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Top Calling Remains a Thankless Job

(July 2, 2006)

Dear Subscribers and Readers,

We entered a 50% long position in our DJIA Timing System on Thursday morning, June 8th at a DJIA print of 10,810.  We then became more aggressive and shifted to a fully 100% long position on the morning of June 12th.  In a real-time email that we sent to our subscribers, I noted to our subscribers: “We have just shifted from a 50% long position to a 100% long position in our DJIA Timing System at DJIA 10,800.  The NYSE intraday ARMS index just touched a hugely oversold reading of 2.46 while the VIX spiked up another 15%.”  Based on Friday's close of 11,150.22, our 100% long position in our DJIA Timing System is on average 345.22 points in the green.  Again, readers who are interested in our historical signals can see more (and learn about our rationale behind those signals) at our MarketThoughts DJIA Timing System page.

As of Friday evening, June 30, 2006, this author still has no intention of shifting our 100% long position in our DJIA Timing System – especially in light of the powerful rally last Thursday.  Again, there is a good chance that the market had already hit an intermediate bottom at a DJIA print of 10,706.14 at the close on June 13th.  At the same time, however, this author recognizes that anything can happen in the markets – especially given an over-eager Fed and continuing tightening from both the ECB and the BoJ – and as such, we have placed a stop on our 100% position at our average entry point of 10,805.  Our stop loss point of DJIA 10,805 was initially set in order to avoid the possibility of a crash (a possibility which was quite real a mere two weeks ago).  But as I mentioned last week, “the time window for a crash is getting narrower by the day.  If the market does not exhibit any significant weakness by early this week, then chances are good that the market has already hit an intermediate bottom.”  Given the strength in the major market indices in the latest week, this author will conclude that the June 13th low represented a significant short-term and intermediate-term bottom for the stock market – but in the meantime, we will just leave the stop out there anyway (with an intention to change it next week).

In last weekend's commentary, we stated that the long bond was starting to become a “buy,” given a benign interest rate environment in the Japanese bond market (the 10-year JGB had a 70% correlation to the 10-year U.S. Treasury over the last six to seven years), a slowing U.S. economy, and the fact that the yield of the 30-year long bond (at 5.26%) was at its highest level since July 2004.  At the same time, however, we also stated that as always, “timing is of the essence,” and while we believe that buying the long bond was starting to become an attractive idea, we also felt that it wasn't the perfect time just yet for the following three reasons:

  1. The fact that the Fed wasn't done with its rate hike campaign yet.  Such a move should also exert continuing upward pressure on the yield of the long bond – as has been the case for the last six months.  Moreover, yield curve flattening trades among hedge funds are no longer popular – and in fact, chances are that the hedge funds are now betting on a steeper yield curve and will thus continue to sell the long bond as long as the Federal Reserve is hiking.

  2. Sentiment of the U.S. long bond is not overly pessimistic at this stage, as exemplified by the Rydex Bond Ratio (bearish assets on bonds divided by bullish assets on bonds) and the latest Commitment of Traders Report on the U.S. Treasury bond futures.

  3. Given that this author is intermediate-term bullish on the stock market, I just cannot envision a scenario where bond yields will just decline from current levels at the same time the stock market is rising.

As of Friday evening, June 30, 2006, the above still holds true.  While the Fed may already be finished with its last rate hike at a Fed Funds rate of 5.25% (the futures market is pricing in a 64% chance of another 25 basis point hike on August 8th), it is difficult to see the yield curve flattening significantly from current levels – given that this author is only envisioning a slow-down scenario and not an outright recession.  Also, sentiment of the U.S. long bond still hasn't gotten to the extremely oversold yet, and finally, there is a very good chance (especially in light of last Thursday's rally) that June 13th represented a significant short-term or intermediate-term bottom in the stock market – paving the way for a still-higher yield going forward for the long bond.

Reading the many commentaries and looking at the various sentiment indicators over the last day, there still seems to be a lot of experts and other investors who are skeptical of the current rally.  As a matter of fact, many of these bears who are still skeptical are actually still quite confident that the current bull market has already topped out at its early May cyclical bull market highs.  At the May closing highs, the Dow Industrials hit 11,642.65 while the S&P 500 hit 1,325.14.  As of the close on Friday, the Dow Industrials is sitting at 11,150.22 while the S&P 500 is sitting at 1,270.20 – a mere 4.2% and 4.1% from their highs, respectively.  In the short-run, the markets can and will do anything and 4.2% isn't that difficult for the market to overcome – especially if second-quarter earnings surprise on the upside.  Given that so many commentators are now claiming that the top has already come in early May, this author wouldn't be surprised if the major market indices surpass those highs before finally making a significant top.

