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A Lowry’s 90% Downside Day Revisited

(May 21, 2006)

Dear Subscribers and Readers,

This week, we are going to discuss the Lowry's 90% downside day (which occurred on Wednesday) and the possible implications.  The last time we had such a discussion was way back in our July 6, 2004 commentary – the day that the NASDAQ had a 90% downside day as defined by Lowry's.  In that commentary, I concluded: “A single 90% downside day like today may create an oversold situation in the short-term - one which would signal a temporary bottom - but with a number of intermediate term indicators (see below charts) still neutral or in an overbought situation, the chances of a bottom here is very low.  In fact, today's 90% downside day could be a signal for further panic declines down the road.”

In retrospect, “further panic declines” in the NASDAQ Composite is what we exactly got, as the index continued its decline over the next five weeks – declining from 1,963.43 on July 6, 2004 to 1,752.49 on August 12, 2004.  The second part of my conclusion was as follows:

“The lack of an oversold situation is also reflected in the VIX (no spike so far despite today's decline) and the fact that the unweighted S&P 500 Index and the S&P 600 actually made a new all-time high as recently as last week.  While there has been some decent selling on the NASDAQ, the amount of volume on the NYSE has been below average - which may be an indicator of potential further losses.  In the intermediate term, however, the author remains bullish - as both my liquidity and psychological indicators remain favorable and still show no signs of deteriorating.”

Except for another brief decline later in October 2004, the market eventually took off during the latter parts of the year and hardly looked back.  In retrospect, the liquidity and psychological indicators helped me out dramatically – as using those indicators, it was “obvious” (well, as obvious as can be anyway) to me that the cyclical bull market that began in October 2002 wasn't over yet at that time.  Today, the situation is different, as most of the world's central banks continue to tighten and as investors have slowly erased the memories of the 2000 to 2002 tech crash from their collective memories.  Bottom line: The market is oversold in the very short-run, but probability suggests that the cyclical bull market which began in October 2002 is now over.

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 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 (11,144.06), this position is 244.06 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.  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.

We then further added a final 25% short position at a DJIA print of 11,610 on the early afternoon of May 9th.  A special alert email was sent to our subscribers in real time – and a message was posted in our discussion forum alerting our subscribers of this change.  Subscribers please note that a real-time “special alert” email was sent out on Wednesday morning informing you of a change in our DJIA Timing System from 100% short back to a 75% short position at a DJIA print of 11,255 – giving us a gain of 355 points of the final 25% short position that we at 10,610.  As we have mentioned before, we were looking to bring our total short position in our DJIA Timing System back to a more “manageable” of 75% - and we got such an opportunity last Wednesday.  Going forward, however, this author would have to say that the internal condition of the market hasn't look this bad since early 2003 – and probability suggests that the market will continue to be mired in a downtrend, even though a short-term bounce is now very much overdue.

Let's now review the implications of a Lowry's 90% downside day on the NYSE.  As I have mentioned before, a 90% downside day occurs when both the declining volume and the number of downside points equal or exceed 90% of the total volume and the total number of points, respectively.  A 90% downside day sometimes signals the beginning of a panic decline, or if the market is already oversold, further evidence of a very oversold market.  Generally, a significant market bottom is preceded by two or more number of 90% downside days.  A single 90% downside day like today may create an oversold situation in the short-term - one which would signal a temporary bottom - but with a number of intermediate term indicators (see below charts) still in a semi-oversold or neutral condition, the chances of a bottom here is very low.  In fact – as Lowry's points out – in four of the last six bull markets since 1980 – a Lowry's 90% downside day has occurred anywhere from 5 to 15 days subsequent to a bull market top.

The occurrence of a 90% downside day on the NYSE has significantly increased the odds that the cyclical bull market which began in October 2002 has now topped out.  Combined with the other negatives that I have discussed over the last couple of months (such as a classic Dow Theory non-confirmation of the Dow Transports by the Dow Industrials on the upside, the non-confirmation of the NYSE A/D line when the Dow Industrials made a new bull market high, continued tightening by the world's central banks, record money inflows into the most speculative sectors of the world, record leverage, and the many divergences such as in the U.S. brand name stocks, etc.) in this commentary, the odds that this cyclical bull market has already topped is almost a given.  As a side note, subscribers can purchase Lowry's historical study (which won the 2002 coveted Charles H. Dow Award for excellence in technical analysis) of 90% upside and downside days at the following Lowry's page.  This author highly recommends it.

