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DJIA Timing System Short at 10,870

(January 22, 2006)

Dear Subscribers and Readers,

Readers who have followed our discussions (and our last Thursday morning's commentary) should notice that we have discussed Intel's business on and off basis – namely the competitiveness of its core microprocessor business against AMD and the recent divergence of INTC (the stock price) vs. the performance of the Philadelphia Semiconductor Index (“the SOX”).  For readers who know Intel's business better than I do, you're definitely encouraged to jump in and join our discussion on “INTC vs. AMD.”  Will Intel continue to lose its edge in the microprocessor market to AMD?  Will that matter?  Will other external forces come into play to disrupt both Intel's and AMD's core businesses?  Please let us know what you think.

As far as the recent divergence of INTC vs. the SOX, I had stated in our Thursday morning's commentary: “… the performance of Intel has been relatively dismal – suggesting that investors are still ignoring the proven, brand name stocks in favor of mid caps, small caps, international and energy stocks.  Could the SOX be correct?  That is, are Intel's woes confined mainly to the company (some would argue “yes” given that AMD just surged 12% in pre-market trading this morning) or will INTC lead the SOX into a decline for the foreseeable future?  Can a whole industry continue to rally without the participation of its bellwether?  This author would argue “no.”  While the fundamentals of the semiconductor industry are now at the best we have seen in over five years (take a look at AMAT), the recent rally of the SOX has most probably been too fast and too much.  We are definitely due for a correction in the SOX here.”  The SOX proceeded to “graciously oblige” by declining more than 4% last Friday.  Going forward, this author is looking for both the SOX to continue to correct and for both the performance of INTC and the SOX to converge over the next three to six months.

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.  We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday at DJIA 10,840.  We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon at DJIA 10,900 – thus giving us an average entry of DJIA 10,870.  E-mails were sent to our subscribers on a real-time basis just seconds after these short positions were initiated.  This author also posted a message on our discussion form on Wednesday afternoon (EST) reminding our subscribers to check their emails.  For a more detailed explanation of the background and what we are trying to achieve with our DJIA Timing System (along with historical signals), please go to the following page.  Please note that this page is only available to current subscribers.

The current stock market is following our 2006 mid-cycle slowdown scenario to a tee.  Further evidence over the last week or so include the 3% decline in the MBA's seasonally adjusted purchase mortgage index – which is considered to be a very reliable real-time gauge of U.S. home sales (of course, all the headlines implied a very robust housing market).  This is confirmed by an 8.9% decline in housing starts and a 4.4% decline in the number of building permits issued – and further compounded by a decline of housing affordability to a new all-time how.  Following is a chart courtesy of the Bank Credit Analyst showing the historical correlation of real consumption and the Housing Affordability Index:

Historical correlation of real consumption and the Housing Affordability Index

As the above chart implies, real consumption is set to decline going forward if we are to follow historical experience.  Like we have mentioned in our past commentaries, the decline of the housing sector (a slowdown in the rise of housing prices, transaction volumes, and creation of real estate related jobs) and the subsequent decline in Mortgage Equity Withdrawal (“MEW” as we have labeled it in our past commentaries) remains the pillar of our mid-cycle slowdown argument – a mid-cycle slowdown that will shave 1% to 2% off U.S. GDP growth going forward in 2006 and which should be accompanied by a correction in many markets, including the commodity, international, and the U.S. stock markets.  This is our most optimistic scenario for 2006 – but which we think has the highest chance to occur.  For a rundown of what we believe pose the greatest risks to our economy in 2006 and 2007, readers are encouraged to go back and read our January 8th commentary, “Identifying Risks in the Upcoming Year.

Any upcoming correction in the world's major markets should affect the U.S. stock market disproportionately.  That is, this author believes that the United States stock market will fare any upcoming “financial storm” relatively well, although I would not rule out a 10 to 15% correction in the Dow Industrials or the S&P 500 in the upcoming year.  The decline in the U.S. stock market last Friday is ominous – and most probably signals a significant reversal in the U.S. stock market, for two major reasons:

  1. Never mind too much that the decline in the Dow Industrials (213.32 points) represented the biggest decline in over two years.  The most significant evidence that we got on Friday is the steady liquidation of stocks – accompanied both by high volume and liquidation in nearly all sectors, with the notable exception of the energy sector.