For now, no one really knows when these markets will top out – time-wise or point-wise.  All we can do is to continue to monitor signs of an imminent top – such as relative valuation between stocks and bonds, the strength of commodities, overbought/oversold indicators, and our most popular sentiment indicators.

Valuation indicators are good – but generally, these are horrible in timing.  Overbought/oversold and sentiment indicators are generally pretty good at predicting bottoms, but also not that reliable when it comes to timing market tops.  In general, there is usually a significant lag time between when the market gets overbought and when it finally tops.  As for commodities, the only useful place for our purposes is to use them to see if the Federal Reserve will continue to tighten at the August 8th meeting.  The first two days after the rate hike haven't been too good to the bulls in this regard – given the strength in both energy and metal prices immediately after the latest rate hike.  Should commodities continue to rise next week and stay strong until August 8th, then the chance of another rate hike will be very real.

While this author believes that the latest inflation “scare” is overblown, and while I believe the U.S. economy is now slowing down significantly (as exemplified by the ECRI leading indicator and the weakness of the U.S. housing market) to justify a pause on August 8th, readers should keep in mind that it is important for the new Fed Chairman, Ben Bernanke, to establish his reputation as an inflation targeter/fighter in his very first rate hike campaign.  While a relatively benign CPI reading later this month may very well do the trick for most of us, it is important to keep in mind that many other folks are watching the commodities as a sign of potential inflation, especially the price of gold and crude oil.  Should the price of gold rise back to above $700 an ounce and should oil stay at current levels come August 8th, then there is a very good chance that the Fed will hike again on August 8th.  For now, we will just have to wait – as there are now rumors flying that the European Central Bank may hike its refi rate again as soon as next Thursday.  How commodities react to the ECB meeting will also be very important leading up to the August 8th meeting.  For now, the Eurodollar market is pricing in a 64% chance of a 25 basis point hike at the August 8th meeting.

So Henry, how do you think the anticipation of the Fed's policy on August 8th will affect the market for the foreseeable future?  I will try to make this as simple as possible (for both the reader and for myself).  Right now, the market has priced in a 64% chance of a 25 basis point hike at the August 8th meeting.  Should commodities continue to be strong in the next six weeks, there will be no doubt that the Fed will hike yet again.  In other words, any strength in gold or oil in the coming weeks will serve to keep a lid on the stock market.  Make no mistake, however: This author believes the market is now in an intermediate uptrend – and so while further rises in commodity prices should serve to put a lid on the stock market, this does not necessarily mean that the market will tank from current levels (unless the price of crude oil hits $80 a barrel, for example).  But with the exception of crude oil, commodity supplies around the globe are now plentiful – given the huge decrease in gold and copper demand in China and India and given the plentiful natural gas inventories.  Whatever investment demand for commodities is remaining after the Fed is done with its rate hike campaign, this author believes that it will be “taken care of” by a series of ECB and BoJ rate hikes.  Moreover, the tightness in the crude oil market is expected to ease a little bit later this year – even assuming current economic growth estimates in the U.S, Europe, and China holds true.  Because of this, there is a good chance that the Fed Funds rate will top out at 5.5% on August 8th, if it hasn't done so already.  Folks looking for a 6% Fed Funds rate going forward will be disappointed.

By far, the most important timing indicator of a top in the stock market is divergences, divergences, and divergences.  For example, the NASDAQ Composite had already topped out in early April in the last rally, and the historically-reliable Dow Utilities had already topped out in early October of last year.  The NYSE McClellan Summation Index had also been making lower highs since February of this year.  For folks who were watching the international markets, many of the Middle Eastern markets either topped out last year or earlier this year.  For now, the market remains okay, but going forward in this rally, readers should continue to monitor for such divergences.  Following is a three-year chart courtesy of showing the lower highs in the NYSE McClellan Summation index:

NYSE McClellan Oscillator (Traditional)

Again, this author believes that the June 13th bottom represented a significant intermediate-term bottom in the stock market – something I have been discussing for the last couple of weeks and that was further confirmed by the powerful Lowry's 90% upside day last Thursday.  Assuming that the current rally is as strong as the rallies we have seen over the last two years, this should take the NYSE McClellan Summation Index back to the downtrend line as shown in the above chart.  From there, it is going to take a little bit of time before this market finally tops out.  This is probably the most optimistic scenario.  In the worst-case scenario, we may see a test of the NYSE Summation Index back to the 1000 level (the red-dotted line) and then see the market plunge from that level (finally ushering the 10% correction we have been waiting for).  Such a scenario is not out of the question – as there is now a noticeable shift in leadership from the small/mid-caps to the large caps in the U.S. stock market in recent weeks (whenever there is a change of leadership, it has always been preceded by a significant correction).

