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The Bulls vs. the Bears

(July 9, 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 11,090.67, our 100% long position in our DJIA Timing System is on average 285.67 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 Sunday evening, July 9, 2006, this author still has no intention of shifting our 100% long position in our DJIA Timing System – even though the upside breadth and volume has been quite weak since the June 13th bottom.  Any selling decision should most probably not be made until after the end of earnings season, as I asserted in our latest mid-week commentary and as I will assert again in the early part of this commentary.  We are leaving our stop loss point at DJIA 10,805, as this author is willing to give the market more leeway in light of the historical volatility during earnings season.

First off, a conversation on the long bond.  For readers who were looking to buy the long bond, please review our June 25, 2006 commentary (“Long Bonds Starting to be a Buy”) on the topic.  Moreover, Bill Gross of PIMCO has just officially declared that the most recent bear market in bonds is now over – after its worse half-year performance since 1999.  At this time, however, our sentiment indicators on the long bond haven't turned very bearish yet, but now is probably the time to start nibbling on bonds for those who had wished to go long.

In our latest mid-week commentary, I asserted that given the dearth of information in both the marketplace and in stock prices in our heavily regulated environment (thanks to Sarbanes-Oxley and “Fair D”), the upcoming earnings season will be very important for determining the future direction of the stock market.  Moreover, this upcoming earnings season is doubly important given the following:

1. The uncertainty surrounding the economy – whether the Fed is done with hiking interest rates and how much the economy is going to slow down.  Some well-known investment figures – such as George Soros – have already publicly stated that a recession is already in the cards in 2007.  As for the slowing housing market and the potential impacts, even Robert Shiller (who had been preaching about a housing bubble for the last few years) isn't willing to make any predictions at this point.  We do know, however, that famed investment manager Bill Miller of Legg Mason has been buying homebuilding stocks hand over fist during the last couple of quarters.  The upcoming wave of earnings reports will serve to clear up some of this uncertainty.

2. Based on corporate profits as a percentage of GDP (which is now at its highest level since the fourth quarter of 1966), and based on the huge run of corporate profits over the last three to four years, there is a good chance that profit growth of U.S. companies will slow down significantly in the coming quarters.  The $64 million question is: Has the market already anticipated some of that slowdown?  Note that during the last corporate profit cycle, both corporate profits and corporate profits as a percentage of GDP had already peaked in 3Q 1997, and yet the market continued its ascent until 1Q 2000.  Again, the next wave of earnings reports over the next several weeks (along with guidance) will give us a very good idea of future earnings growth going forward.  Following is a quarterly chart showing corporate profits vs. corporate profits as a percentage of GDP from 1Q 1980 to 1Q 2006:

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 1Q 2006) - Both corporate profits and corporate profits as a % of GDP rose to a new secular high in the first quarter of 2006 (with corporate profits rising to an all-time high). Please note that corporate profits as a % of GDP (at 10.9%) is now at its highest level since the fourth quarter of 1966. Given the slowing economy, and given the rate of ascent in corporate profits in the last three to four years, it seems like the easy money has already been made here. Remember: In the long-run, corporate profits of domestic companies can only grow at the same rate as U.S and world GDP - with periodic over and understatements in between.

3. Japanese corporations have signaled their intent to again significantly boost capital spending for the rest of this year and into the first quarter of 2007.  As a matter of fact, large companies as a whole have indicated they will boost capital spending by 11.6% in the fiscal year to March 2007 – representing the strongest rise in capital spending since the bubble era days of 1990.  This is bullish for U.S. large caps such as MSFT and INTC – the latter of which derives 12% of its total revenue from Japan.  Moreover, this author still stands by my views that capital spending will get a significant boost once MS Windows Vista is released in the first quarter of 2007.  Whether this is true (and whether this has already been going on), however, will be made much clearer once we receive the latest earnings results from both MSFT (July 20th) and INTC (July 19th).

The Bulls vs. The Bears

Getting away from earnings season, this author would now like to tell you what I am trying to come to terms with as regards to the current stock market.  As our commentaries have implied over the last several weeks, there are now two distinct bullish and bearish forces squaring off in the stock market – each with their own valid arguments.  I will now reiterate what they are – and hopefully use these arguments to come up with a clearer picture of where the market may be heading going forward.  Following are what we believe are the various “conflicts” which the bulls and bears are fighting against one another:

Bulls vs. Bears Conflict # 1

As I stated in our most recent mid-week commentary, Lowry's has already declared we are in a bear market – citing the lack of demand from investors and the lack of broad-based strength in many industries and individual stocks.  However, please keep in mind that Lowry's does not analyze its “buying power” or “selling pressure” indices separated/based on each class of individual investors, such as corporate insiders, hedge funds, or retail investors.  Looking at mutual fund inflows over the last 12 months, it is obvious that the retail investor has continued to shun domestic equities – and thus we know that retail investors have been directly responsible for the weakness in many of Lowry's technical indicators.  On the other hand, TrimTabs claims that corporate managements have been buying back their own shares at a record pace.  Combined with the record amount of cash acquisitions in recent months and the lack of IPOs, and you have a wildly bullish leading indicator – as corporate insiders have historically been much “smarter” than retail investors in predicting future stock price trends.  The question now is: Will retail investors continue to exit the market and if so, will it crash the major market indices?