  2. This steady but relentless liquidation was further accompanied by a still highly overbought market and extreme complacency on the part of both retail and institutional investors.  That is, there was definitely no panic selling in the markets on Friday, despite a $68 oil price and relatively bad earnings reports from both GE and Citigroup.  Make no mistake: GE's earnings report – given that it is the world's fourth most valuable brand name as ranked by Interbrand.com and given that its business encompasses nearly all aspects of the world's economy – is important.  The fact that GE's revenues were light and that it only met earnings estimates (historically, GE has always beat estimates by a penny each quarter) is ominous for the stock market going forward.

At this point, the intermediate trend of the stock market definitely remains down – although this author would not rule out a consolidation phase ahead of the all-important Fed meeting and Google's earnings report on January 31st.  This is further confirmed by our liquidity indicators, such as our “MarketThoughts Excess M” (MEM) indicator, the relative strength of the Bank Index vs. the S&P 500, as well as a flattening yield curve.  Readers can read more about the details our MEM indicator in our October 23, 2005 commentary, and following is an update of our liquidity analysis as communicated by our MEM indicator:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-3 (April 1985 to Present) - 1) 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... 2) Speculators continues to be aggressive in the face of the Fed reining in the monetary base. Our MEM indicator perked up slightly from negative 4.54% two weeks ago to negative 4.20% in the latest week - but is still at its lowest since Jan 2002. This does not bode well for the markets going forward.

While our MEM indicator did perk up slightly in the latest week, this author believes that the damage has already been done.  In fact, a rising MEM indicator (after coming off from such negative territory) is actually bearish – as it signals that speculators now are becoming more risk-adverse and taking money off the table (e.g. slowing housing market, and so forth).  The continue deterioration in liquidity can also be witnessed in the relative strength of the Philadelphia Bank Index vs. the S&P 500.  While relative strength of the Bank Index has been weak and deteriorating since February 2005, it is interesting to note that relative strength took another substantial plunge in the last week, as shown by the following weekly chart of the 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 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. 2) 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. 3) Relative strength of the Bank Index finally broke through support convincingly approximately nearly a year ago and and has stayed down since - with the exception of a back-kiss off the same line in April 2005 and early November 2005. Note that relative strength of the Bank Index has recently been trying to push through major resistance, but has so far, failed to do so. In fact, the significant decline of the Bank Index relative to the S&P 500 last week most probably signaled a new downward trend in relative strength. Bottom line: Global liquidity continues to deteroriate. 

Since relative strength of the Bank Index has been a very good leading indicator for the broad market (and for the world markets) on a historical basis, the latest weekly decline of relative strength is a significantly ominous indicator.  The fact that the European Central Bank is scheduled to raise its short-term rates three times in the upcoming year, and the fact that the Japanese monetary base only grew 1.0% on a year-over-year basis in December further tells us that global liquidity will continue to decline going forward – unless our new Fed chairman, Ben Bernanke, dramatically reverses Fed monetary policy in the upcoming January 31st meeting.  Like we mentioned earlier, however, the damage has been done.

However, assuming that the U.S. only experience a mid-cycle slowdown and thus does not enter a recession, my guess is that the stock market (particularly U.S. large caps) will present a once-in-a-decade buying opportunity sometime later this year (like I have mentioned before, many of the U.S. large cap, brand name stocks are trading at valuations not seen in ten years).  The $64 million question to ask is whether the small cap outperformance (relative to large caps) and bull market will remain intact.  The current small cap outperformance began in 2002.  History suggests that small cap outperformance tends to last eight to nine years (as exemplified by the 1938 to 1946 and 1975 to 1983 huge bull markets in small caps), but history also suggests that buying large caps at near-current prices (especially subsequent to any general sell-off in the stock market later this year) is also going to be a pretty safe long-term bet going forward.  Speaking of large caps, we will perform our analysis of more of the “brand name stocks” that we like in this Thursday morning's commentary (since this commentary is getting quite long already) – and how they are continuing to foreshadow a weak stock market just up ahead.  Just for the record – in a typical bull market – one always wants the small and mid caps (or in other words, breadth) to confirm the major indices (such as the Dow Industrials and the S&P 500) on the upside.  In a small cap bull market such as what we have been experiencing from 2002 to the present, one wants the large caps to confirm the small cap and mid cap indices on the upside.  In other words, the lack of breadth usually sounds a warning for the bulls in a typical bull market (breadth leads the way), but in a market such as the one we are currently experiencing, it works the other way around.  That is, the major market indices such as the Dow Industrials and the S&P 500 become the leading indicator.  The fact that both the Dow Industrials and the S&P 500 had not been confirming the record highs in the NYSE A/D line (along with record highs in the S&P 600 and the Russell 2000) should have been enough warning for the bulls to stay aside before last Friday's decline.