Probability now favors a bounce in the short-term – given that the market is oversold, but there is no question that the market is now mired in an intermediate-term downtrend.  The following three-year chart (courtesy of showing the NYSE McClellan Oscillator and the McClellan Summation Index tells the story:

NYSE McClellan Oscillator and the McClellan Summation Index - 1) The NYSE McClellan Oscillator touched negative 230 on Thursday – an oversold level not seen since October of last year. 2) The declining tops of the NYSE Summation Index suggests that the cyclical bull market is ending.  Also note that the current condition is nowhere near as oversold as it was during April of October of last year – suggesting that there is more downside to go.

As mentioned on the above chart, the daily NYSE McClellan Oscillator touched a very oversold level of negative 230 last Thursday – an oversold level which hasn't been since October of last year.  This suggests at least a bounce in the very short-run.  At the same time, however, the NYSE McClellan Summation Index (which is more of an intermediate technical indicator) is still only at 633.04 – which is nowhere close to the oversold levels we saw in either April or October of last year.  To top it all off, the fact that the NYSE McClellan Summation Index has been making lower highs since the end of 2003 further suggests that this cyclical bull market is now in the midst of ending.

This “prediction” of the market can also be argued by the recent action in the NYSE ARMS Index.  Following is a daily chart showing the 10-day and 21-day moving average of the NYSE ARMS Index vs. the Dow Industrials:

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 1.240 and 1.074, respectively. The 10-day MA is suggesting a ST oversold condition, while the 21-day MA is still not close to oversold levels yet. Again, probability now suggests a ST bounce - but since the 21-day MA is not oversold yet, chances are that this decline still has further to go.

As outlined in the above chart, the 10-day moving average of the NYSE ARMS Index is now flashing an oversold reading of 1.240 – which is approximately where short-term bounces have occurred in the past.  At the same time, the 10-day moving average is still not “fully oversold” yet (this would require a reading of 1.50 or higher).  Given that the 21-day moving average is only at 1.074, chances are that there is further downside to go in the major market indices.

On a slightly different topic, this author would like nothing more than for the NYSE to release their margin debt data earlier.  Now Henry, why do you say that?  Well, the latest April margin debt data was released last Wednesday – a full 15 days after the end of the month.  While this may not have posed a problem in “normal times,” I bet readers will agree with me that the action of the last two weeks is definitely something that is “not normal.”  My guess is that the earlier release of the April margin debt data would definitely have induced more folks to get out before the latest decline.  This becomes obvious when one takes a look at the following monthly chart showing the Wilshire 5000 vs. total margin debt vs. the margin debt to Wilshire 5000 ratio from January 1997 to April 2006:

Wilshire 5000 vs. Margin Debt (January 1997 to April 2006) - Total margin debt increased $4.8 billion during April from $259.4 billion to approximately $264.2 billion - a margin debt level not seen since September 2000. The margin debt to Wilshire 5000 ratio* remains at a five-year high at 1.99 - a high not seen since November 2000. Margin debt levels, however, have still yet to surpass their all-time highs made in March 2000.

As shown on the above chart, total margin debt of NYSE and NASD members (the latter is an estimated amount since NASD data isn't released until a month later – my point exactly) increased another $4.8 billion in April – after already having climbed a whopping $9.8 billion during March.  More importantly, the margin debt to Wilshire 5000 ratio rose from 1.97 to 1.99 – a level not seen since November 2000 and which is actually higher than the ratio in January 2000 (the record high is 2.14 for the month of February 2000) – signaling that the leverage in the U.S. stock market is once again at a very dangerous level.  Since the April data wasn't released until last Wednesday (the day of the 90% downside day), it was already too late for individual stock investors to get out based on the margin debt indicator.

On Dell and Intel

As I discussed in last week's commentary, both Dell and Intel have been two of the relatively few companies that have benefited from a “double merit” scenario in the PC industry during the 1990s – a double merit scenario which benefited from rising incomes around the world (known as the concept of “acceleration”) and from falling component costs (electronic products are known to have very high “elasticities” to both income and to costs).  Unfortunately, what was once a structural story ultimately turned out to be a cyclical story, as the valuations of both these companies were taken to extremes in the spring of 2000.  At the height of the tech bubble, Dell exhibited a P/E of 70 while INTC had a P/E of 40 – and while earnings have been growing relatively steady since that time, the current stock price of both DELL and INTC are still not anywhere close to their all-time highs.  The end of this cyclical bull market notwithstanding, this author has just purchased some DELL and INTC at the end of last week (the former 10 minutes before the close on Thursday and the latter on Friday morning), given the following:

  1. The inevitable growth in corporate capital spending – which has been subdued for the last few years even after the recovery in the stock market.  Unless the U.S. economy enters into a recession (most likely a consumer-driven recession as opposed to a capital-spending driven one in 2001), corporate capital spending should pick up once Microsoft rolls out the Windows Vista system starting in March 2007.

