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A Market Slowdown Still Looms

(March 26, 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 (11,279.97), this position is 409.97 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 mid-week commentary two weeks ago, 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.

The current story of the market does not dramatically change from the story that we have been telling for the last couple of months.  Sure, the leverage has come down a bit (I will discuss margin debt later in this commentary), short interest increased slightly from February, and there are now signs that the Fed will finally stop its rate hike campaign in June, but overall, the story still holds.

So, Henry – just what is the story?  While I am personally not a fan (and I bet many of you are not as well) of “top-calling,” this author believes precisely that this cyclical bull market is now in the midst of topping out.  I have gone through many of these issues in our previous commentaries, but for David's subscribers and for our newer readers, I will go through this “laundry list” of things again – and provide updates as appropriate.  I will also discuss a new indicator (the leading indicator of the OECD leading indicators – see below) that this author is adopting – as well as a final update on margin debt and on NYSE short interest.

The gauge of how strong a particular stock market is can usually be measured by looking at the internals of the market – such as using breadth and volume, etc.  As a bull market ages, the breadth of any further rallies tend to narrow in focus.  That is, the action tends to occur in fewer and fewer stocks – as exemplified by a topping out of the NYSE A/D line or in the declining number of new highs vs. new lows.  Sometimes, such a decline is not that obvious (as opposed to the topping out of the A/D line in the spring of 1928 and in April 1998, 18 and 21 months prior to the top in the Dow Jones Industrial Average, respectively) – especially during a cyclical bull market that is mostly focused on small cap and mid caps stocks.  Readers should note that this is precisely what we have been experiencing – as according to Ibbotson Associates, small caps have outperformed large caps by approximately 130% since 1999.  Following is a table I have posted in our commentary previously – chronicling the periods in the U.S. stock market when small caps have outperformed large caps (note that data for 2005 will be updated soon):

Periods of Small Cap Outperfermance in the U.S.

The average small cap outperformance since 1928 lasted a little over five years resulting in a 129% outperformance over large cap stocks.  Looking at the table, there are two notable tops that come to mind which occurred at the same time as the NYSE A/D line topped out – those being the 1946 and 1976 bull market tops.  The 1968 market top came close as well, with the NYSE A/D line failing to confirm the top in the Dow Industrials only by a slight margin.

My point is: We all know that the NYSE A/D line just made a new all-time high as recently as last week – but history has shown that there does not need to be a divergence in the NYSE A/D line before the major market indices top out.  This is especially true if we have been in a small cap bull market – such as the one we have been experiencing since 1999.

In a small cap bull market that we have been experiencing, it is better to gauge the current internals of the bull market by looking at the number of new highs vs. new lows on the NYSE.  The following three-year chart, courtesy of Decisionpoint.com, shows the number of new highs vs. new lows along with a 10-day differential of new highs vs. new lows on the NYSE:

NYSE New Highs and New Lows - 1) The NYSE had less than 200 new highs on the most recent rally in both the Dow Industrials and the NYSE Composite. 2) The NYSE 10-day differential of new highs vs. new lows has been on a declining trend ever since January 2004!

As indicated on the above chart, the NYSE 10-day differential of new highs vs. new lows has been on a declining trend ever since January 2004 – more than two years ago.  Moreover, the number of new highs on the NYSE failed to break the 200 mark even in light of the most recent rally in both the NYSE Composite and the Dow Industrials.  This is all the more ominous for the major market indices given that the NYSE had as many as 450 new highs in late January of this year, and as many as 600 new highs during the December 2003 to January 2004 period.

As I have discussed before, the failure of the hottest sectors in this cyclical bull market to participate in the most recent rally – the homebuilders, Google, and Apple – is also an indication that this cyclical bull market is getting “long in the tooth.”  More importantly, the latest “blow off” rally of cyclical stocks such as Boeing, Caterpillar, and the domestic airlines can only mean two things – that either we are in the beginning of a new bull market or that we are near the end of the current bull market (cyclicals tend to rally both in the early stages of a bull market and in the final “blow off” rally – similar to what semiconductors did in the October 1998 to March 2000 period).  No points for guessing what this author is looking for!

