(February 12, 2006)
Dear Subscribers and Readers,
As I am writing this in relatively balmy Houston, the second most powerful snow blizzard is in the midst of pounding New England and the New York Metropolitan area. According to Accuweather.com, New York's Central Park recorded 22.8 inches of snow – just shy of the all-time high of 26.4 inches set during December 26 to 27, 1947. Moreover, this cold weather is expected to affect the Deep South as well, with Florida averaging temperatures in the 50s (Fahrenheit) after having experienced temperatures in the high 70s and low 80s as late as Saturday.
The question to ask is: How will this affect natural gas prices? And if temperatures are to stay cold for the rest of February, how will this affect spending and home sales patterns? Given that we just had one of the warmest Januarys on record, my answer is “not good.” The retailers will definitely take a hit on this one. As for the answer to the first question, it should be noted that based on the latest natural gas storage report from the EIA, natural gas stocks are still 437 Bcf above levels to that of last year and 649 Bcf above the five-year average. Unless colder-than-expected weather prevails until March, there is still plenty of natural gas. That being said, there is a good chance that the spot price of natural gas will spike and that hedge funds and retail investors alike will try to pile into the market on the long side as well.
Before we go on to our main commentary, let's recap and take a look at the following chart showing the month-end natural gas price vs. the crude oil price from November 2003 to February 2006 (using data as of February 10, 2006 as the February month-end prices):
In our July 31, 2005 commentary (“Natural Gas – The Other Bull?”), we explored the possibility of an upcoming spike in natural gas prices, given the historical volatility of the commodity, tight domestic supplies, and the fact that its price has been lagging that of oil prices ever since late 2003. In the days immediately after that commentary, natural gas proceeded to rocket nearly $5.00/MMBtu higher (basis the December 2005 forward contract) – with the spot price tacking on more than $7.50/MMBtu in the days leading up to and immediately after the landing of Hurricane Katrina. Since that peak in August to September, and since another brief spike in December (which is not shown on the above chart since the above chart only shows month-end prices), the price of natural gas has come down significantly mainly due to warmer-than-expected weather in the last week of December 2005 and all of January. Given that storage levels were at all-time highs, this wasn't a surprise. In fact, the only reason why natural gas is staying as such elevated levels (relative to its price during most of the 1990s) is because of elevated crude prices (>$60 a barrel) and the perception of tight supplies going forward. The fact that LNG imports/supplies (due to demand competition from Western Europe and Asia) has been dismal has also helped natural gas price stay at such elevated levels.
It is important to note that the United States depends on natural gas for 22% of its energy requirements (with oil accounting for 41% and coal accounting for 23%) – which is pretty substantial. Readers should also keep in mind that every dollar increase in natural gas is equivalent to a $5.80 rise in a barrel of oil, given that a barrel of oil is roughly equivalent to 5.8 MMBtu. Going forward this year and into the rest of the decade, both the U.S. and the world economy will continue to be held hostage by both crude oil and natural gas – unless we manage to develop viable alternative energy sources in the next five to ten years. It should be noted that the topic of natural gas prices and supplies was also at the top of the agenda in the most recent G-8 meeting in Russia.
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. As of the close on Friday (10,919.05), our position is 49.05 points in the red – but given all the weakening fundamental and technical indicators that this author is currently witnessing, I believe that this short position will ultimately work out well.