  2. Both stocks have been very heavily oversold – and the fact that both exhibited somewhat convincing reversal patterns on Friday signals to me that it may be worth “a gamble” to ride these two stocks at least in the short-run.

  3. The story of the demise of DELL at the hands of HPQ has fully gained steam – and capitulation among many DELL faithfuls is now widespread, as evident by the following Houston Chronicle article.  While HPQ may very well eat DELL's lunch at some point down the road (at this point, HPQ has no intentions of further cutting prices to gain market share, however), this author believes that the “Dell demise” story is now too widespread and should be used as a contrarian indicator.

  4. Finally, the Dell announcement regarding adopting AMD processors is also over-hyped  – creating a buying opportunity that this author had been looking for in INTC.  For investors who were looking to get out of their INTC long positions, this was probably the perfect time for them to capitulate.  There are also signs that INTC's microprocessors will leapfrog AMD's by the end of this year – with INTC not only closing AMD's current advantage but actually surpassing them.

  5. I know, I know. There is a good chance that the market has already topped out, and if so, why would you want to purchase stocks, even “undervalued” ones such as DELL and INTC?  Well, first of all, this author believes that an upcoming bounce (however weak it may be) is inevitable given the short-term oversold condition of the market, but folks should also keep this in mind: What happened to the small and mid cap value stocks when the technology bubble went bust in spring 2000?  The answer is: Not much, and these stocks (along with utility stocks) proceeded to have their best year in a long time.  At this point, one can argue a similar situation for U.S. large-cap brand names, as most of these stocks are now hugely oversold and are selling at valuations not seen in over ten years.

As a newsletter writer, I am forced to make this disclaimer to my subscribers: The above discussion of DELL and INTC should not be construed as investment advice.  And given the unpredictability and emotions experienced by the market in recent weeks, this author would continue to evaluate these positions in the days ahead – but for now, this author does not believe that buying DELL at $23.83 or INTC at $18.03 was a bad deal.  We will see.

In our commentaries from last weekend and the week before last, we stated: First of all, readers should note that “the tape” is still very much split – with many large caps still underperforming while small and mid caps continue to power ahead.  In our January 19, 2006 “Brand Name” update, we had discussed that bull markets do not last long when the major brand names do not confirm – and since that time, three of the top five U.S. brand names (MSFT, IBM, and INTC) have declined further – while the other two (KO and GE) have only gotten marginally better.  At the same time, two of the fastest-growing brand names, Google and Apple, have also underperformed the market tremendously over the last six months.  This is a significant divergence – and should definitely be taken into account by our readers, even as both the Dow Industrials and the Dow Transports continue to rally to new cyclical bull market highs.  The $64-million question: Will the rallying Dow Industrials “pull” the U.S. brand names up, or will the U.S. brand names lead the broad market down?  History suggests that before any change in leadership (such as from small caps to large caps), the market has always corrected.  Will this time be different?  As can be seen in our DJIA Timing System, our answer is “no” but we are willing to change our positions should we turn out to be wrong.

In retrospect, our bearish view on the major market indices was correct – and the action of last week continued to prove our case.  The decline of last week in the major market indices was also confirmed by the Dow Utilities, as it declined a further 3.32 points to close at 396.75 for the week – a full 35 points away from its all-time high made in early October of last year.  As I have mentioned before, this is significant, as the Dow Utilities tend to top out three to nine months before the Dow Industrials during a typical cyclical bull market.  I will be honest, dear subscribers: There really isn't anything new to discuss this week.  Everything is going to script at this point, but given the unpredictability and emotions in the markets right now, whatever I say tonight may end up changing tomorrow.  At this point, we will need to reevaluate our position on a daily basis.  Therefore, subscribers are encouraged to check our discussion forum on a daily basis since I will most likely be doing daily updates (if any) on our discussion forum.  But at the same time, I believe that WE WILL get some kind of bounce this week, but if the bounce is relatively weak, then watch out below.

As we now end this commentary, I leave our subscribers with this thought: In the early part of a substantial decline, it is usually okay if your timing is off even if you are a bull – since it is normal for the market to experience periodic bounces – bounces that are usually substantial enough for you to get out.  As an illustration (and this is for illustration purposes only), let's look at the progression of the Dow Jones Industrial Average from the top of the bull market on August 25, 1987 to Black Monday, October 19, 1987:

Daily Action of the Dow Jones Industrials (August 25, 1987 to Black Monday, October 19, 1987) - Assuming one had gone long on the Dow Jones futures (okay, the Dow Jones futures did not exist back then, but the S&P 500 futures did exist) three days after the top on August 25, 1987, one could actually have gotten out with a one-point gain as late as October 5, 1987. But if you had missed that final exit point, there is no question you would have been wiped out - possibly even as early as the Friday before Black Monday, since the Dow had already declined 17.5% from October 5 by that time.

