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Keep Your Head Straight

(April 9, 2006)

Dear Subscribers and Readers,

From a political and economic standpoint, the biggest news item of this weekend is the New Yorker article on a possible pre-emptive strike on the nuclear facilities in Iran.  Following the publication of that article, numerous folks have come out and tried to discredit the contents of the New Yorker article, including the Foreign Secretary (Jack Straw) of Great Britain.  Obviously, the Administration wants every option available on the table – but to suggest a tactical nuclear strike at this point is a bit irresponsible.  At the same time, there is no doubt that the U.S. Administration would never tolerate a nuclear Iran.

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 (11,120.04), this position is 250.04 points in the red.  We then added a further 25% short position the afternoon of 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.  In our mid-week commentary three 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.  As of Friday evening, this position is 154.96 points in the black.  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.  We are now 75% short in our DJIA Timing System.

As of Sunday evening, April 9th, this author is still looking to get out of our March 20th 25% short position in our DJIA Timing System in order to control our risk and our volatility in our DJIA Timing System.  I apologize to our readers for having to trade so much in our DJIA Timing System recently, but even as this author believes that the market is in the midst of forming a top, I am still not totally convinced that the Dow Industrials has made its final top yet.  At this point, a 50% short position in our DJIA Timing System is bearish enough, especially given the short-term (somewhat) oversold conditions in the current stock market.  We will reenter on the short side again should the Dow Industrials rally further in the weeks ahead.  We will let our readers know on a real-time basis once we have exited our March 20th 25% short position.  We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: “A Change in our DJIA Timing System”).

In the short-run, however, the market should continue to trend down – given the lack of an oversold condition subsequent to Friday's decline.  Moreover, corporate buying and cash takeovers during the first week of April has slowed down to a trickle.  At the same time, the supply of common shares has been increasing – as the dollar amount of both primary and secondary offerings during the last week hit its second highest level for this year.  Moreover, the bond market has continued to act horribly (see our March 12, 2006 commentary, “Rising Rates Now a Given”).  Readers should note that in a typical post World War II demand driven economic cycle, bond prices (and the Dow Utilities) have typically led equity prices anywhere from three to 12 months.  Given the phasing out of the “quantitative easing” policy of the Bank of Japan over the next two months, U.S. long bond prices should continue to decline going forward.  Readers who want a “refresh” on the reason why should go back and read/study our March 12th commentary.  However, this author believes that a quick update is now in order.  Following is an update of our original monthly chart showing the yield of the 10-year Japanese government bond vs. the 10-year U.S. Treasury bond from January 1999 to last Friday, April 7, 2006:

Yield of Japanese 10-Year Government Bonds vs. 10-Year U.S. Treasuries (January 1999 to April 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) March 2001 to March 2006 correlation: Nearly 70%! 4) 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 has increase upward pressure on both European and U.S. 10-year yields and should continue to do so for the foreseeable future.

Please note that the yield of the 10-year JGB (at 1.88%) is now near a seven-year high.  Typically, the peak of Japanese buying of U.S. Treasuries occurs in April.  If the Japanese fails to come to the party in the next two weeks or so, then the latest decline of U.S. bond prices may go further than anyone could currently imagine.  Note that prior to the implementation of Japan's quantitative easing policy in March 2001, U.S. ten-year rates were closer to the 6% level whenever the yield of the 10-year JGB came close to its current levels (approximately 2%).

