small caps.
In last weekend's commentary, we mainly focused on the declining liquidity both in the financial markets and specifically in the stock markets. I argued that declining liquidity is bearish, but more importantly, I wanted our subscribers to experience a "sense of urgency" - given that we are concurrently experiencing an increase in speculative activity in the financial markets amid a decline in global liquidity. This weekend's commentary will be more of the same. Like I said in our previous commentaries, I believe the market is now in the midst of tracing out a significant top - a top that has a high probability of signaling the end of the cyclical bull market that began in October 2002. As the title suggests, however, it is still too soon to call a top at this point (and this is very important for subscribers who want to short stocks, the major market indices, and commodities), and I will now illustrate why there should still be some more upside to go in the major market indices in the short to intermediate term.
As I have said in our commentaries many times before, this author is inherently a cautious individual. We all know that many of the world's largest economies had been pumping great amounts of liquidity into the world financial system with the bursting of the technology bubble in 2000 and after the horrible events of September 11th. Much of this liquidity flowed into the emerging markets (think China and India) and the domestic housing sector. The resultant boom in emerging markets helped drive up energy commodity prices and boosted investments in energy-exporting countries, such that equity markets in Dubai in Saudi Arabia, for example, are now whipped into a speculative frenzy. At the same time, we also know that much of his liquidity had been having a very difficult time in finding a "home." As we are currently speaking, the hedge fund industry has grown to an "asset class" of $1.2 trillion, private equity firms had gone on a buying spree, and year-to-date, the Nikkei 225 has appreciated over 35%. Both the precious metals and the base metals have been on a near-exponential uptrend, spurred on by huge amounts of fund buying. But how long can this last? Since 18 months ago, the Federal Reserve has been gradually (or as least, has tried) removing liquidity from the world's financial markets - which could be witnessed in the dismal growth in the St. Louis Adjusted Monetary Base and foreign reserves held in the custody of the Federal Reserve. Most recently, the Japanese monetary base has also been experiencing dismal growth. At the same time, speculative activity has reached a fever pitch. The Chinese keeps on buying raw materials even as costs are skyrocketing and even as 50% of all steel companies in the country are losing money. Same with automobile companies here in the U.S. - the more cars they sell, the more money they have been losing. Something sure does not "smell right" here. When borrowing costs are low and monetary policy is loose, everyone is encouraged to borrow no matter how feasible one's idea is (think the negative profit margins in China). As Warren Buffett says, it is only when the tide goes out that we find out who has been swimming naked. More importantly for us, the immediate effects - I believe - are most probably a deflating commodity market as well as a deflating stock market, although the U.S. stock market should perform relatively well in such a scenario compared to international and emerging market equities. My guess is that we will find out over the next 12 months.
From a liquidity standpoint, most of you may already be getting tired of this indicator, but since our last update in last weekend's commentary, our proprietary MarketThoughts "Excess M" (MEM) indicator has continued to deteriorate. A recap of how to quantify or interpret our MEM indicators is as follows.
As most of you know, the MEM indicator consists of two components - that of the St. Louis Adjusted Monetary Base and that of the M-3 monetary aggregate. In our November 10th commentary, we tried to quantify and explain the consequences the four possible scenarios that the MEM can fall under. These four scenarios are:
1) Monetary base rising, M-3 declining
2) Monetary base rising, M-3 rising
3) Monetary base declining, M-3 rising
4) Monetary base declining, M-3 declining
How does "monetary velocity" (i.e. the amount of speculative activity) fit into this? Well, we know, BY DEFINITION, that the monetary aggregates in the "outer parts" (M-3 excluding M-2) of M-3 have inherently higher turnover. That is, assets in this component are inherently more risk-seeking, and thus when assets in this component or when the growth of M-3 is increasing, we know the market is starting to get frothy. Of course, this is not a complete measure, but it is probably one of the best measures we have - at least one that can be useful for investing and speculative purposes (much more real-time than the Fed's Flow of Funds, for example).
A rising M-3 is usually OK, as long as the monetary base is increasing at the same rate or higher. This is important, since the monetary base is the only aggregate that the Fed possesses direct control. A rising monetary base means the Fed is trying to be accommodative, which in turn suggests that they are encouraging investors and speculators to take risk. In a bear market in real estate, for example, the decreasing volume of transactions in the real estate market will be reflected in declining M-3 numbers, as debts are paid off and thus money is destroyed. In a bear market in houses, the reluctance to take on new and increasing mortgage debt will decrease significantly. Not only that, there will also be a rush to conserve cash and pay off debt, which will in turn decreases the growth of M-3 (or plunge it into negative territory).