So Henry, are you saying that we may hit another all-time high in the Dow Industrials before we see the next significant top in the stock market?  Like I said before, anything is possible in the stock market – and in the stock market, the “impossible” or “improbable” usually occurs more often than one thinks.  Moreover, it has been nearly 6 years and 6 months since the last peak in the Dow Industrials when it peaked at 11,722.98 on January 14, 2000 (on a closing basis).  Following is a table showing the longest time periods between successive highs in the Dow Industrials.  Note that there are only three other time periods in the history of the Dow Jones Industrial Average that are longer than the current drought:

DJIA Study: Longest Time Periods Between Successive Highs

If the Dow Industrials does not surpass its January 14, 2000 high in another three months, then you could in a way argue that this current secular bear market in equities (especially U.S. large caps) has already surpassed the February 1966 to December 1974 secular bear market in duration.  Of course, from the January 11, 1973 peak, the Dow Industrials would take another 9 years and 10 months to surpass that peak again, but please keep in mind that during that time period, we witnessed the second oil embargo, the monetizing of commodity inflation which eventually resulted in a 15% inflation rate, the American loss of the Vietnam War, and the international debt crisis in 1982 (which threatened to take down many of the world's largest commercial banks, including Citigroup).  With the exception of “Peak Oil” (which this author doesn't totally buy into) or the continuing demise of the Euro Zone as an economic force (see our last commentary: “Spain – One of the Weakest Links in Europe”), there are current no signs of any impending fiscal or financial crisis that would rival those of the mid 1970s to early 1980s.  But keep in mind that this author does not see a new bull market emerging anytime soon – given the lack of an oversold condition (historically speaking compared to other major stock market bottoms such as October 1990 or October 2002) on June 13, 2006.

Again, this will be somewhat of an abbreviated commentary since I will be leaving for Austin in about an hour.  I apologize – but this period of R&R will allow me to reflect on the stock and commodity markets and will provide me a fresher perspective on where things may be heading in the coming weeks or months.  I view this break as essential – and I promise to “come back with a vengeance” next week and provide our subscribers with fresher ideas.  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 June 30, 2006) - For the week, the Dow Industrials rose 161 points while the Dow Transports rose 156 points. Last week, I stated that: 'Given that the Dow Transports has been leading the Dow Industrials since the beginning of the cyclical bull market in October 2002, probability implies that we have already seen a ST low in the Dow Industrials on June 13th.' Given the continued strength in the Dow Transports in the latest week (it is now only 70 points away from its all-time closing high made on May 9th), probability implies that the rally in the Dow Industrials still has some ways to go before topping out.

For the week ending June 30, 2006, the Dow Industrials rose 161 points while the Dow Transports rose 156 points – resulting in the strongest showing (given that both indices experienced a significant rally at the same time) in weeks and confirming the intermediate bottom made on June 13th in both the Dow Industrials and the Dow Transports.  At this point, it is too soon to conjecture how long this rally will last for – but given the 90% upside day last Thursday, I would not be surprised if we see an all-time high in the Dow Industrials before we see a significant top.  For now, we will continue to maintain a 100% long position in our DJIA Timing System with a stop at our average entry point of 10,805.  We will readjust our stop next week.

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 bounced from an extremely oversold level of 1.7% to 1.9% in the latest week – again, a low not seen since April 2003!  More importantly, there is a good chance that sentiment has reversed – paving the way for a further rally in the weeks ahead.  Moreover, given that this author will not be looking for a significant top before we see an overbought level in these sentiment indicators again, we are now at least four to six weeks away from a significant top.  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) - There is a good chance that bullish sentiment has now reversed - with the four-week MA of the combined Bulls-Bears% Differentials increasing from 1.7% to 1.9% in the latest week. Given that this author will not be looking for a top before we see an overbought level in these sentiment indicators again, we are now probably at least four to six weeks away from a significant top.

Conclusion: Based on our most recent commentaries, the record increase in NASDAQ short interest (as outlined in our mid-week commentary), the bounce in the above sentiment indicators from extremely oversold levels, and the 90% upside day on Thursday, there is now nearly no doubt that June 13th represented an intermediate-term low for the stock market and that we are currently in an intermediate-term uptrend.  For now, no-one really knows how long or how far this rally will go – but all the folks who are now calling that a significant top had already occurred in early May would probably have to retract their views in the coming weeks.  Please keep in mind, however, that the latest rally did not come from an extremely oversold situation (an oversold situation similar to the October 1990 or the October 2002 bottom).  In fact, the Dow Industrials did not even experience a 10% correction in the latest decline – and therefore, there is no reason to believe that any rally that emerges from the June 13th bottom will be any stronger than the rallies we have witnessed over the last couple of years.  Subscribers please stay tuned.

Signing off,

Henry K. To, CFA

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