Some Parting Thoughts
(March 16, 2006)
Dear Subscribers and Readers,
We switched from a 25% short position to a neutral 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, January 18th 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, January 19th at DJIA 10,900 – thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,021.59), this position is 151.59 points in the red – but again, given that the market is now showing signs of a classic “blow off” top, this author is betting that this position will ultimately work out.
We then added a further 25% short position on Monday afternoon (February 27th) at a DJIA print of 11,124 – thus bring our total short position in our DJIA Timing System at 75%. However, I have warned our readers that we were looking to exit this 25% short position as soon as we could – in order to control for risk/volatility. We subsequently decided to exit this last 25% short position last Friday morning at a DJIA print of 11,035 – giving us a gain of 89 points. This latest signal was sent to all our subscribers on a real-time basis. For now, we will remain 50% short at least until the next Fed meeting on March 28th.
Since our weekend commentary, the Dow Industrials has rallied a further 133.75 points – making another five-year high closing at 11,209.77 on Wednesday afternoon. At the same time, the Dow Transports closed at another all-time high – rising 97.06 points to close at 4,591.76. In light of this rally in both the Dow Industrials and the Dow Transports, a couple of subscribers have asked me if we have set a certain point when we will cut our losses on our remaining 50% short position on our DJIA Timing System – in other words, a stop that is strictly mechanical in nature.
The answer is “No.” As a rule, I don't like setting absolute stop levels on an index such as the Dow Industrials, for example. Individual stocks maybe, but not a major market index. My view of the market depends firmly on what I believe the overriding secular trend is at any point in time. If one can get the overriding picture correct, then one is way ahead of many of the analysts out there who don't believe that there is a secular trend. That is why many of them undershoot their estimates in a bull market, and conversely, overshoot their estimates in a bear market.
The P/E multiple expansions that occurred during the 1980s and 1990s are over, for the most part. Today and for the foreseeable future, price levels on the major market indices will mostly be dictated by future earnings trends - and thus will be more "cyclical" as opposed to the 1980s and 1990s when we saw a secular uptrend in stock prices - about half of which was due to P/E multiple expansion. My guess is that the trailing P/E of the S&P 500 will fluctuate around a "mean" of 15 or so for the rest of this decade - with "undershots" to 10 and "overshots" or 20 or so. I also look at breadth, liquidity, and sentiment indicators, and given all the recent developments, I still have no problems shorting into rallies and covering on oversold declines. In actuality, shorting the Dow Industrial Average in our DJIA Timing System is getting more attractive by the day. Like we mentioned in our weekend commentary, this author would not be surprised by a further rally to the 11,250 to 11,400 area – but I don't believe that the DJIA can make an all-time high unless the Federal Reserve lets the headline CPI-U number statistic get out of hand.
Also as a rule, this author does not like buying on breakouts and selling on breakdowns – not because this author is stubborn but mainly because such a system would have produced a lot of losses over the last few years. Let me reiterate what I have mentioned before: Buying on breakouts (in general) only makes sense in a rip-roaring bull market AND ONLY when not many folks are doing the same thing. Today – with the proliferation of momentum trading systems and momentum publications like Investors Business Daily – and given that we are no longer in a secular bull market – it can be argued that neither of these conditions hold. Sure, one of these days we will get the lone exception. But please keep in mind that being able to navigate the markets successfully involves knowing the probabilities and be disciplined enough so as not to fade them. Wishing for the “long shot” should be strictly relegated to the gambling table and the Power ball.
In a recent article on trending in the S&P 500, TradingMarkets.com pointed out that short-term positive correlation (short-term trends) in the S&P 500 more or less faded away since September 2001. That article is a must-read, but for convenience sake, following is a reproduction of the critical chart (period covering January 1966 to March 9, 2006) in the TradingMarkets.com article:
So what is the above chart saying? Quoting from the article:
I went back to January, 1966 and investigated 250-day periods in the market--periods amounting to roughly one year of data. I counted each occasion in which the market was either up following an up day or down following a down day. These I called two-day trends. My goal was to determine the percentage of occasions in a moving 250-day period that qualified as two-day trends.
Before we examine the data, let's think about this logically. If the odds of the market rising or falling on a particular day are 50/50, then we should see roughly one-quarter of all occasions displaying two-day uptrends; one half of all occasions showing no trend; and one-quarter of all occasions exemplifying two-day downtrends. So, all in all, we should see--in any moving 250-day period--about 125 trending occasions. If we see many more trending occasions, then we have a directional bias: market direction is likely to persist. If we see many fewer trending occasions than 125, then we are displaying anti-persistence: the market is biased toward reversing prior movement.