In a way, the deteriorating internals of the stock market is also a reflection of declining global/stock market liquidity – as less money is devoted to the majority of issues and as the level of speculation is further focused on a few selective sectors or issues.  Make no mistake: Global liquidity has declined for awhile and is continuing to do so.  Readers who have been with us for awhile know that this author likes to measure liquidity by looking at the relative strength of the Philadelphia Bank Index vs. the S&P 500, as well as the shape of the domestic yield curve.  In addition to these two indicators, this author has previously developed another liquidity indicator – which I have named the “MarketThoughts Excess M” indicator – or “MEM” for short.  Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages).  The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve.  One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base.  By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity).  On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking.  If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing.  Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3.  Instead, M-3 is directly affected by the ability and willingness of commercials banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has just stopped publishing M-3 statistics, this author will present a modified version of this indicator the next we discuss monetary liquidity.  For now, however, the latest weekly statistic is updated enough for our purposes.  Following is a weekly chart showing our MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 from April 1985 to the present:

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 a bottom of negative 4.42% seven weeks ago to negative 4.07% 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 has perked up slightly from a low of negative 4.42% seven weeks ago to negative 4.07% in the latest week, readers should keep in mind that this indicator is still firmly in negative territory and is in fact, still at a low not seen since January 2002 (and we all know what happened afterwards).  More importantly, the willingness of the private sector to speculate (and for commercial banks to lend) in the face of Fed and global central bank tightening is definitely a red flag.  Historically, it has not been a good idea to fight the Fed, and this time should be no different.  After all, wasn't it just three years ago when folks were stating that the Fed was “pushing on a string” and that interest rate cuts would have no discernible effect on the stock market or economy?

I would now like to take some time and discuss our opinions on the yield curve.  When looking at the historic shape of the yield curve, this author prefers taking the difference between the Fed Funds rate and the 30-year government bond; as such a measurement takes into account the yields across the entire spectrum of the yield curve.  In our December 15, 2005 commentary (“Yield Curve Continues to Flatten”), we discussed the implications of a flattening/inverting yield curve, as well as why it may have outlived its usefulness.  However, we also concluded that even though the yield curve may have somewhat outlived its usefulness, it was still nonetheless an indicator to take heed, given its role as an excellent leading indicator of the stock market since the Russian, Brazilian, and LTCM crises during late 1998.  In our December 22, 2005 commentary (“Flattening Yield Curve: Does the Stock Market Care?”), we further extended our yield curve analysis  back to January 1975 and concluded that while the implications of a flattening/inverted yield curve has changed somewhat in the last 30 years, one thing does not change.  I will now quote from our December 22, 2005 commentary:

History has shown that a flattening or an inversion of the yield curve is usually a precursor to a financial crisis somewhere in the world - said target being an area (either geographically or a particular asset class) which has seen the most speculation prior to the inversion.  While the forecasting significance of the yield curve may have lessened over the years (as we discussed in last Thursday's commentary), this does not mean we should not be careful, unless one thinks that "things are truly different this time."  Moreover, while chances are that this "excess speculation" hasn't occurred in the U.S. stock market (except perhaps in U.S. mid caps and small caps), that does not mean any emerging market crisis will not impact the valuation of U.S. stocks in an adverse way - especially during a general "flight to safety" scenario similar to what occurred during the Fall of 1998.  However, please keep in mind that it is this author's contention that we are still in a secular bear market in U.S. equities (similar to the secular bear market of 1966 to 1974) - and so despite a relative lack of speculation in the U.S. stock market in recent years (relative to the housing, commodity, and emerging markets), I would not be surprised if the inversion of the yield curve (decreasing risk-taking) is followed by a general liquidation of U.S. equities. 