Let's now cut to the chase and get into our main commentary – that of divergences in the current stock market. Speaking of divergences, this commentary will not be complete without a discussion of the Dow Theory and a quick look at the performance of the Dow Industrials vs. the Dow Transports over the last few years. Readers should keep in mind that when it comes to the study and application of the Dow Theory, the foremost consideration should be valuations. And on this point, both the Dow Industrials and the Dow Transports still do not qualify as undervalued or even at fair value levels – relative to historical P/E ratios. The second consideration is the concept of the primary trend, such as the secular bull market of 1949 to 1966 or the secular bear market of 1966 to 1974. In a secular bull market, bulls should be given the benefit of the doubt. That is, in a secular bull market, it is wise to treat non-confirmations on the downside as a bullish development, while a non-confirmation on the upside should be taken with a grain of salt. This author has gone through this many times before – but let me reiterate once again: I believe we are still in a secular bear market – a secular bear market which began with the bursting of the technology bubble in 2000, and accompanied by huge overvaluations in most other large cap stocks at the time. In a secular bear market, non-confirmations on the upside should be taken seriously. I will now break tradition and show the following chart of the Dow Industrials vs. the Dow Transports as the first chart in this commentary as a prelude to a discussion of this non-confirmation:
It is always difficult when one studies a daily chart, but please keep in mind that an astute investor should always take into account “the big picture” before making an investment decision. As the above chart mentioned, the “big picture” story according to the Dow Theory right now is the “primary non-confirmation” of the Dow Transports on the upside by the Dow Industrials. This is something this author has been discussing since the Dow Transports broke its previous all-time high way back in December 2004. Such a “primary non-confirmation” also acted as an early warning to the impending end of the October 1966 to 1968 and the May 1970 to 1972 cyclical bull markets (within the secular bear market of 1966 to 1974). In order for this cyclical bull market to resume, the Dow Industrials will have to confirm on the upside by breaking its all-time high of 11,723 established at the close on January 14, 2000. And given the dismal performance of the DJIA McClellan Oscillator and Summation Index in recent months (as you will see below) – this is not likely to occur.
Continuing on our discussion of the Dow Jones Industrial average, this author would like to now take a look at the action of the DJIA McClellan Oscillator and the DJIA McClellan Summation Index. Readers should go back to our “stock market indicator section” and refresh one's memory on both the McClellan Oscillator and the McClellan Summation Index – but note that while they can be regarded as an overbought/oversold indicator, they are essentially foremost a breadth indicator. When the McClellan Oscillator or the Summation Index spends most of their time in negative territory – it usually means that money is leaving the market. Following is a three-year chart (courtesy of Decisionpoint.com) showing the Dow Industrials vs. the Dow Industrials McClellan Oscillator and Summation Index:
Please note that the DJIA McClellan Summation Index has been getting progressively weaker since March 2003. In fact, the DJIA Summation Index actually spent most of its time in negative territory during 2005 – suggesting that money has been leaving the Dow components en masse. While there was a brief spike towards the end of 2005, it should be noted that the DJIA Summation index is once again in negative territory, despite the brief rally in the Dow Industrials during the early part of January. This is a huge divergence – and suggests that the Dow Industrials should be getting progressively weaker going forward. It is just a matter of time before this weakness is reflected in the price of the DJIA as well.
Another divergence that this author is currently witnessing is the reluctance of retail investors to get back into the markets – as witnessed by the dismal performance of the large caps and of the S&P 500 (relative to the small and mid caps and every other equity market in the world, except for domestic Chinese stocks). Both Trimtabs and I have previously discussed this phenomenon. Trimtabs claims the reluctance of retail investors to participate in this market rally (especially during 2005) should be treated as a contrarian indicator, and given huge recent corporate buybacks and private equity buying, the S&P 500 should rally approximately 20% in the coming months. This author cannot disagree more.
Yes, anything that retail investors do can usually be treated as a contrarian indicator, but the reluctance of retail investors to get back into the market in droves is normal in a secular bear market. After all, what can one expect – it has only been three years since many retail investors got wiped out in their tech portfolios. Such a “slaughter” usually takes a lot of time to heal. A steady outflow from mutual funds is normal during a secular bear market. In a secular bull market, mutual fund outflows tend to be one or two-week events, and should definitely be treated as contrarian indicators and be bought. The current outflows is different – and is definitely not unprecedented. Let me quote from the October 22, 1971 edition of Richard Russell's Dow Theory Letters: “Mutual fund net redemptions over purchases in September hit a record $166 million (see letter 506), for the 4th net deficit month out of the last five.” Note that such consistent mutual fund liquidations by retail investors occurred right smack in the May 1970 to 1972 cyclical bull market within the 1966 to 1974 secular bear market. Make no mistake: The only thing currently supporting the Dow Industrials and the large caps is corporate buybacks and private equity buying. Once either of these two “pillars” disappear (further rate hikes would definitely do it), I would not be surprised if the Dow Industrials or the S&P 500 decline 10% to 20% from current levels.