Since September 2001, the 250-day moving average of two-day trends have been consistently below 125 – suggesting that an up day is now most likely followed by a down day as opposed to vice-versa. Translation: Not only is the market no longer displaying trending behavior that was very prevalent during the 1960s and early 1970s, it is actually displaying an anti-trend behavior (most probably due to the increasing popularity of trend-following systems in the last 30 years). As a matter of fact, we are now at a point where the S&P 500 is displaying the strongest “anti-trending” behavior. This is one more reason why this author does not like to cover on breakouts or sell-short on breakdowns. Usually, these are followed by short-term reversal patterns – even if the one is “in harmony” with the more intermediate trend.
In other words, should the author determine that he is wrong in maintaining the 50% short position in our DJIA Timing System, I will cover our short position – but not until we get a neutral or oversold reading in the stock market.
Let's now ignore the day-to-day movements of the major market indices and focus on the bigger picture. First of all, we know that the sectors (the energy sector, the homebuilders and the utilities) that have been leading the stock market since the cyclical bull market began in October 2002 are breaking down or have already broken down (especially in the case of homebuilders). Second of all, we know that the majority of the DJIA component stocks are now many percentage points off their bull market highs (even the Dow Industrials just made a new bull market today). We also know that two of the biggest leading names in this bull market – GOOG and AAPL – have most likely topped out for this cycle. This second point of “brand name watching” has been discussed extensively in many of our past commentaries and most recently in our January 26, 2006 commentary (“Bernanke and Brand Name Watch”). Third of all, both the stock market and the commodity markets are still very much “fighting the Fed” – and with the end and the gradual phasing out of Japan's “quantitative easing” policy, the long-end of the yield curve in both the Euro Zone and the United States will also increase going forward as well. Even in the absence of an inverted yield curve, the stock market can only take so much interest rate increases all across the board (along the yield curve and across the developed world). This is being reflected in the huge underperformance in the Dow Jones Utility Average in recent months – which has (appropriately) also historically acted very well as a leading indicator of the general stock market.
Speaking of the Dow Jones Utility Average, the index topped out way back in the first week of October – nearly six months ago. Given that the Dow Utilities has led the stock market by three to nine months in a typical bull market, and given that interest rates should continue to head higher (the components of the Dow Utilities are very sensitive to interest rates since they are highly leveraged companies), the Dow Utilities should continue to underperform going forward.
As I discussed in our February 26, 2006 commentary, the consumer discretionary sector has also tended to lead in a typical bull market. This makes sense – as consumer discretionary spending (flat-screen TVs, vacation trips, Coach Briefcases, etc.) is usually the first to take a hit in an economic slowdown. Unlike the last cycle (when the recession was primarily driven by a plunge in capital spending), this current cycle has been driven primarily by the housing sector (mortgage equity withdrawal, creation of jobs in the housing sector, etc.) and the resultant increase in consumer spending because of the booming housing market. Therefore, any slowdown in the economy or the stock market going forward should first been reflected in the stock prices of the consumer discretionary sector. Again, uising consumer discretionary stocks as a leading indicator is all the more important in this cyclical bull market, since the recovery from the 2001 recession has very much been consumer-driven. Below is a weekly candlestick chart showing the AMEX Consumer Discretionary Select Sector SPDR (XLY) and its relative strength vs. the S&P 500 from January 2002 to the present (courtesy of Decisionpoint.com):
In our February 26, 2006 commentary I stated: “As mentioned on the above chart, the absolute level of the XLY peaked in January 2005 and has been trending down and making lower highs ever since. More importantly, the relative strength of the XLY vs. the S&P 500 also peaked in January 2005 and is now in fact at the lowest level since March 2003. Historically, the consumer discretionary sector is an “early cyclical” and thus is a very good leading indicator of the stock market, especially since this cyclical bull market has mostly been consumer-driven. The top ten holdings (in order of percentage makeup) of the XLY are Home Depot, Time Warner, Comcast, Lowes, Viacom, eBay, Target, Disney, McDonalds, and News Corporation. Other notable holdings include Carnival, Starbucks, and Best Buy. As a matter of fact, this author is now watching Starbucks and Best Buy like a hawk, as these two stocks have been two of the hottest stocks (with still very compelling growth stories) in this cyclical bull market and is still near or at all-time highs. Once either Starbucks or Best Buy takes a hit, this cyclical bull market in all likelihood will be over. Note that Best Buy announces its next quarterly earnings report on March 30th, with Starbucks reporting on May 3rd.” As of the close on March 15th, both Starbucks and Best Buy are still trading near all-time highs – and thus are not even close to breaking down yet. Will the consumer discretionary sector plunge below support or will it stage an impressive upward reversal in the weeks going forward? Probability suggests the former – but given the fact that consumer discretionary has been underperforming and not confirming the market for the last 14 months already, the damage may have already been done. However, once people stop buying US$3 coffee, then we will absolutely know for sure that the slowdown has arrived.