Speaking of buying U.S. large cap, brand name stocks at a discount, let's now go back and explore Benjamin Graham's definition of what constitutes a “bargain issue.”  Note that this definition does not include “secondary stocks” – or stocks that are defined as not a leader in a “fairly important industry.”  By definition, this will eliminate most of the stocks that are trading in the U.S. stock exchanges today.

In the 1973 (the fourth revised) edition of “The Intelligent Investor,” Benjamin Graham states: “We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling for.  The genus includes bonds and preferred stocks selling well under par, as well as common stocks.  To be as concrete as possible, let us suggest that an issue is not a true “bargain” unless the indicated value is at least 50% more than the price.  What kind of facts would warrant the conclusion that so great a discrepancy exists?  How do bargains come into existence, and how does the investor profit from them?

What Henry, have you gone crazy?  How do I know whether a stock is trading 50% below its “intrinsic value?”  Good question.  For our purpose, it is important to focus only on the last two questions in the above quote.  That is, how do we know when is a good time to purchase these large cap, brand name stocks, according to Benjamin Graham?  Before we begin, it is important to note that for most of the life of the post World War II U.S. stock market, the large cap, brand name stocks have usually been trading at fair valuations or above-average valuations.  That is, such large cap brand names do not usually sell at any discount in the normal sense of the word, unless such companies stumble very badly or their industries become very out-of-favor.  Note that such “bargain-hunting” time has usually occurred in the past, such as Buffett buying American Express in the midst of the “Salad Oil Scandal” in 1963, the successful turnaround of IBM by Lou Gerstner in 1993/1994, and buying Philip Morris in 2000 when it looked like the entire tobacco industry was heading for bankruptcy.

For folks who are not brave enough to buy into such turnarounds (and this is very understandable, as many former blue chip stocks have indeed not ever turned around but instead filed for bankruptcy), what do we do?  We now delve deeper into Graham's words: “The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.  Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.”  Furthermore: “At low points in the general market a large proportion of common stocks are bargain issues … (A typical example was General Motors when it sold at less than 30 in 1941, equivalent to only 5 for the 1971 shares.  It had been earning in excess of $4 and paying $3.50, or more, in dividends.)  It is true that current earnings and the immediate prospects may both be poor, but a levelheaded appraisal of average future conditions would indicate values far above ruling prices.  Thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.”

Given that we are heading for at least a mid-cycle slowdown scenario, this author believes such a buying opportunity (where the general market sells off enough to create a very attractive valuation in many of the large cap, brand name stocks) will occur later this year.  With the Fed Funds rate due to increase to 4.5% at the end of this month, and with fourth-quarter real GDP growth expected to slow to 2.8%, many companies may also find it more attractive to conserve cash (and essentially put it in short-dated Treasuries) and wait for a lower interest/higher growth environment before they invest this excess cash back into their own businesses.

Bottom line: Unless investors believe U.S. households are entering a prolonged period of balance sheet recession, any general market sell-off this year could lead to a huge buying opportunity for some of the large cap, brand name companies.  For now, the intermediate trend is down – and should remain so until the market and sentiment declines to a classic oversold level.  We will keep our subscribers up-to-date as we get closer to such a condition – both in our twice-a-week commentaries and through our signals in our DJIA Timing System.