The lesson above is clear: Playing for a bounce in the current market is okay as long as one has tight stops or if one is doing it in the early part of the decline (similar to where we are now).  But as the decline matures, the harder it is for the long trader to get out – even if that trader is a very nimble one.  As an aside, this analysis also applies to catching tops as well (which is why timing is always of the essence when it comes to catching bottoms or tops).  Let's now take a look at the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to May 19, 2006) - Both the Dow Industrials and the Dow Transports continued their declines in the lastest week - with the former declining 237 points and 214 points for the week. Last week, I posed the question: 'Was this a legitimate reversal? Have the two popular Dow indices topped out for this cycle?' I noted that it was still too early to tell, but that 'there is a good chance that the top has already been seen - and if not, it will most probably come in the next few weeks.' Given the continuing plunge in the two popular Dow indices last week, and given the continuing weakness in the Dow Utilities (which had already topped out in early October 2005), and given the Lowry's 90% downside day last Wednesday, probability now highly suggests that the cyclical bull market top has already been seen.

As I mentioned on the above chart, the lack of a confirmation of the Dow Transports by the Dow Industrials ever since the Dow Transports surpassed its all-time high during December 2004 is one of the most flagrant non-confirmations in history – and is an ominous signal that something is very wrong with this bull market.  The fact that the Dow Industrials was only 80 points away from its all-time high a couple of weeks ago – and yet failed to confirm – is very reminiscent of the October 1966 to December 1968 and the May 1970 to January 1973 cyclical bull market tops.  To paraphrase Mark Twain: History does not repeat itself, but it surely rhymes.  If May 10, 2006 marked the top of this cyclical bull market, then it would have been a classic textbook “topping out” case in Dow Theory terms.

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.  Over the last two months, the average of our most popular sentiment indicators has remained very steady (the calm before the storm?) – and 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.  At this point, the author does not see an intermediate bottom in any of the major market indices until they reach a more oversold level – with the four-week moving average sinking to below the 15% level at the very least.

During the latest week, the four-week moving average of the bulls-bears% differentials of these three popular sentiment indicators decreased slightly from 22.7% to 22.0%.  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 still slightly oversold in the short-run. For the week, the four-week MA of the combined Bulls-Bears% Differentials decreased slightly from 22.7% to 22.0% - suggesting that we are nowhere even close to the oversold condition during October 2005 just yet.

In last weekend's commentary, I stated that: Given that the market is most probably now in a downtrend, probability suggests that this reading will at least reach the October 2005 level before a sustainable market bottom can be reached.  And again, given the weakening breadth numbers, tightening liquidity, and the lack of an oversold condition in our other technical indicators, this author won't be willing to bet on the long side here until our sentiment indicators get significantly move oversold (for example, readings that would put us at the October 2005 levels).

Okay, I admit: I shouldn't have purchased my shares of DELL or INTC based on the above statement – but given Wednesday's 90% downside day, and given the superficially horrendous news coming out of both companies, and given Friday's reversal in these two stocks, there is a good chance that these two stocks are now fully oversold – at least for the next couple of weeks.  The above statement applies more to the speculative stocks, such as commodities, internationals, and cyclicals such as GM and Ford, the airlines, and most manufacturing companies.

Conclusion: All throughout the last month or so, I have stated that the probability of a significant stock market top continues to increase by the day- as evident by declining liquidity, historically significant divergences, as well as a “dash to trash” – a phenomenon that typically only occurs at major stock market tops.  In last weekend's commentary, I stated that “there is probably a 50/50 chance that we have already seen the all-time high for this cycle…”  With the appearance of a 90% downside day on the NYSE last Wednesday, the odds of a cyclical bull market top has significantly increased – putting the odds closer to 60% to 70% rather than 50%. 

At this point, readers are urged to be very defensive and to be very aggressive in culling weaker-performing stocks from their portfolios.  We will continue to maintain a 75% short position in our DJIA Timing System – but don't be surprised if we shift it to a 100% short position again if the market rallies on weak breadth (or to a more conservative 50% short position should the market reach an even more oversold condition this week).  Again, don't be surprised – as the market can go either way pretty quickly, although as always, we will alert our subscribers through email should we make any changes in our DJIA Timing System going forward.

Signing off,

Henry K. To, CFA

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