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Many U.S. Mega Caps Now Oversold

(May 28, 2006)

Dear Subscribers and Readers,

I hope all of you are enjoying a relaxing Memorial Day Weekend, and have found a moment to remember those who have fallen to defend the U.S. and democracy around the world.  While there are folks out there who could always find faults with the current state of the world (and there are many things wrong with it), there is no doubt that we are now living in the most prosperous, tolerant, and technologically-advanced times in world history.   The bears would like to cite the amount of leverage on U.S. households' balance sheets – but this does not take into account the fact that an asset-to-debt ratio of over five is still financially sound, especially given the increased financial knowledge of the U.S. population over the last two decades and the amount of financial management tools we have at our disposal.  Heck, this author is carrying a credit card balance of several thousand dollars himself – all at a 0% interest rate.  For the first time in history, U.S. households (short of doing an IPO) can manage their balance sheets just like the U.S. corporations of 20 years ago.  Moreover, much of the leverage over the last few years had occurred in the residential sector – with much of the debt being carried at historically low interest rates.  The following chart showing the annualized consumer credit growth (total, as well as revolving and non-revolving) supports this, as consumer credit growth has been on a secular decline since the mid 1990s and is now at its lowest level since the end of the last consumer-driven recession in 1991 to 1992:

Monthly Annualized Consumer Credit Growth (12-Month Smoothed)* (January 1989 to March 2006) - Both revolving and non-revolving consumer credit growth has been on a declining trend in the last four years - even as the U.S. emerged out of its latest recession in November 2001.

Looking at the above chart, there are two possible and logical implications:

  1. There is no doubt that the U.S. housing bubble is in the midst of popping – but unlike the technology bubble in spring of 2000, this process will more resemble a slow leak from a car-tire than a sudden crash in housing prices.  This makes sense, as housing turnover (even at the margin) is less so than the turnover of common stocks (many folks who bought a house at higher prices may just stay with it as opposed to selling it, as everyone needs a place to live), and as the housing sector is very illiquid.  First of all, please note that total consumer credit outstanding does not include debt backed by real estate, such as mortgages or home equity loans.  Moreover, the total consumer credit outstanding as of March 2006 is $2.14 trillion.  Assuming that housing continues to be weak going into 2007, consumers may very well be able to cushion against most of this blow by borrowing from more traditional sources (e.g. Goldman Sachs has previously projected a 0.7% to 1% hit in GDP due to a housing slowdown in 2006 – but should consumer credit growth increase by 5% this year (over $100 billion), this will be enough to offset the slowdown in housing).

  2. Readers who have a good memory should note that the U.S. stock market had already bottomed nearly two years before the last significant trough in consumer credit growth in July 1992 (in October 1990, as a matter of fact).  This means that the above chart is more of a tool to tell you what has happened instead of telling you what will happen – particularly when it comes to individual stock investments.  Once in awhile, even this author has to be reminded of the fact that the stock market is the ultimate leading indicator!  This lesson can be perfectly illustrated by looking at the daily closing price of WMT during that time period:

Daily Split-Adjusted Closing Price of WMT (January 1990 to December 1996) - Note that the stock price of WMT had also already bottomed in October 1990 - nearly two years before the trough in consumer credit growth in July 1992. Interestingly, WMT actually made a significant top a mere nine months after the trough in consumer credit growth - and despite continuing strong consumer credit growth through the end of 1996.

As I mentioned on the above chart, the stock price of WMT actually bottomed in October 1990 – nearly two years before the trough of consumer credit growth in July 1992!  Folks who did not buy WMT or other retailers during the bottom in October 1990 simply because of declining consumer credit growth missed out on a great run.  Interestingly, the same retail investor who bought WMT right at the bottom of consumer credit growth in July 1992 saw the stock price of WMT rise from $12 to nearly $16 over the next nine months – but $16 would mark a significant top WMT for the next four years.  The price of WMT would not reach $16 a share again until July 1997.

So Henry, what are you now saying?  Are you saying that WMT may actually be a buy here?

