Market Internals Still Weakening
(March 23, 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 Wednesday (11,317.43), this position is 417.43 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%. We subsequently decided to exit this last 25% short position on the morning of March 10th 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.
In our previous mid-week commentary, we stated that we will remain 50% short in our DJIA Timing System until at least the March 28th Fed meeting. Whether we were slightly early or not, this was not to be – as we subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. This was also communicated to our readers on a real-time basis. For readers who did not receive this “special alert,” please make sure that your filters are set appropriately. Our new position was also published in our Subscribers' area of our website that very night.
Let's cut to the chase and get right to the heart of our commentary. In our special alert on Monday morning, we stated: “Over the last three months, we have seen many divergences not just in the broad market, but also in the 30 components of the Dow Industrials itself – especially in hugely weighted stocks (but small companies in terms of market cap) such as Boeing and Caterpillar (they are weighted 5.5% and 5.3% in the Dow Jones Industrials, respectively). At the same time, the two stocks that have been underperforming the most in recent months (Intel and GM) have the smallest weightings in the Dow Industrials – weightings of 1.4% and 1.6%, respectively.”
While casual observers of the stock market may find today's 81-point rise in the Dow Industrials impressive, a further breakdown of each of the Dow 30 components suggests a different story. Following is a table of the Dow 30 components along with Wednesday's daily percentage return sorted by weighting (the Dow Industrials is a price-weighted index) and divided into six quintiles (both in descending order):
Today's performance of each of the Dow 30 components basically tell the whole story for the first three months of the year – that the components with the highest weighting (such as Caterpillar and Boeing) has performed the best while stocks with the lowest weighting (but very important nonetheless), such as GM and Intel, has been underperforming all year. Note that as you get further down the table, performance has generally declined.
Two of the highest-weighted stocks in the Dow Industrials – Caterpillar and Boeing (weighted 5.39% and 5.56%, respectively) – has disproportionately contributed to a great deal of the Dow Industrials' outperformance since October 2005 – with the former rising nearly 60% and the latter rising nearly 25% from their respective October 2005 lows! Following is a daily chart of both CAT and BA, courtesy of Stockcharts.com:
Like I mentioned in the above chart, the rise in CAT since late October has been relentless – with only a brief pause in the early parts of this month. Let's now take a look at the daily chart of BA – also courtesy of Stockcharts.com:
While the rise from late October in BA is definitely not as impressive as the rise in CAT, please note that during the last two months alone, the stock price of BA has appreciated nearly 20%. The action of BA is even more impressive if we only look at the daily action of the last two weeks, as BA appreciated a whopping 10% during that short period of time! I am not sure about you, but this looks like a “blow off top” to me, dear readers.
The relentless rise in both CAT and BA is even more interesting given that both of these are very cyclical stocks and as thus, are very interest-rate and emerging market sensitive. As a rule, cyclical stocks tend to outperform the non-cyclical stocks by a significant margin during two phases of a bull market – either at the beginning or at the end of the bull market. Such a phenomenon is also being witnessed in the Dow Transports – as the recent outperformance of the Dow Transports has been in part due to the huge rally in the legacy airlines, such as AMR and Continental. For illustration purposes, following is a weekly chart of AMR, courtesy of Stockcharts.com. Note that AMR – despite a $60 oil price, huge legacy costs, and being in a highly competitive industry – recently just made a new cyclical bull market high.
The rise in AMR is even more impressive considering that it hit a low of $10 a share as recently as eight months ago (when Delta and Northwest filed for bankruptcy). Since then, the stock has appreciated nearly 190%. All of a sudden, every Wall Street analyst likes the airlines. Has the fundamentals changed that drastically over the last seven months? Definitely not. Moreover, given the ability of the airline industry to disappoint over the last 20 years, it seems to me that the Wall Street analysts have gotten it wrong once again. By the end of this year, this author believes that the shares of legacy airlines such as AMR, Continental, and LCC will be selling at substantially lower prices.
In a nutshell, it all comes down to this: Are we in the beginning of a new bull market or are we nearing the end of one? No points for being able to guess where this author stands! The recent moves in CAT, BA, and the airlines are most probably signaling an impending top in the major market indices – especially viewed in the context of a continuing tightening global liquidity environment, record low emerging market spreads, and bullish complacency among retail investors – as exemplified by the recent inflows to Charles Schwab and the still-bullish readings in the Market Vane, AAII, and the Investors Intelligence Surveys. Sure, the most recent weekly readings in both the AAII and Investors Intelligence surveys have tilted towards more bearish readings – but take a look at the following chart, and you will see why this author believes we are closer to the end of this cyclical bull market as opposed to the beginning of a new cyclical bull market. Note that these readers are readings from last week, as the latest weekly readings do not get updated until tomorrow morning (I will provide an updated chart this weekend):
As of tonight, the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Bulls-Bears Differentials stand at 21.5%. Note that at the most recent bottom in late October 2005, the four-week moving average hit a low of 11.6%. The lowest reading of this cyclical bull market was 8.5% - which came in the midst of the April to May 2005 decline. For comparison purposes, the low during July 2002 and March 2003 were -26.9% and -22.6%, respectively. More important, many stock market analysts out there have been comparing current conditions to those of 1994 – claiming that the stock market will take off (just like 1994) once the Fed is nearly done with its rate hikes. What they have ignored, however, is that sentiment was pitch black during most of 1994 – unlike the sentiment readings of today.
From a fundamental standpoint, we also know that a significant portion of recent growth in CAT's and BA's business has been done in emerging markets – especially in the Middle Eastern countries. In fact, Boeing is actually the largest exporter of U.S. goods, while Caterpillar has been a great contributor to both the mining and the construction industries in the Middle East. Readers who have been keeping track with our commentaries and our postings on our discussion forum should know, however, that the Middle Eastern markets haven't been faring so well lately – given that the Saudi market is down over 22% from its all-time high on February 25, 2006 and given that the Dubai stock market is down 36% from its 2005 close and 50% from its all-time high made last August. At its height, the total market cap of the Saudi stock market topped US$1 trillion. In other words, much of the “hot money” has left the Arab markets – and the “hot money” in both the construction and real estate sector should also follow in due time as well. The Washington Post has previously mentioned that 16% of the world's construction cranes are located in Dubai. Given the following (recent) pictures of Dubai (courtesy of the following website), this statistic is definitely very believable:
Can one say “overcapacity?” And all in the midst of a global tightening situation and a diverging stock market. Unless the price of oil hits $80 or over in the months ahead, it seems very likely that the Dubai construction craze (and the Middle Eastern stock market rallies) have popped for now. While fund managers bidding up CAT and BA (two of the companies which will be hurt most by a decline in world trade) can most probably ignore the rise of protectionism in the U.S. Congress, it is definitely not a good idea to be bidding up the shares of these two stocks at current levels and given the fact that the Middle Eastern bubble has already popped.
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 lone hold-out has been the Canadian dollar – but that also now looks to be changing. It is just a matter of time before the Dow Jones Industrials decline in earnest.
More to follow in this weekend's commentary. I will also provide an update on both NYSE short interest and margin debt outstanding as well.
Henry K. To, CFA