Okay, we all know that the bonds are oversold now – so at some point (it could be a few days, a few weeks, or even a few months) going long the long bond for a trade could potentially be a very profitable endeavor.  At this point, this author still does not see a very good risk/reward ratio yet, given the following:

1) The gradual phasing out of Japan's “quantitative easing” policy is still not over yet.  That means Japanese demand of government bonds across the developed world is still going down – at least for the foreseeable future (next two months).  Moreover, the lack of meaningful demand from Japan during the seasonally high-demand month of April continues to bother this author.  Finally, the Japanese equity market is showing signs of life for the first time in six years – and there is a very good chance that domestic investors (such as Japanese pension funds and households) will finally shift more of their holdings from cash and bonds to domestic equities.  This is significant since relative to the United States, Japanese investors have typically shunned domestic equities as an investment class for the last few years.  For example, following is a chart comparing the weighting of various asset classes for Japanese and U.S. pension funds as of the end of 2005 (source: Bank of Japan).  Note the significant overweighting of bonds (which includes domestic as well as international holdings) of Japanese pension funds relative to U.S. pension funds:

Financial assets held by pension funds (End of December 2005)

2) The lack of evidence suggesting U.S. pension funds will load up on long-dated bonds in order to “better match” their long-term liabilities (whose value is more or less dependent on long-term treasury or corporate bond rates).  Sure, our UK counterparts have adopted this “immunization” strategy, but so far, U.S. pension funds have chosen to instead diversify into hedge funds and private equity funds (which is not totally surprising).  If across-the-board demand of Treasuries fails to show up among U.S. pension funds soon, then this huge pillar of support for U.S. Treasuries will also go away.

3) Sentiment of the bond market is somewhat oversold – but not enough to suggest a sustainable bottom per the HBNSI (Hulbert Bond Newsletter Sentiment Index) as compiled by Mark Hulbert of, and the amount of assets in the Rydex Juno (Inverse Government Bond) fund.  In fact, the latter has been suggesting that we may be due for a sustainable rise in interest rates since at least the middle of last year, as shown by the following chart courtesy of

Rydex JUNO (RYJUX) - 1) Huge inflow into the Rydex Juno fund during 03/04 - suggesting that individuals were getting too bearish on bonds. 2) Individuals starting to give up on rising yields in the middle of last year. From a contrarian standpoint, this is bullish for interest rates and thus bearish for bonds.

As mentioned on the above chart, retail investors were very receptive to the idea of a rising yield during the latter part of 2003 and the early part of 2004 – and they put their money where their mouths were by “investing” heavily into the Rydex Juno Fund starting in late 2003.  Fundamentally and logically, this was a high probability scenario – but in retrospect, it was not to be.  Retail investors actually hung in there for a little over a year, before they finally started giving up during the middle of 2005.  Since that time, the cumulative net cash flow into the Rydex Juno Fund has declined by 40%.  More importantly, this has continued to decline despite the recent rise in yields – indicating that retail investors don't yet believe the latest rise in yields is sustainable.  From a contrarian standpoint, this is bullish for interest rates (and thus, bearish for bonds).

Rising yields should continue to weigh on the market going forward.  Again, at some point, I believe there will be at least a trade on the long side of the long bond, but for now, the risk-to-reward ratio still isn't there yet.

Again, while I don't believe the Dow Industrials or the S&P 500 have made a final top yet, we are definitely getting very close.  Glancing at the Investors Business Daily Top 100 list, one can see a very long list of small cap, low float speculative stocks on there – suggesting that speculation has now taken over the markets.  One can also witness this in the relentless rise of the commodities (despite a continuing rise in “carrying costs”), the narrowing of the markets, the rise of the cash-crunching airline sector, and the continuing huge inflows into emerging market and international stocks (even after the bursting of the Middle Eastern stock market bubble).  As implied by the title of this commentary – it is very important to “keep your head straight” during such emotional times.  Readers should be reminded that it has never been profitable to “fight the Fed.”  Monetary policy has always operated with a lag (readers should be reminded that many commentators were claiming the Fed was “pushing on a string” – right before this cyclical bull market began in force during October 2002).  At some point, the Fed will get its way.  Even during the 1994/1995 tightening cycle (a rare instance when the market took off right after the Fed has finished tightening), there were many significant corrections and sell-offs at that time.  So far, we have not had a single 10% correction in the S&P 500.  Moreover, investor sentiment during the 1994 cycle was extremely pessimistic – contrary to what we are currently experiencing.