Let's now end with a discussion of the most recent action in the stock market.  While nearly everyone is focused on the huge 292-point decline in the Dow Industrials and 26-point decline in the S&P 500, it is important to note here that the Dow Transports actually rose 11.38 points in the latest week – which qualifies as one of the most flagrant short-term divergence in Dow Theory history.  In other words, the Dow Transports is not confirming the Dow Industrials on the downside.  This is doubly significant given that the Dow Transports has been one of the most reliable leading indicators of the major market indices since this cyclical bull market began in October 2002.  Following is the daily chart showing the most recent action of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to January 20, 2006) - For the week, the Dow Industrials declined a huge 292 points while the Dow Transports actually rose 11.38 points! While everything else that this author is currently watching is signaling a new downtrend, the fact that the Dow Transports is not confirming makes me wary - especially given that the Dow Transports has been one of the best leading indicators in this cyclical bull market. This recent divergence is one of the most flagrant ST divergence in Dow Theory history. As long as the Dow Transports remains above Tuesday's closing low 4,090.95, the bulls should be safe for now. For now, we will continue to stay 50% short in our DJIA Timing System until the market starts to get oversold or unless the Dow Transports continue to stay stubbornly above last Tuesday's closing low.

The bears who are gloating right now should keep a close eye on the Dow Transports in the coming days.  In order for the Dow Transports to confirm on the downside, it needs to close below last Tuesday's closing low of 4,090.95 – which is a whopping 67.53 points below last Friday's close.  Should the Dow Transports continue to stubbornly stay at current levels, there is a chance that we may have to pare down our 50% short position in our DJIA Timing System.  Again, the real test of the markets will come after the official appointment of Ben Bernanke as the new Chairman of the Federal Reserve on January 31st, as well as UPS' earnings this Thursday (which is a bellwether for the Dow Transports) and Google's earnings on January 31st.

Let's now discuss our most popular sentiment indicators.  Last week I had stated: “Let me try to sum it up in one sentence: Things are not looking so great for the bulls right now.  Just as the latest weekly readings in the American Association of Individual Investors Survey were starting to become oversold, the Bulls-Bears% Differential in the AAII survey unexpectedly jumped up again in the latest week – from a very benign reading of negative 1% all the way to positive 40%!  This latest jump represents the largest weekly rise since March 2004.  We are also now getting highly overbought readings in both the Investors Intelligence Survey and in the Market Vane's Bullish Consensus.”  In retrospect, it looks like our fears were well-founded – and based on the latest weekly readings in our three popular sentiment indicators (which are still very overbought although it looks very likely that they are turning down), it now looks highly likely that the stock market has now reversed and is embarking on a multi-week downtrend.

Let's now start with the American Association of Individual Investors (AAII) Survey.  During the latest week, the Bulls-Bears% Differential in the AAII survey declined from a highly overbought reading of 40% to a more manageable 24% reading.  Meanwhile, the ten-week moving average decreased from an overbought reading of 24.5% to 23.3% - suggesting that this survey (and thus, the stock market) may be in the midst of embarking on a new downtrend.  Following is the weekly chart showing the Bulls-Bears% Differential in the AAII Survey vs. the Dow Industrials from January 2003 to the present:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey declined from a whopping 40% to a more managable 24% in the latest week. Meanwhile, the ten-week MA decreased from an overbought reading of 24.5% to 23.3% in the latest week - suggesting that the AAII survey (and thus, the market) is now in a downtrend. For now, we will remain 50% in our DJIA Timing System until this survey gets to the oversold area - which will most probably involve at least two weekly negative readings and a ten-week moving average below 10%.

Last week, I had stated: “Meanwhile, the ten-week moving average increased from a still-neutral reading of 22.0% to finally an overbought reading of 24.5% in the latest week – still not at a point which this author will start to “panic” although we are definitely getting pretty close.”  In retrospect, it took this author only two-and-a-half days to “panic” and implement a 25% short position in our DJIA Timing System on Wednesday afternoon.  This was followed by another shift to a 50% short position on the next day – which is our maximum allowable short position in our DJIA Timing System.  As Keynes had often said, it is time to change your position when the facts change, and last week, the “facts” did definitely change.  For now, we will remain 50% short in our DJIA Timing System until the AAII survey “sells off” to an oversold area (which will most probably involve at least two weekly negative readings and a ten-week moving average below 10%).