A further divergence that we are currently witnessing and which has a great relevance in this current market (given our mid-cycle slowdown scenario due mainly to decreased consumer spending) is the performance of the retailers vs. the performance of the broad market (i.e. the S&P 500). Such a divergence can be witnessed in the following weekly chart showing the relative strength of the Retail HOLDRS (RTH) vs. the S&P 500:
Please note that the relative strength of the RTH vs. the S&P 500 over the last four weeks has declined to a level not seen since March 2003. Please also note the since the cyclical bull market began in October 2002, the relative strength of the RTH vs. the S&P 500 has been a great leading indicator of the broad market – typically leading the stock market from a period of two to eight weeks. The fact that relative strength of the RTH is still very weak – and the fact that the final two weeks of February could be one of the coldest Februarys on record (thus further adversely affecting consumer spending in the days ahead) suggests that the stock market is currently on very dangerous ground. This is not the time to go long, folks.
The final divergence which we will discuss in tonight's commentary comes more in the form of a “psychological divergence.” What do I mean by that? Well, when an indicator that has been pretty reliable over the years in calling for at least a slowdown or even a recession, and when this same indicator is being ignored by many Wall Street analysts (similar to what occurred in early 2000), it is time to sit up and take notice. One can measure whether the yield curve has inverted by looking at the difference between the yield of the two-year Treasury bill or the 10-year Treasury note – but this author prefers looking at the difference between the extremely short end (the Fed Funds rate) and the extremely long end (the 30-year Treasuries). Following is a weekly chart showing the differential between the yield of the long bond and the Fed Funds. When this differential approaches or goes into negative territory, some kind of financial or economic crisis has always occurred. Come March 28, 2006, the red line showing on the following chart will most likely decline into negative territory, and chances are that no matter what happens (Another spike in energy prices? A GM bankruptcy? An emerging market crisis?), the Dow Industrials (given that it is still overvalued and given the divergence of the DJIA McClellan Oscillator and DJIA McClellan Summation Index) will follow on the downside as well.
Readers should also keep in mind that the May 1970 to December 1972 cyclical bull market (within the 1966 to 1974 secular bear market) ended close to the day that this differential touched the zero line, as shown by the following chart:
As I have also mentioned over the last couple of weeks, there is now a lot of mounting evidence that the small caps will start to underperform the large caps during the next few years. History has shown whenever there is a change of leadership between small caps and large caps, it is nearly always preceded by some kind of stock market correction. We are definitely now very overdue.
At the same time, many commodities also took a hit last week, including commodity stocks like PD, FCX, X, PCU, and even the precious metals sector, including NEM. Homebuilders (which have been a great performer in this cyclical bull market) also continue to lag – as well as Google and CME. While AAPL recovered somewhat on Friday, it is still more than 20% off from its mid-January all-time high. Again, it is time to sit up and take notice, even though the Dow Industrials is still flirting with the 11,000 level (in fact, this author believes that the current DJIA reading is the most deceptive we have ever seen in awhile).
Let's now discuss our most popular sentiment indicators and 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 reading of 12% to 5% – which qualifies a pretty oversold weekly reading but one which doesn't signify an imminent rally. In fact, the ten-week moving average declined yet again from 17.0% to 14.6% - signaling that the survey (and thus, the stock market) is still in a downtrend, although this longer-term indicator is now getting pretty oversold as well. Following is the weekly chart showing the Bulls-Bears% Differential in the AAII Survey vs. the Dow Industrials from January 2003 to the present:
At this point, our longer-term indicator (the 10-week moving average) is still signaling for us to stay short – so 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 more weekly negative readings and a ten-week moving average at the 5% to 10% level or even below 5%). Again, if our sentiment or technical indicators sell off to a very oversold level in the short run (such as a daily NYSE ARMS Index level of over 2.5 or a NYSE McClellan Oscillator reading of below negative 200), then this author will not hesitate to cover half (25%) of our 50% short position in our DJIA Timing System – and reentering once the market gets back to a more neutral or overbought level. No matter what happens, we will most probably not start to cover until we have seen a significant correction in both the Dow Industrials and in the broader market.