As of Friday at the close, the yield curve (as measured by the difference of the Fed Funds rate and the 30-year long bond) is still 20 basis points shy of inverting, but come this Tuesday, it will be a different story.  Following is a weekly chart showing the differential between the yield of the long bond and the Fed Funds rate vs. the Dow Industrials from January 1991 to the present:

Differential Between the Long Bonds and the Fed Funds Rate vs. the DJIA (January 1991 to Present)

So where are we now?  We know that the Federal Reserve, the European Central Bank, and the Bank of Japan have been tightening liquidity.  At the same time, financial and commodity speculation remains rampant, signaling that "financial velocity" has been increasing significantly - which I have discussed many times before and which has been captured and measured by our MEM indicator.  Increasing "financial velocity" basically means a higher willingness to take on risks - and with the proliferation of hundreds of hedge funds, lots of borrowed money, and subdued returns over the last two years, it is no wonder investors have taken on a lot of risks - probably more than what is prudent.  Interestingly, however, the current flattening of the yield curve is telling us that "financial velocity" (willingness to take on risk) is about to decrease!  Combined with a world of declining liquidity, then you have a recipe for disaster going forward.  Again, the logical question to ask is: Which market will blink first?  Will it be the U.S. housing market?  Or will it be the base metals market or emerging markets?  We know that the Middle Eastern markets has already “blinked” – as evident by the nearly 40% decline in the Saudi markets and a 50% decline of the Dubai stock market from their all-time highs.  How about China - given its huge overcapacity in nearly everything from steel manufacturing to commercial real estate to automobile manufacturing?  Note that U.S. money inflows and asset allocation to emerging markets are at their highest since 1994 - the year during the Mexico Crisis and the year before a huge down year for Latin American equities during 1995.  This author continues to believe that any financial crisis that emerges from here will also adversely affect the U.S. stock market.

Any “financial accident” in the developed or emerging markets will most likely precipitate a typical “mid-cycle slowdown” scenario – something which this author has been discussing since the beginning of this year (the risks are high that we will have at least have a mid-cycle slowdown during 2006).  Ever since the beginning of 2005, the OECD leading indicators have been persistently turning down, as measured by our MarketThoughts Global Diffusion Index (MGDI, which we first discussed in our May 30, 2005 commentary).  Even though the MGDI have perked up slightly (as measured by the year-over-year change and in the second derivative – or rate of change) in the last six months, it is still acting rather poorly, and given global liquidity tightening around the world, this author would not be surprised if it turns down again over the course of this year.  For newer readers and David's subscribers, 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 January 2006. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to March 24th (the February OECD leading indicators won't be released until early in April). In addition, all four of these indicators have been smoothed using their three-month moving averages:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the Dow Industrials & the CRB Energy Index (March 1990 to January 2006) - Historically, the rate of change in the MGDI has also led or tracked the YoY% change in the CRB Energy Index very closely. The divergence continues, despite the 2nd derivative of the MGDI going into positive territory for the second consecutive month since November 2004.

Historically, the rate of change (second derivative) in the MGDI has lead or tracked the year-over-year change in the CRB Energy Index (and to a lesser extent, the Dow Jones Industrial Average) very closely.  Over the past 18 months, however, there has been a significant divergence – as weakness in the MGDI did not precipitate either a weakness in energy prices or weakness in the stock market (as exemplified by the Dow Industrials).  In fact, the former actually took off in light of unforeseen rising demand from China and the lack of spare production capacity both in OPEC and non OPEC countries, while the latter stayed within a trading range before breaking 11,000 early this year.

The relatively weak bounce of our MGDI over the last six months suggests that any strength in energy prices or the stock market going forward will be muted – especially in light of a continuing tightening in global liquidity.  But in light of this, readers should note that there actually is a leading indicator of the OECD leading indicators, so to speak.  Following is a monthly chart (over the same period) showing the year-over-year change in our MGDI, the rate of change (second derivative) of our MGDI, as well as the year-over-year change (three-month smoothed) of an equally-weighted basket of the developed world's leading “commodity currencies” – those being the Australian Dollar, the Canadian Dollar, and the New Zealand Dollar:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the Average of the AUD, CAD, and NZD (March 1990 to January 2006) - Historically, the annual change in the three major commodity currencies has led change in OECD leading indicators by three to six months. For the first time since March 2002, the annual change in the three major commodity currencies is now in negative territory, suggesting that the OECD leading indicators will follow in due time.