At the same time, while the Bulls-Bears% Differential in the Investors Intelligence Survey has not turned down yet, it remains extremely overbought – as the weekly reading declined slightly from 34.7% to 34.4% in the latest week.  Meanwhile, the ten-week moving average increased from 33.3% to 34.2% - which is definitely in an extremely overbought area.  In last weekend's commentary, I stated: “While this author would like to see a 40%+ reading in this survey before going 50% short in our DJIA Timing System, that is no longer the necessary condition.”  This has turned out to be precisely the case.  Following is the weekly chart showing the Bulls-Bears% Differential in the Investors Intelligence Survey vs. the Dow Industrials:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey decreased slightly from 34.7% to 34.4% in the latest week. Meanwhile, the ten-week moving average increased from 33.3% to 34.2% - which represents a very overbought reading. Given the recent broad decline in the stock market, and given the huge overbought conditions in the Investors Intelligence Survey, this author will have to conclude that the market is in a new downtrend.

While the ten-week moving average has not officially reversed yet, it should be noted that the ten-week moving average is now in an extremely overbought condition – and can reverse to the downside at anytime, especially since the ten-week moving average reading in the AAII survey has officially turned down. 

Meanwhile, the Market Vane's Bullish Consensus gave us the first 70%+ reading last week and the highest so far that we have registered (73%) in this cyclical bull market and the highest weekly reading since November 1998.  During the latest week, the Market Vane's Bullish Consensus declined slightly from 73% to 71% - managing to hold on to the 70%+ level for a second consecutive week.  In last weekend's commentary, I had stated: “Based on the history of the Market Vane's Bullish Consensus, such high readings (over 70%) can only mean two things: That we are in the midst of a significant top or that the bull market will now reassert itself in a powerful way.  Since this author is very cautious in nature and since I believe 2006 will be a year fraught with risks, probability suggests to me that it is the former rather than the later:” The action of the last week has thus far proven true.  It is now left to both the Dow Transports and Google to confirm on the downside (former breaking its last Tuesday low and latter breaking below $400 a share convincingly).  Following is the weekly chart showing the Market Vane's Bullish Consensus vs. the Dow Industrials:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - Over the last week, the Market Vane's Bullish Consensus decreased from an extremely overbought reading of 73% to 71% - another 70%+ reading and the second highest reading we have gotten so far in this cyclical bull market. Our message from last week does not change. Such overbought readings cam only mean two things: That we are in the midst of a significant top or that the bull market will reassert itself in a powerful way. Again, the author is opting for the former. Meanwhile, the ten-week MA rose from 68.5% to 69.3% - the most overbought reading since August 1997 and which puts us officially in the 'danger zone.' Again, all three of our sentiment indicators are now on the overbought or extremely overbought side. For now, we will remain 50% short in our DJIA Timing System until our sentiment indicators decline to an oversold level.

At the same time, the ten-week moving average increased from 68.5% to 69.3% - which is again extremely overbought and represents the most overbought reading since August 1997.  Given that all three of our popular sentiment indicators are now very or extremely overbought, and given that the ten-week moving average of the AAII survey has reversed – we will remain 50% short in our DJIA Timing System until the readings of these surveys decline back to at least a moderately oversold level again (or unless the Dow Transports fail to confirm on the downside in the week ahead).  At this point, the author still believes the market has reversed to the downside and is now embarking on a volatile, multi-week decline.

Conclusion: As we mentioned to you in our real-time emails on Wednesday and Thursday afternoon, our DJIA Timing System is now in a 50% short position – implemented at an average price of 10,870.  Make no mistake: Friday's decline was significant, given the huge downside breadth, the huge volume, as well as a lack of panic in a still overbought stock market (not only in the U.S. but worldwide as well).  For now, our mid-cycle slowdown scenario remains in play for 2006.  We will continue to hold this short position until the market declines to an oversold level or unless the Dow Transports managed to hold up in the coming days.  For now, readers should continue to watch the Dow Transports, the reaction to the UPS' earnings report on Thursday after the close, as well as the reaction to Google's earnings report on January 31st after the close.  For those who are not comfortable with the short side, this author is again suggesting you to “go back to basics” in 2006, and to focus on valuations and researching businesses instead, as many of the most valuable, large cap brand names are now selling at valuations not seen in over ten years.  Any market sell-off that we see in 2006 due to a mid-cycle slowdown or some other economic shock should provide a great opportunity to load up on those shares and hold them for the long-run.  Again, this is based on the assumption that we will only experience a mid-cycle slowdown in 2006, and not a full-blown recession.

Signing off,

Henry K. To, CFA

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