Should retail and foreign investors continue to shun U.S. domestic equities; will insiders and private equity funds have enough firepower to keep stock prices afloat?  Given the amount of cash held by corporations, and given still relatively low financing rates (by historical standards), as well as the fact that M&A activity still hasn't reached the late 1990s peak, there is a good chance that both cash acquisitions by both U.S. corporations and private equity investors, as well as share buybacks by corporate management will continue to prove robust going forward.  Following is a chart showing that M&A activity is set to continue (courtesy of the Bank Credit Analyst from three months ago).  Please note that this story still remains valid three months after the fact:

Merger & Aquisition Activity as percentage of GDP

Unless crude oil rises to $90 a barrel or unless there is bird flu pandemic, there is a good chance that the liquidity coming from both corporate insiders and private equity investors will continue to provide a reliable floor for the stock market – despite a continuing exodus by retail and foreign investors (who are both historically great contrarian indicators).  Again, we will continue to monitor this situation going into and through the 2Q earning season.  Should corporate management fail to announce any significant share buyback schemes during the latest earnings season, however, then look out below.

Bulls vs. Bears Conflict # 2

With the exception of the 1994 to 1995 rate hike campaigns, the U.S. economy has always had to endure a recession soon after the end of its latest rate hike campaign – and which has typically been accompanied by a severe underperformance of the U.S. equity market.  Most notably, the 1960s and the early 1970s U.S. stock market has almost always gone up while the Fed is on its rate hike campaign, and does not usually correct or crash until after the Fed is for the most part done.  Could we see another repeat this time around?

Bear Sterns certainly thinks so.  The position of Bear Sterns is that the 1960s and the early 1970s U.S. stock market is and remains the best comparison to today's stock market – given that today's stock market environment is no longer supported by a continuing disinflationary environment (which is essentially the 1980 to 2000 environment when the yield of the long bond embarked on its historical secular decline).  But unlike the late 1960s and early 1970s, however, the U.S. economy today isn't mired by unprecedented inflationary pressures or expectations either (the ECRI Future Inflation Gauge readings have been benign for four months in a row).  Case in point: While the stock market did crash during the December 1968 to May 1970 and the January 1973 to December 1974 cyclical bear markets only after the Fed was done, it really did not decline substantially until the country realized inflation had gotten out of control.  By that time, the effective Fed Funds rate had already hit 8.67% and 6.58%, respectively.  If the Fed is able to stop hiking at a Fed Funds rate of 5.25% and 5.50%, then the market does not need to necessarily decline.  Please see the following two charts showing the average monthly Fed Funds rate and the DJIA during those two fateful periods:

Monthly Chart of Fed Funds Rate vs. DJIA (January 1967 to December 1969) - The trough of the Fed Funds Rate was made in July 1967 at a rate of 3.79%. The DJIA did not peak until 16 months later. At the peak of the DJIA, the Fed Funds Rate was at 5.82% (a full 200 basis points higher). Moreover, the DJIA did not decline substantially until the Fed Funds rate hit 8.67% - a full 22 months later.

Monthly Chart of Fed Funds Rate vs. DJIA (January 1971 to December 1973) - The trough of the Fed Funds Rate was made in February 1972 at a rate of 3.29%. The DJIA did not peak until 10 months later. At the peak of the DJIA, the Fed Funds Rate was at 5.33% (approximately 200 basis points higher). Moreover, the DJIA did not decline substantially until the Fed Funds rate hit 6.58% - a full 12 months later.

Bulls vs. Bears Conflict # 3

There is no doubt that the economy is already slowing down – but it is too premature to conclude that the U.S. economy will have to suffer through a recession at this point – even as notable investment figures such as George Soros have already been calling for one to occur sometime next year.  In a simple consumer spending slow-down scenario, there is no guarantee that the stock market will even correct – especially if certain sectors of the stock market have already been discounting for such a slowdown (see the P/E ratios of many retail and homebuilding shares).  The 1995 slowdown was a perfect example.

Moreover, on glancing at the most recent action of the MarketThoughts Global Diffusion Index (the MGDI) compared to the Dow Industrials and the CRB Energy Index, one could conclude that energy is still overbought – but that the Dow Industrials could still go either way.  For newer subscribers, I will begin with a direct quote from our May 30, 2005 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 [and CRB Energy 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 May 2006. Please note that the data for the Dow Jones Industrials and the CRB Index are updated to June 30th (the June OECD leading indicators won't be released until early August). 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 May 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 over the last two years suggests that oil prices will correct sooner or later - but given the strength in the MGDI since November, oil may go on to make one more new high before correcting.