Note that the year-over-year change in the world's leading commodity currencies (three-month smoothed) is updated to March 23, 2006.  As I mentioned previously, the latest OECD leading indicators as of February 2006 will be released early next month.  For those that have trouble or do not have the ability to read the above chart, one can see that historically, the year-over-year change of the world's three leading commodity currencies has led the action of the OECD leading indicators by approximately three to six months since March 1990.  More importantly, the year-over-year change in the commodity currencies has recently gone into negative territory for the first time since March 2002 – suggesting that our MGDI should follow in due time.  In our past commentaries, I stated that the lone holdout had been the Canadian dollar (and thus, it is the currency to watch), as both the Australian and New Zealand dollar has taken quite a beating and is now officially in a downtrend.  My message does not change this week: Continue to watch for weakness in the Canadian dollar going forward.  Any further weakness does not bode well for either the U.S. economy or for the stock market going forward.

In previous paragraphs, I discussed the fact that the Bank of Japan has been “tightening” as well.  What does that mean, Henry, since short-term rates in Japan will still remain near zero for the foreseeable future (some would argue that a 50 basis rate hike will not do much since ST rates will still be essentially at zero)?  By “tightening,” I meant the end of the “quantitative easing” policy that the Bank of Japan began adopting in March 2001.  As I have mentioned before, an important part of the BoJ's quantitative easing policy (see our March 12, 2006 commentary, “Rising Rates Now a Given”) involved purchasing Japanese government bonds in both the short-end and the long-end of the Japanese domestic yield curve (see following paper from the Bank of Japan).  Not only did this compress yields in the domestic market, this also had the effect of compressing yields all across the world, including yields in the U.S. bond markets.  Let me quote from our March 12, 2006 commentary:

First of all, it is imperative to explain what the policy of “quantitative easing” that began in March 2001 entailed.  Starting in March 2001, both the Japanese government and the Bank of Japan decided that a “non-traditional” monetary policy was needed in order to prevent Japan from falling deeper into a deflationary spiral – especially in light of the bursting of the technology bubble both in the United States and in Western Europe.  Short-term interest rates were already near zero, so similar to what Paul Volcker did in the late 1970s and 1980 (when he set a monetary target ceiling instead of a Fed funds target in order to kill inflation), the Bank of Japan set a monetary target (US$250 to US$300 billion) it force fed into the bank system everyday.  These funds were mainly injected via the purchase of government and commercial securities by the Bank of Japan.  At the same time, the Bank of Japan bought approximately 1.2 trillion Yen worth of government bonds every month – including long-term (10-year) Japanese government bonds.  This had the significant effect of capping domestic yields at the long-end and lowering yields all across the Japanese yield curve, with the 10-year yield falling to 0.53% by the end of May 2003 (even though Japan's sovereign rating is rated lower than Botswana's by S&P and Moody's).  For readers who recall Ben Bernanke's anti-deflation (“dropping money from helicopters”) speech in 2002, what the Japanese government and the Bank of Japan did over the last five years with their “quantitative easing” policy came as close to “dropping money from helicopters” as any developed country has gotten since the end of World War II.  It is interesting to note that all the Austrian economists had a field day with Bernanke's 2002 anti-deflation speech, and yet most of them had no idea that the Japanese had been doing this very precise thing since March 2001.

The policy of “quantitative easing” has officially ended, but it will take a few more months for the Bank of Japan to wind down all their operations.  In the meantime, the Bank of Japan will continue their policy of purchasing government securities all across the yield curve – but this too, shall pass.

Given the lack of a meaningful yield in investing in domestic assets, both Japanese pension funds and private investors had to go elsewhere in their “search for yields.”  The world's stock markets were mostly off-limits to pension funds (who were quite happy to settle for a 3% guaranteed rate of return), and thus they naturally turned to the world of Western European and U.S. government long-dated bonds.  Make no mistake: Japan is the largest credit nation in the world, and it is the largest player when it comes to the world's developed sovereign bond markets.  It is certainly true that the Chinese government holds a significantly large amount of U.S. Treasuries, but it is important to keep in mind that this amount is dwarfed by holdings in the private sector – and when it comes to the private sector, the Japanese private investor is by far the largest holder of U.S. Treasuries.  As such, the yield on both long-dated U.S. and European government bonds had and will be determined by Japanese pension funds and private investors for the foreseeable future.