No, I am not saying this at all.  At the end of the day, everyone will need to make his or her own decisions as an investor, but the above example is a lesson that “nothing is obvious” – and that any slowdown in housing may just prove to be relatively shallow as a revamped growth in consumer spending (not to mention corporate capital spending) take up the slack.  Moreover, many of the U.S. mega-caps have been severely oversold and are undervalued relative to their valuations over the last 10 to 12 years – assuming that the bond market holds up over the next few years (even though I believe long bond yields have bottomed, I don't believe they will skyrocket from current levels).  It is no coincidence that virtually all the recommendations of the Motley Fool's “Inside Value” publication have been the U.S. mega caps.  Let's once again take a look at the most recent chart of WMT:

Wal-Mart Stores, Inc. (WMT) - From the cyclical bull market top of $60 a share in early 2004 to its most recent low of $42.50 in late September 2005, the price of WMT has dropped nearly 30%.  The size of this drop is even greater than the decline of WMT from July 1990 to October 1990.  Moreover, a price of $42.50 puts it at an even lower level than the levels experienced during the July 2002 and early 2003 bottoms.

It is very difficult to envision WMT just taking off from its September 2005 lows, given that evidence is pointing to the end of the cyclical bull market that began in October 2002.  However, readers should keep in mind that WMT has already appreciated nearly 17% (to $49.65) since its September lows, and $42.50 may very well hold even should the Dow Jones Industrial Average decline 1,000 points from current levels over the next six months.  Again, keep in mind that both the retailers and consumer discretionary shares have led almost every bull market since the end of World War II.  The severe oversold condition of the retailers can also be witnessed in the following weekly chart showing the relative strength of the Retail HOLDRS (RTH) vs. the S&P 500 from May 2001 to the present:

Relative Strength (Weekly Chart) of the Retail HOLDRs vs. the S&P 500 (May 2001 to Present) - Four week ago, the relative strength of the RTH vs. the S&P 500 declined to a level not seen since March 2003 - suggesting that 1) the RTH is severely oversold, and 2) the market is not out of danger territory just yet.

Please note that the relative strength of the RTH vs. the S&P 500 declined to a level not seen since March 2003 a mere four weeks ago.  Please also note that since the cyclical bull market began in October 2002, the relative strength of the RTH vs. the S&P 500 has been a great leading indicator of the broad market – typically leading the stock market from a period of two to eight weeks.  The fact that relative strength of the RTH has now declined to a new low – and the fact that both the gasoline prices and interest rates continues to remain high – suggests that 1) the RTH is very oversold, and 2) the stock market is still very much on dangerous ground.

Could many of these retail stocks (especially the U.S. mega-caps like WMT at $42.50 a share in September 2005, HD at $35 a share in April 2005, etc.) have already bottomed even as the Dow Industrials or the S&P 500 have topped out for this cycle?  Stranger things have happened – but I would not be surprised one single bit given the oversold condition in these stocks and giving the dark pessimism surrounding consumer spending – especially discretionary spending on home improvement products (contrary to popular belief, Goldman Sachs has found that only 5% of mortgage equity withdrawal flows through to home improvement spending, with the rest going to regular consumption and the payment of higher carrying debt).  While Warren Buffett may not have bought WMT at the bottom (he bought in at an average of approximately $47.50 a share), it may not ultimately proved to be so bad an entry point.

And finally, investing guru Bill Miller, who is made famous by beating the S&P 500 for 15 consecutive years, currently has a greater than 30% weighting in consumer discretionary stocks in both his Value Trust fund and his Opportunity Trust Fund.  If one wants to go long some individual stocks over the next three to six months, I highly recommend looking for picks in this sector.

Let's now take a time out and discuss the broad stock market.  Let's first recap our most recent signals in our DJIA Timing System:

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 (11,278.61), this position is 378.61 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 (which was exited last Friday morning at 11,260).

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.  This position was subsequently exited on Wednesday morning, May 17th 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 (which shifted our DJIA Timing System from 100% short to 75% short).  Last Friday morning, we further pared down our short position from 75% short to 50% short, and exited our March 20th position at a DJIA print of 11,260 (giving us a gain of 15 points in this position).  In a special alert on Friday morning, I stated:

I know, I know - this is not much but sentiment indicators (including back-to-back weekly mutual fund outflows) are still very oversold at this point and there is a good chance that the Dow Industrials could potentially test its recent highs over the next few weeks.  The success of the Mastercard IPO also signals that there is some liquidity in the stock market right now.