Make no mistake: The recent outperformance of the major market indices like the Dow Industrials, the Dow Transports, and the S&P 500 hides a dull fact (at least to the bulls) – and that “dull fact” is that global liquidity is continuing to deteriorate at a dramatic pace. The gradual phasing out of Japan's “quantitative easing” policy (said policy which also involves manipulating rates at the long-end of the curve – thus driving down long-term rates across the world) will put the final nail in the coffin in global liquidity. The recent huge corrections in the Middle Eastern markets should not be taken lightly and is a further reflection of the decline in global liquidity. Moreover, the Nikkei also closed down over 200 points last night. In the domestic market, the new highs made by the Dow Industrials, the Dow Transports, and the S&P 500 were not confirmed by other indices such as the Russell 2000, the S&P 400, the S&P 600, the Dow Utilities (as I mentioned above), the OIH (Oil Service HOLDRS), and the Philadelphia Semiconductor Index (the SOX). In fact, the SOX is still trading at more than 8% below its February highs.
This lack of confirmation in many of the leading indices should be treated as a huge warning sign. Okay, so you may now say: All that is well and fine, Henry, but can't the Dow Industrials rally further even as breadth continues to deteriorate?
Yes, it definitely can – and this is precisely what our weekend commentary discussed – as I said that the Dow Industrials could conceivably rally to the 11,250 to 11,400 range before topping out. The following chart shows the Dow Industrials vs. the percentage of component stocks in the Dow Industrials over their 20-EMAs, 50-EMAs, and 200-EMAs. As the following chart (courtesy of Decisionpoint.com) shows, however, the recent rally of the Dow Industrials may now be very close to ending – as the percentage of Dow Industrial stocks above their 20, 50, and 200-EMAs are all above 80% - which is consistent with levels (see circled areas) that are very overbought on the index and which has historically led to significant corrections in the past:
As the above chart illustrates, the Dow Industrials is now hugely overbought – and given the lack of confirmation in many other leading market indices, there is a good chance that the Dow Industrials is now topping and subsequently correct in a big way.
Finally, readers should continue to watch the commodity currencies such as the Canadian dollar, the Australian dollar, the New Zealand dollar, and the South African Rand – given that they have been very good long leading indicators of the global economy in the past. We all know that the later three have completely broken down. As I mentioned in previous commentaries, the long hold-out has been the Canadian dollar – but that too may now be changing. The Canadian dollar may a new 14-year high as recently as two weeks ago, but has since corrected even as the Central Bank of Canada hiked its short-term rate and even as the dollar continues to tread water against the Euro.
For now – despite the impressive rally in the Dow Industrials, the Dow Transports, and the S&P 500, virtually all the evidence is still telling me that the market is in the midst of topping out. This is confirmed by the recent weakness in the Nikkei and the Middle Eastern markets, as well as the lack of confirmation in energy stocks, small and mid caps, and the utility stocks. This is also confirmed with the lack of recent volume on the upside, as well as the dismal statistics in the new 52-week highs vs. new 52-week lows on both the NYSE and the NASDAQ. Furthermore, the Dow Industrials is now hugely overbought – and may just correct at any time without warning. We will reevaluate again when the latest margin debt and NYSE short interest data is released (hopefully by the early parts of next week), but given higher interest rates and a continuing deterioration in global liquidity – the Dow Industrials and the S&P 500 should at least correct here.
Again, there will be no official commentary this weekend. But I will post an “ad hoc” commentary illustrating some of my “weekend thoughts” this Sunday from Connecticut.
Henry K. To, CFA