Note that the correlation of the 10-year JGB and the 10-year U.S. Treasury note since March 2001 is a very high 70%!  Following is a monthly chart comparing the yield of the 10-year Japanese government bond and the yield of the 10-year U.S. Treasuries from January 1999 to March 2006 (data updated as of March 24, 2006):

Yield of Japanese 10-Year Government Bonds vs. 10-Year U.S. Treasuries (January 1999 to March 2006*) - 1) The Bank of Japan began its 'quantitative easing' program in March 2001. From a level of 1.27% in March 2001, the yield of the 10-year Japanese government bond started to decline in earnest until it bottomed at 0.53% in May 2003. The action of the 10-year U.S. Treasuries followed a very similar pattern - declining from 4.89% in March 2001 and finally bottoming at 3.33% in June 2003. 2) Now that the Bank of Japan has officially ended their 'quantitative easing' policy, the yield of the 10-year JGBs should be more in line with economic growth going forward - probably somewhere north of 2%. This should increase upward pressure on both European and U.S. 10-year yields as well.

When I wrote our March 12, 2006 commentary, the yield of the 10-year Japanese government bond stood at 1.66% - having already risen 19 basis points since the end of 2005.  As of Friday at the close, the yield of the 10-year JGB has risen further and now currently stands at 1.74% - a high not seen since July 2004.  Moreover, the world's most influential savers (the Japanese private sector) is projected to start running a consistent current account deficit starting in five to ten years.  That is – at some point in the not-too-distant future – Japan will start importing savings instead of exporting savings.  In the process, many of these same individual or pension funds who are currently accumulating U.S. government bonds will be consistently selling them off month-after-month in order to fund the retirements of the Japanese population and consumption.  In other words, the Japanese is doing this out of necessity.  This is no conjecture.  Unless the Chinese or the Indians can take the place of private Japanese investors (which is very doubtful given that the demographics of China isn't much better than the U.S. or Japan and given that both countries are still relatively poor compared to Japan), then yields will most probably embark a sustainable rise for the rest of this decade.

A rising rate environment (both in the short-end – for now – and in the long-end) further raises borrowing costs and the carrying (storage) costs of commodities.  It also discourages investments in new ventures and capital spending by corporations all around the world.  Both retail and institutional investors will demand a higher ‘risk premium” for holding equities.  Note that as much as half of the rise in equities during the 1980s and 1990s can be attributed to an environment of sustained disinflation and the decline in bond yields during that period of time.  While this author is definitely not looking for a 15% or 20% yield in the near future, the environment for equities can be disastrous even if yields on the long-end rises 50 or 100 basis points from current levels – especially since many stock investors (and especially homeowners with adjustable rate mortgages) are not prepared for higher yields at this point.

Let's now take a look at the most recent action in the stock market, starting off with the daily chart of the Dow Industrials vs. the Dow Transports.  Long-time readers should know that I am at heart a Dow Theory fan (not many of you may know this, but the basis of the Dow Theory has more to do with values than primary or secondary trends or the confirmation of one Dow index of the other, etc.).  As a result, I usually provide a weekly summary of the most recent action of the stock market by looking at a daily chart of the Dow Jones Industrial Average vs. the Dow Jones Transportation Average.  For the week ending March 24th, the Dow Industrials rose a negligible 0.32 point while the Dow Transports declined 36 points:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to March 24, 2006) - For the week, the Dow Industrials rose a negligible 0.32 point while the Dow Transports declined 36 points. While this daily chart looks good for both the Dow Industrials and the Dow Transports, readers should know that there has been significant divergences within the components themselves - such as the 'blow off' of cyclical stocks like BA, CAT, and the airlines - even as the rest of the components continue to languish. Moreover, the Dow Utilities (an index which has more often than not led both the Dow Industrials and the Dow Transports by a period of three to nine months) has most probably topped out in early October - signaling that both the Dow Industrials and the Dow Transports should follow in due time.

As I mentioned in the above chart, the recent daily action of both the Dow Industrials and the Dow Transports continue to look good on the surface.  Underneath the surface, however, there has been significant deterioration in the internals, as we are seeing cyclical issues such as BA, CAT, and the airlines “blowing off” while the rest of the list continues to languish.  It is even more interesting when one notes that both BA and CAT make up two of the three components with the highest weightings in the Dow Industrials (since the Dow is a price-weighted index).