The same story also applies to the Bulls-Bears% Differential readings in the Investors Intelligence Survey, although the readings of this survey are definitely not as oversold as those of the AAII survey. The current readings of this survey suggests that it is still in a downtrend, with the latest weekly reading declining slightly from 26.8% to 26.3% and the longer-term ten-week moving average declining from 33.6% to 32.8% in the latest week. This current downtrend is doubly authoritative given that both the weekly readings and the ten-week moving average are turning down from very overbought levels. Following is the weekly chart showing the Bulls-Bears% Differential in the Investors Intelligence Survey vs. the Dow Industrials:
Given that the readings of the AAII survey is still mired in a downtrend, and given the weakness in the DJIA McClellan Oscillator and the DJIA McClellan Summation Index (despite the rally in early January), there is a strong chance that the readings in the Investors Intelligence Survey (and thus, the stock market) will not reverse to the upside again until we start getting very oversold readings in this survey again. Moreover, readers should keep in mind that the most serious stock market corrections have come in the midst of an oversold reading in the AAII survey – which is consistent with what is currently occurring. For now, we remain comfortable with the 50% short position in our DJIA Timing System. As of Sunday evening, the position of this author remains the same – but like I have mentioned, this author will also not hesitate covering half of our short position in our DJIA Timing System should the market get very oversold in the short-run. For now, we will again take it one day at a time.
Meanwhile, the Market Vane's Bullish Consensus finally reversed to the downside in the latest week – with the ten-week moving reversing to the downside from an extremely overbought reading of 69.7% (the most overbought reading since August 1997) to 69.5%. Meanwhile, the weekly reading declined from 68% to a more “neutral” 66%. Such a reversal from such a highly overbought reading in the Market Vane's Bullish Consensus is an indication that the market has made a significant top. Following is the weekly chart showing the Market Vane's Bullish Consensus vs. the Dow Industrials:
Given that all three of our popular sentiment indicators have reversed from very highly overbought levels, and given that the AAII survey is now oversold (history has indicated that market corrections tend to occur while the AAII survey is oversold), 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 (again, this author would like to see a 50% reading in the Market Vane's Bullish Consensus before I would commit to the long side here). We will also switch back to a less aggressive 25% short position in our DJIA Timing System should the market get very oversold in the short-run (such as a daily NYSE ARMS Index reading of 2.5 or a NYSE McClellan Oscillator reading of less than negative 200). At this point, the author still believes the market has yet to finish its downside correction and thus is very vulnerable to a multi-week decline.
Conclusion: Divergences, divergences, divergences – this is the theme of this weekend's commentary. At this point, the divergences are giving us a lot of warnings about the stock market – but will investors bite? Based on historical precedent, my guess is that they won't – and the many major market indices are actually deceptively attractive right now (even though both the fundamentals and technicals are deteriorating in front of our very eyes). In light of our relatively bearish commentaries on small caps during the last two weeks, readers should also keep in mind that the stock market has virtually always suffered a correction whenever there is a change of leadership from small caps to large caps, and vice-versa – and this time should prove no different.
For now, our most objective longer-term technical and sentiment indicators are still telling us that the downtrend is still in play– and so we will remain 50% short in our DJIA Timing System until we start getting more oversold readings in our technical and sentiment indicators. In fact, our indicators are now virtually telling us to “get the heck out.” Readers should continue to forgo or hesitate from buying “risky assets” going forward in 2006 – said risky assets including small and mid caps stocks, emerging market equities, and energy and metal commodities.
Henry K. To, CFA