Speaking of monetary policy and liquidity, it is now time for an update on what our MarketThoughts “Excess M” (MEM) indicator is saying.  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 has now revised our MEM indicator accordingly.    Instead of using M-3, we are now choosing to use a monetary indicator that most closely resembles the usefulness of M-3 – that is, a measurement which tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy.  We went back and found one measurement which is very close – that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 which the Fed is still publishing on a weekly basis).  That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator.  Following is a new weekly chart showing our old and new MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present (I apologize for the “busyness” in our chart):

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-3 vs. M-2 outside of M-1 plus Institutional Money Funds (April 1985 to Present) - Speculators continues to be aggressive in the face of the Fed reining in the monetary base. While the signals from our new MEM indicator are not as bearish as the signals from our old MEM indicator, they are still clear nonetheless: Liquidity continues to be restrained - the folks in control of world liquidity right now are essentially the BoJ and the MoF in Japan.

As one can see, our new MEM indicator (brown line) has historically tracked our old MEM indicator (blue line) very well – with the exception of the late 1989 period and until very recently (this author does not agree with the Fed that the publication of M-3 adds no value).  Interestingly, our new MEM indicator was more accurate during those fateful days in 1989 – as the stock market fell into a swoon soon afterwards (in mid to late 1990).  This recent divergence is very concerning to me, but please note that similar to the readers of our old MEM indicator, our new MEM indicator is still calling for a continued tightening in liquidity.  At this point (similar to the 1995 to 1998 period), the world is being “held ransom” by both the Bank of Japan and the Japanese Ministry of Finance, as the Bank of Japan is now playing the role of “liquidity provider of last resort.”  That is, while it is now very expensive to borrow in US$ (and to a lesser extent, the Euro), hedge funds can still more or less leverage up by borrowing Yen (also known as the “Yen Carry Trade”).  Since Japan runs a current account surplus, however, Japan is thus not a natural exporter of their currency (unlike the U.S.).  That is – if this continues – at some point, there would be a liquidity squeeze in Yen – not unsimilar to what occurred during the Fall of 1998 (when the Yen appreciated over 10% in an hour).  Readers should continue to both watch the level of the Yen and the actions of the Federal Reserve for signs of a continued decline in world liquidity.

Going forward, this author will delete both M-3 and our old MEM indicator from the above chart.

Even though the Dow Transports was strong until Friday of last week, this author believes we are now in a short-term downtrend.  In a prior paragraph, I also stated the market is still not close to being oversold yet – despite Friday's decline.  The million-dollar question is: When will the market be qualify as “oversold,” and at one point will we get out of our March 20th 25% short position in our DJIA Timing System?

Besides our most popular sentiment indicators such as the Investors Intelligence and American Association of Individual Investors (AAII) surveys, we also keep an eye on other indicators such as the equity put/call ratio, the NYSE ARMS Index, and the VIX, and so forth.  Both the equity/put call ratio and the VIX are still at moderately overbought levels, while the 10-day and 21-day moving averages of the NYSE ARMS Index are actually at very overbought levels, as shown by the following daily chart from January 2003 to the present:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - The 10-day and 21-day MA of the ARMS Index is currently sitting at 0.985 and 0.957, respecitvely - suggesting that we are not even close to an 'oversold' condition in the stock market. Even if the market is to rally from current levels, chances are that the rally will not go far.

As I mentioned on the above chart, both the 10-day and 21-day readings of the NYSE ARMS index are actually closer to “very overbought” levels – suggesting that either the current downtrend is not over yet, or that any subsequent rally from current levels will not be sustainable.  This author would like to optimally at least see a 10-day NYSE ARMS reading of 1.2 or over before we will cover our March 20th short position in our DJIA Timing System (which would bring us from the current 75% short position back to a 50% short position).  Should the market continue to sell off after reaching that level, however, we will further ratchet down our short position in our DJIA Timing System to a 25% short position or even a completely neutral position.  We will keep our readers more informed in the days ahead.