As I promised previously, I will now discuss the latest developments in the areas of stock market margin debt and the outstanding short interest on the NYSE.  Bulls can certainly look at the following chart (which shows the Wilshire 5000 vs. the three-month, six-month, and 12-month change in margin debt from January 1998 to February 2006) and smile, since growth in margin debt has been quite subdued over the last six months.  In fact, the latest margin debt data shows that margin outstanding for NYSE members actually declined approximately $10.5 billion during February:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to February 2006) - As shown on this chart, the rise in margin debt got slightly out of hand in late 2003 but it has certainly been dying down since then (with the exception of November and December of last year) - especially during February of this year. Please note, however, that margin debt has not 'enjoyed' a sustainble decrease since 2002 - are we overdue for some liquidation of margin debt here?

Keep in mind, however, that it has been more than three weeks since the end of February, and therefore, this author wouldn't be surprised if investors and traders leveraged themselves back up since then.  That being said, there has not been a substantial liquidation of margin debt since 2002 – are we now due for another round of liquidation given the continued increase in borrowing costs?  The longer this drags on, the more likely it is going to occur – and once it does, then it is going to result in some fireworks on the downside.

Let's now take a look at NYSE short interest in the context of the NYSE short interest ratio.  This commentary is getting quite long, already, so let me cut to the chase and present you the following monthly chart showing the NYSE Short Interest Ratio vs. the Dow Industrials from January 1994 to the present:

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present) - The latest NYSE SI ratio rose from a near-record low level of 4.5 to 5.1 in the latest reading - mostly because of a decrease in trading volume over the last month or so. However, the NYSE SI ratio is still at a level that has in the past lead to substantial declines. With this latest two-month decline in the SI ratio, a good pillar of support has been removed from the stock market.

As the above chart shows, the latest NYSE short interest ratio rose from a near-record low level of 4.5 to 5.1 in the latest month – mostly because of a decrease in NYSE trading volume over the last month or so.  That being said, the latest NYSE short interest ratio is still relatively low – and is at a level which has in the past preceded a substantial decline in the stock market.  With the latest decrease in the NYSE short interest ratio over the last two months (the ratio two months ago was a higher 5.6), a good pillar of support has been removed from the stock market.

I will now end this commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  Ever since we seriously started writing our twice-a-week commentaries in August 2004, following these individual weekly sentiment indicators every week has been a ritual for us.  That being said, while this was a very profitable game to following in a range-bound market (similar to what we have been experiencing since January 2004), this author is not so sure going forward – as weekly sentiment readings (unless they were very oversold or overbought) a pretty much useless once the market starts trending in a big way.  Since this author believes we are now in the midst of forming a top, following these weekly sentiment indicators may not be as much of a ritual for us going forward.  As a result, we will – for the first time in a long time – stop featuring these indicators in our commentaries on a weekly basis starting this week.  Instead, we will continue to follow the AAII, the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys in a more condensed format – by looking at the four-week moving average of these three popular sentiment indicators and reporting back to you if we are seeing some kind of divergence or extremely overbought or oversold readings.  However, we will also continue to report these readings in our MarketThoughts discussion forum – and so readers who want to continue to follow them can do so without this author having to try to interpret them going forward – and instead spend time on other indicators that may be of more value.

So what are these three popular sentiment indicators saying now?  There are some bullish folks out there who cite the latest weekly oversold readings in either the AAII or the Investors Intelligence Survey, but what they are ignoring, however, is the fact that the most accurate of these sentiment indicators thus far in this bull market is the Market Vane's Bullish Consensus.  If one takes the average of bulls-bears% differential of these three surveys (and smoothed them on a four-week basis), readers may be surprised that we are still getting readings that are at the high end of their historical trading range.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from July 1987 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (July 1987 to Present)

As indicated by the above chart, the current weekly reading is still showing somewhat bullish sentiment.  More importantly, the average of these three popular sentiment indicators is telling us that over the last two years, bullish sentiment has actually been trading near record high levels – suggesting that a sustainable uptrend from current levels is not very likely.  Instead, this author would argue that at this point, the cyclical bull market that began in October 2002 is “long in the tooth” and is in the midst of topping out.  For now, we will remain 75% short in our DJIA Timing System – with an option to go 100% short should the Dow Industrials continue to rally in the days ahead even as the A/D line of the Dow Industrials continue to deteriorate.

Signing off,

Henry K. To, CFA

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