A rising M-3 COMBINED with a declining monetary base is very bearish (scenario 3 above). This is basically the scenario we currently have. It means that even as speculators are now very bullish (think the rise in natural gas, gold, silver, copper, stocks, international equities such as Japan, orange juice, etc.), the Fed is now severely discouraging such speculation. Moreover, except for the European Central Bank, we are also now seeing continued tightening from the Bank of Japan - meaning that there will be no Yen carry trade to significantly feed liquidity into the world financial system. At this time, I doubt that speculators are fueling a Euro carry trade, given that the Euro has held up so well even as the economies in the Euro Zone continue to slump. That is, global liquidity is now drying up - and yet most investors continue to be very complacent by driving up precious and base metals prices, energy price, stock prices, real estate prices, etc.
Following is a weekly chart of our MEM indicator vs. the Monetary Base vs. M-3 from February 1985 to the present:
During the latest week, our MEM indicator continued to plunge - declining from negative 4.06% last week to 4.30% this week. A further plunge below negative 4.41% would take us back into territory that we have not witnessed since the days immediately before September 11th! What we need now and what this author believe will happen is a huge deflationary correction in both the commodity markets and the stock markets sometime next year. The new Federal Reserve Chairman, Ben Bernanke will then open the "floodgates" - which should put us back in scenario one above (monetary base rising, M-3 declining). This will be immensely bullish, and is now the scenario I am looking for before I commit hugely on the long side (not only in stocks but in energies, metals, and alternative energies as well).
Of course, a discussion of the commodity market would not be complete without a discussion 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. In short, the latest reading of the MGDI still suggests that both the CRB Index and energy prices will continue to correct going forward. 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 October 2005. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to the end of November (the November OECD leading indicators won't be released until January 6th). In addition, all four of these indicators have been smoothed using their three-month moving averages:
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 Index very closely. While the rate of change in the MGDI has ticked up slightly in recent months, it should be noted here that the divergence between the rate of change in the MGDI and the year-over-year change in the CRB Index continues. Because of this unusually long period of divergence, this author fully expects the commodities that have been driving the rise in the CRB Index (energies and metals) to be significantly lower in price come 2006 (most recently in September, export volumes of commodities from Australia have declined on a year-over-year basis all across the board after three quarters of average growth).
For subscribers who have been watching the action of the Japanese Yen over the last 12 months, it has definitely been very difficult to overlook the dramatic decline of the Yen during that time. Over the last 12 months, the Yen has declined 16% against the dollar - with the Yen retesting a two-year low as I am currently typing this. Among all the developed countries in the world, it should be noted here that the Yen is the only currency that has an effective borrowing rate at close to zero, and therefore, it should be no surprise that the Yen has been the logical currency to borrow for investors and hedge funds alike. That is, in today's environment, the Yen is the only effective currency that is providing liquidity to the world - a very telling reflection of the current, precarious situation in global liquidity. In fact, the action of the Yen has historically been a good leading indicator of global liquidity. That is, decline of the Yen over the last 12 months signals to me that global liquidity (and subsequently, global economic growth) will continue to slow down dramatically in the coming months.
While this author believes the markets should top out sometime early next year, my belief is that in the short and intermediate term, the trend for the stock market still remains up - given that many of my technical indicators are still not at the "very overbought" stages. Besides the popular sentiment indicators that I have been outlining every week, this lack of a "very overbought" condition can also be witnessed in the NYSE McClellan Summation Index and the NYSE ARMS Index. Let's first take a look at the following three-year chart of the NYSE Composite vs. the NYSE McClellan Summation Index:
At the core, the McClellan Summation Index is a breadth indicator. That is, while breadth in the markets have recently been relatively dismal, the Summation Index is still not saying "danger ahead," given that it is now solidly in positive territory and is still trending up. Another useful purpose of the NYSE McClellan Summation Index, however, has been its usefulness as an overbought/oversold indicator. That is, while the NYSE McClellan Summation Index can definitely reverse here and crash, any sustainable reversal here is historically not a high-probability event. In fact, as shown on the above resistance line dating back to June 2003, the NYSE McClellan Summation Index most probably won't top out until the 3,750 to 3,800 level - suggesting that this rally coming off from the late October bottom is most probably not done yet. At this point, this author is still comfortable with calling for a top in the stock market sometime during the late January to late March period. As with most significant tops in the stock market in the 20th century, I believe that the commodity markets will top out before the stock market does. That is, for folks who are thinking of shorting stocks or the major market indices sometime next year, the warning signals will first emerge in the commodity markets - thus saving you a lot of stress and effort in trying to call for a top based strictly on pure stock market trends and patterns.
A much shorter-term indicator is the 10-day and the 21-day moving averages of the NYSE ARMS Index. Like I have mentioned before, my preference has been to use the NYSE ARMS Index as an overbought/oversold indicator, although it has been more useful as an oversold indicator in the past. That being said, most significant tops in the stock market have been accompanied by an overbought reading in the 10-day moving average of the NYSE ARMS Index, and this author does not see why we would stray from that pattern at this point in time. Following is a daily chart showing the 10-day and 21-day moving averages of the NYSE ARMS Index vs. the Dow Industrials:
As I mentioned on the above chart, the 10-day moving average of the NYSE ARMS Index - at 1.146 - is still relatively oversold. This author would like this reading to decline back to the 0.90 area before he would be willing to call for a shortable top in the stock market. For now, bears should sit still and wait on the sidelines. Like I said in our last week's commentary: At some point early next year, the stock market and the commodity markets will be a significant short - but for now, let's just go ahead and enjoy our Christmas holidays.