As of Memorial Day, May 29, 2006, I still stand by the above statement – even though I believe we have already seen a significant top in many of the major market indices.  The severe oversold condition can also be witnessed by a NYSE 10-day ARMS index reading of 1.34, as well as a Rydex Cash Flow Ratio of 1.10 earlier last week (the most oversold since October 2005 and prior to that, October 1999).  Again, I believe we will see a bounce in the weeks ahead, but probability still suggests of a further correction later this summer or fall (autumn).  Whether the end of this cyclical bull market will usher in a quick bear market or a longer one I cannot foresee, but chances are that it may be rather shallow in nature, given the already huge oversold condition and undervaluation of the U.S. mega-caps.  For folks who are invested in the Russell 2000 or commodities (or GM), the upcoming bear market could be pretty ferocious in nature.  Going forward, I will post more of my daily thoughts on the stock market such as updates on the ARMS Index, the Rydex Cash Flow Ratio, etc., on our discussion forum.  I urge every one of you to visit our forum at least once a week since the quality of many of our posts are exceptional (what can I say, we have many intelligent and independent-thinking subscribers!) and since many of the things I post on there are not mentioned in our regular twice-a-week commentaries.

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 26, 2006) - Both the Dow Industrials and the Dow Transports bounced a little bit in the latest week - with the both indices bottoming by mid-week and proceeding to rise 134 and 49 points for the week, respectively. Given the severe oversold conditions in many of our short-term indicators, and given the higher low as exhibited by the Dow Utilities in the latest week, chances are that this bounce will have some legs. While I still believe the Dow Industrials (and especially the small and mid caps) have effectively topped out for this cycle, I would not be surprised if it makes a retest of its recent highs over the next few weeks.

As I mentioned on the above chart, given the severe oversold condition in many of our short-term indicators and given the higher low as exhibited by the Dow Utilities in the latest week (relative to its early April lows), probability suggests that the current bounce in the major market indices will gain some traction over the next six to eight weeks.  Depending on how strong any upcoming bounce may be, we may or may not shift back to a 75% or 100% short position in our DJIA Timing System.  Readers should continue to monitor the NYSE A/D line, the NYSE McClellan Summation Index, along with NYSE and NASDAQ volume for any signs of a stronger-than-expected recovery.

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.  The latest four-week moving average of these sentiment indicators plunged below 20% (sinking from 22.0% to 18.4%) for the first time since early November of last year – suggesting a moderately oversold condition (at least relative to the readings we have been getting over the last three years).  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:

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 now moderately oversold in the short-run. For the week, the four-week MA of the combined Bulls-Bears% Differentials decreased significantly from 22.0% to 18.4% - a low which we haven't seen since early November 2005. However, this is still not low enough to sustain a decent rally, and chances are that we will at least consolidate more before retesting recent highs.

Given that the four-week moving average is still not as oversold as where it has been during the market bottoms over the last few years, there is a good chance that we will need to wait a couple of more weeks before getting one.  However, readers should keep in mind that our sentiment indicators can reach a similar oversold level simply with the markets consolidating or drifting lower.  That is, the market does not have to plunge from here.  Most likely, we will see the major market indices consolidating over the next week or so – with a subsequent retest of their May highs sometime in July or early August.

Conclusion: Readers may notice that I have changed the tone of our commentaries significantly this week, as I have gone from “proving” that the market is making or has made a significant top to looking for the next sector or the next group of stocks to buy.  As always, dear subscribers, we will need to be one step ahead of the game – especially given the weight of evidence suggesting that many of the emerging markets and commodities have already topped out.

Going forward, readers should keep an eye on stocks such as WMT and HD.  While the first chart on WMT does not show the complete picture, readers should keep in mind that both WMT and HD did not do well in the 1990s bull market until January 1997 – when many Asian economies were starting to slow down or collapse due to over-speculation and central bank tightening.  This makes intuitive sense, as both WMT and HD benefited from a dramatic decrease in labor and commodity prices from that point onwards.  Could we see a repeat this time around (my guess is that the U.S. Federal Reserve will stop tightening sometime this year while the Bank of Japan will only START raising rates this year) – assuming that the U.S. consumer does not suffer a total collapse and that bond prices continue to hold?  My answer is a “yes” – especially given their current valuations.  And having both Warren Buffett and Bill Miller on your side should not hurt either (at the very least, you should able to sleep soundly at night).

A must-read piece this week: George Gilder's chapter on John Mauldin's “Just One Thing.”  After reading this chapter, you will never look at the current state of the stock market the same way again!

Signing off,

Henry K. To, CFA

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