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.  Sharp-eyed readers will notice that the Dow Industrials has now been lagging the action of the MGDI (both the first and the second derivative) for the past six months.  Obviously, the MGDI is not an infallible indicator (far from it), but bears should definitely sit up and take notice.  Again, it is interesting to note the following: In a consumer-slowdown scenario, the obvious stocks to get hit first will be in the consumer discretionary group.  However, Bill Miller of Legg Mason (who has outperformed the S&P 500 for 16 consecutive years in a row) is now significantly overweight the consumer discretionary sector.  Unless one is looking for a huge 15% to 20% correction in the stock market over the next six months, it probably isn't a safe bet to fade Mr. Miller's current position.

Bulls vs. Bears Conflict # 4

Subscribers who have studied stock market history will know that the P/E of both the S&P 500 and the broad market are now in traditionally overvalued territory – said P/E being 15 or above (it is currently at 17.7 according to  However, subscribers should also know this: That valuation tools are traditionally a lousy indicator.  Moreover, unless the world is going to hell in a hand-basket (e.g. when real interest rates – nominal interest rate minus inflation – went sky-high such as during the early 1930s and the 1970s), it is usually a good bet to use alternative financial assets such as bonds or even real estate when trying to gauge the “proper value” for equities. 

In the most recent past, the Barnes Index (please see our March 30, 2006 commentary for a description) has served us especially well in this regard, and this author will continue to use it going forward as a relative valuation tool between equities and bonds.  Following is the chart courtesy of plotting the weekly values of the Barnes Index vs. the NYSE Composite from January 1970 to the present:

Barnes Index

Note that the Barnes Index has been instrumental in calling the most recent top in the stock market (even though as we have mentioned before – valuation indicators tend to be lousy timing tools).  In our May 7, 2006 commentary, we noted that the Barnes Index had hit a level of 67.60 – thus putting us in the “danger zone” of 65 to 70.  Sure enough, May 10th would mark the significant top of many major market indices and even equity markets around the world.  In our most recent mid-week commentary, we stated: “Given the hugely oversold condition in many of our intermediate-term indicators, this author is revising the “danger zone” in the Barnes Index from a range of 65 to 70 to a range of 70 to 75.”  And given the most recent reading of 61.60 (as shown in the above chart), this author believes the stock market is not at risk of an imminent decline just yet – and probably won't be so especially after the latest earnings reports have been taken into account.

Note that in last weekend's commentary, I stated that the most reliable indicators for calling a significant stock market top were: divergences, divergences, and divergences.  For now, I don't see any divergences of significance.  So Henry, why are you choosing to discuss the four above “conflicts” if all you are interested in is divergences?

Here's why: Divergences are meant to be used as confirmation of a top – while discussing the above four “bulls vs. bears conflicts” is meant to take you behind the scenes and help predict possible divergences or upcoming stock market declines.  At the very least, monitoring these “four conflicts” on a day-to-day basis will allow you to understand any divergences should they occur going forward – and will definitely help you to conclude if such divergences are important or not.  For now, I will let our subscribers make up their own minds – but it definitely does not look like the stock market has topped out yet (on May 10th). 

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 July 7, 2006) - For the week, the Dow Industrials declined 59 points while the Dow Transports declined 85 points. Given the immense rally we have seen since the June 13th bottom, last week's correction in the two popular Dow indices was inevitable. But given the resilence in the Dow Transports and its tendency as a leading index since the cyclical bull market began in October 2002, there is a good chance that the rally in the Dow Industrials will have some ways to go before topping out.

For the week ending July 7, 2006, the Dow Industrials declined 59 points while the Dow Transports declined 85 points.  This latest correction in the two popular Dow indices was inevitable – given the immense rally we have seen since the June 13th bottom.  At this point, it is too soon to conjecture how long this rally will last for – especially in light of the earnings season – but given the fact that the IPO calendar should remain sluggish until Labor Day, and given that the Fed should pause at or after the August 8th meeting, there is a good chance the stock market would move steadily upwards until late August.  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.

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% two weeks ago to 3.2% in the latest week – signaling that both sentiment and the stock market have definitely reversed upwards.  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 3.2% over the last two weeks. Given that this author will not be looking for a top before we see an overbought level in these sentiment indicators again, we are at least four to six weeks away from a major top.

Conclusion: Subscribers who were interested in going long the long bond may want to start nibbling on it, even though our sentiment indicators for the long bond are not at extremely oversold levels just yet.  As for the current market, it remains in an uptrend – with the longer-term outlook slated to become much clearer after the next several weeks of earnings report releases.

Speaking of the longer-term outlooks, this author is currently looking at the bullish and the bearish forces at work in four different areas, with those being the supply & demand dynamics of the stock market, the current rate hike campaign and its historical context, the upcoming economic slowdown and its implications, along with the current valuation of the stock market and its interpretations.  This author will expand on this as we move forward – so for now, we will let our readers come up with their own conclusions and investment decisions.  For now, all I am going to say is that 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.  We will remain 100% long in our DJIA Timing System with a stop loss point at DJIA 10,805.  Subscribers please stay tuned.

Signing off,

Henry K. To, CFA

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