Let's now take a look at the most recent action in the stock market and wrap up our commentary, since it is getting late in the evening for me! Last week saw an extension of the consolidation phase which began two weeks ago, and while the stock market remains slightly overbought in the short-run, this author will not be surprised if the rally resumes shortly, especially since there could be a potential "trigger" (the Fed meeting) this Tuesday. Over the intermediate term, the current uptrend remains very much intact - with the Dow Industrials a mere 162 points away from breaking to a new cyclical bull market closing high. Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:
For the week ending last Friday, both the Dow Industrials and the Dow Transports continued their consolidation phase - with the former declining 99 points and the latter declining 36 points. In the short-run, the market is no longer hugely overbought, and therefore, a resumption of the uptrend from the late October bottom could occur at any time. Note that we are now only 162 points away from topping the March 4th high and "only" 222 points away from the psychological 11,000 level in the Dow Industrials. Like I have mentioned over the last several weeks, the breaking out of the Dow Industrials from these two levels is nearly inevitable at some point within the next couple of months.
Let's now discuss our most popular sentiment indicators. In a nutshell, even though are popular sentiment indicators are signaling highly overbought signals in the short-run, the longer-term signals (i.e. the ten-week moving averages) are still at close to neutral levels, suggesting that this current rally has not been played out yet. Let's start with the Bulls-Bears% differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials. During the latest week, the Bulls-Bears% differential readings in the AAII Survey increased slightly from 29% to 31% - which is consistent with a stock market that is in a neutral to up trend:
Meanwhile, the ten-week moving average rose from an oversold reading of 15.3% to a more neutral reading of 19.1% - suggesting that there is still more room to go on the upside. Again, this author would not call an imminent top in the stock market until we see at least a 25%+ reading in the ten-week moving average of the Bulls-Bears% differential in the AAII survey. More likely, however, I would like to see a reading in the ten-week moving average of 30%+.
The Bulls-Bears% Differential in the Investors Intelligence Survey decreased slightly from 34.7% to 34.3%. Meanwhile, the ten-week moving average increased from 23.7% to 24.5% - again, suggesting a continuation of the current intermediate uptrend, given that the ten-week moving average is still close to a neutral reading, at best:
In last week's commentary, I stated: "Given that the market still remains highly overbought on a short-term basis, this author is expecting the market to consolidate further this week - with the market vulnerable to significant corrections in the order of two to three percent. For now, both the readings in the AAII and Investors Intelligence Surveys are still implying a continuation of the current intermediate uptrend over the next couple of months." The continuation of the consolidation phase that we had expected last week did materialize, and while this market still remains slightly overbought in the short-run, I would not be surprised to see a resumption of the uptrend sometime this week, given that we are now in a low-volume, seasonally strong market.
The one surprise was the jump in the Market Vane's Bullish Consensus in the latest week - rising from 68% to a highly overbought weekly reading of 70%. For comparison purposes, we have not witnessed such a highly overbought reading in the Market Vane's Bullish Consensus since June earlier this year. Meanwhile, the four-week moving average increased from 66.0% to 67.8% - which is starting to become a highly overbought reading. Given the relatively mild ten-week moving averages of the AAII and the Investors Intelligence Survey, however, this author is still relatively comfortable with the 70% in the Market Vane's Bullish Consensus at this point:
Please keep in mind that just like the AAII survey, the first 70%+ reading that comes out of the Market Vane's Bullish Consensus is usually not indicative of a top in the stock market. It usually takes two or three 70%+ readings to achieve that. At this point, all of the longer-term readings (four-week and ten-week moving averages) of the three popular surveys that we keep track of are still sufficiently oversold to give us some further upside. Over the next several weeks, however, this author is still looking for the Dow Industrials to make a new cyclical bull market high, as well as pierce the 11,000 level for the first time since June 2001. Bears should still definitely stay on the sidelines for now. However, this stock market will most probably again be "a short" once the four-week or ten-week moving averages of these surveys become overbought. For now, we will remain completely neutral in our DJIA Timing System.
Conclusion: The liquidity situation continues to deteriorate as we speak - with both the commodity and the global stock markets continuing to be very vulnerable going into 2006. That being said, this author is not expecting the commodity and stock markets to top out until two to three months from now (with the commodity market leading the stock market), and so in the interim, the uptrend in both markets still remain intact. For now, we will remain completely neutral in our DJIA Timing System, and if all goes according to plan, we will establish a short position again sometime within the next few months.
Henry K. To, CFA