Let's now discuss the most recent action in the stock market.  Okay, we know that both the S&P 500 and the Dow Transports again made a new high last week (along with the NYSE A/D line) – but this author is still witnessing weakening breadth across the board – such as the number of new highs vs. new lows, and the declining tops in the NYSE McClellan Summation Index.  The Philadelphia Semiconductor Index bounced a little bit to the 515 level, but it is still significantly below the 550 level that was established as recently as a month ago.  More importantly, the Dow Utilities closed at yet another new low – declining from 389.01 to 386.12 for the week.  Like I have mentioned before – the Fed will not stop until either the stock market or the commodity market cracks.  Readers who want a further update on our views can read our latest post (on Saturday morning) on this topic in our discussion forum.  Serious Fed watchers should really buy the book “Inflation Targeting: Lessons from the International Experience” by Ben Bernanke and other notable authors.

Let's now go ahead and discuss the most recent action in our two popular Dow indices, that of the Dow Industrials vs. the Dow Transports.  For the week ending April 7th, the Dow Industrials rose 10 points while the Dow Transports rallied 122 points:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to April 7, 2006) - For the week, the Dow Industrials rose 10 points while the Dow Transports rose a whopping 122 points - hitting another all-time high as recently as Thursday evening. It is interesting to see that the most recent rally in the two popular Dow indices has been driven significantly by very cyclical issues, such as CAT, BA, and the airlines (the airlines are still losing a lot of money, by the way). 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. In spite of this, however, the markets can still go anywhere in the short-run, and thus we will be closing our March 20th 25% short position in our DJIA Timing System as soon as the opportunity arises.

As I mentioned last week and two weeks ago, “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).”  Our position on this does not change in the latest week – but given that the market can do anything in the short-run, we will continue to look for an exit point in our March 20th 25% short position in our DJIA Timing System over the coming days.  Over the next couple of weeks, however, probability continues to favor the downside.

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.  Readers who want us to periodically show you the individual weekly charts should let me know – but in the meantime, I will only report to you a condensed format of our three popular sentiment indicators.  While the short-term readings of these indicators may be more on the neutral side (relative to the readings we have gotten over the last couple of years), readers should note that these readings are still pretty overbought relative to the readings since January 1997.

Moreover, following is a quote from last week's commentary but one which I find well worth repeating: As I mentioned previously, there are still many 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.  During the latest week, the four-week moving average of the bulls-bears% differentials of these three popular sentiment indicators actually rose a little bit further – from 20.9% to 23.3%.

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 January 1997 to the present week (note that I have redid the scales and shortened the time period by changing the starting month from July 1987 to January 1997):

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - Bullish sentiment actually still near record highs, but getting slightly oversold in the short-run. For the week, the four-week MA of the combined Bulls-Bears% Differentials rose from 20.9% to 23.3% - suggesting that the market is nowhere near oversold.

As indicated by the above chart, the four-week moving average increased from 20.9% to 23.3% in the latest week.  In light of the weak performance in the market during the last week, this increase should thus be bearish from a contrarian standpoint.  Moreover, readers should note that these surveys do not take into account the really great things that Mark Hulbert at is doing – such as the compilation of stock newsletter sentiment via the HSNSI.  As recently as five trading days ago, the HSNSI hit a level of 60.8% - which is close to its historical bullish extreme and is thus very bearish from a contrarian standpoint.

In the short-run, this author is still looking for a more oversold reading before we will pare down our 75% short position in our DJIA Timing System.  Should this indicator get to more oversold levels (such as those we witnessed during October 2005), then we may even pare down our short position back to 25% or even to a completely neutral position – and re-enter our short position from a high level in the Dow Industrials.  Like I said before, we will continue to update our readers in the days ahead – but things are about to get interesting.  For now, stock selection (both on the long and the short side) continues to be the key.

At this point, readers should continue avoid purchasing long-dated bonds altogether.  At some point, there should at least be a trade on the long side – but as I detailed in our commentary in the above paragraphs, the risk-reward ratio is still not there yet at this point.

Signing off,

Henry K. To, CFA

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