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The Fed Meeting and My “Preferred” Scenario

(August 6, 2006)

Dear Subscribers and Readers,

A Note on Technology: I am continually amazed at the (accelerating) pace of innovation in the technology sector.  Just as Sony's Blu-Ray Disc solution is touted as the successor to the DVD, a new kind of storage has crept up – that of holographic storage, which is scheduled to be shipped later this year by Hitachi and Maxell (and the Sony Playstation 3 still hasn't been released yet!).  As the majority of the population in China and India continues to gain more education and scientific know-how, there is no doubt that the pace of innovation will continue to accelerate going forward.  Now all I need is a faster internet connection…

Our 100% long position in our DJIA Timing System was stopped out at its average entry point at a DJIA print of 10,805 on July 14th.  As mentioned in our July 16th commentary, this author was looking for a way to get back into the market on the long side – as I had believed we were now entering a quick “capitulation phase” in the stock market due to the violence that was going on in the Middle East and the wide scale dumping of equities by both individual and institutional investors.  Based on my commentaries and postings over the last weeks, we went 50% long in our DJIA Timing System at a DJIA print of 10,770 on the afternoon of July 18th – which was communicated to our subscribers by a real-time email.  I continue to believe that August will be biased to the upside, given the inevitable pause in the Fed's hiking campaign, the deep correction suffered by equities from the May 10th top, and given the traditionally “quiet period” on the IPO and secondary offering calendar (which will dampen supply of shares coming onto the markets).  In our commentary last weekend, I stated: "Given that the market ran away from us on the upside last Friday, this author will have no choice but to wait for a correction in the Dow Industrials before going fully long.”  I continue to stand by this view.  For now, I do not anticipate making any changes in our 50% long position in our DJIA Timing System – unless the market suffers another correction over the next few weeks.  Again, this author will communicate to our subscribers via a real-time email once we decide to go 100% long in our DJIA Timing System.

August is usually the traditionally “quiet period” of the year – and in a “normal market year,” it actually may be better off for some our readers (especially traders) to take the time off and enjoy your vacation.  But this year should prove differently, given the highly anticipated Fed meeting this upcoming Tuesday.  As of Friday at the close, the Fed Funds futures are only factoring in a 16% change of a 25 basis point rate hike on August 8th.  While many analysts were “predicting” that the Fed would stop after Hurricanes Katrina and Rita and even earlier this year, this author was saying otherwise – claiming that the Fed would not stop until either commodity prices take a hit or if the stock market starts getting weaker.  Since that time, gold has pulled back significantly from its mid-May highs of approximately $725 an ounce.  At the same time, many of the world's equity markets have suffered, including the U.S. mid and small caps – not to mention the retail, transportation, and semiconductor stocks (the weakness of the stock market last Friday despite the probability of a rate hike declining from 41% to 16% must be cause for concern for Chairman Bernanke).  Moreover, the weakness of the U.S. housing markets and the weakness in the ECRI Weekly Leading Index and the ECRI Future Inflation Gauge are all signaling “slowdown with benign inflation” right up ahead – which inevitably leads to my current conclusion: The Fed will stop its series of rate hikes this Tuesday afternoon, and may even ease sometime later this year, especially if the yield curve becomes inverted any further (long-term yields during further from current levels).

One of the many axioms in Wall Street is this: It is immensely hard to outperform the averages or to do well in the stock market once you become a celebrity.  It is altogether impossible to recover and even to beat the averages once the hedge funds and the rest of Wall Street find out you are in difficulty, and that is no more true than in Bill Miller's Legg Mason Value and Opportunity Trust mutual funds today.  Bill Miller started becoming a celebrity since a couple of years ago when it was publicized that he had outperform the S&P 500 by 13 consecutive years.  By the end of 2005, that streak was up to 15.   For the first six months of 2006, however, Bill Miller's flagship fund, the Legg Mason Value Trust, is down 4.59%, vs. a rise of 2.71% in the S&P 500.  To rub more salt on the wound, Sprint-Nextel, the Value Trust's biggest holding at 5.7% of the fund, took a huge 12% hit from the end of the second quarter to last Friday at the close.  While an underperformance of more than 700 basis points vs. its benchmark is a pretty big deal in the mutual fund industry (an underperformance which could cause redemptions), it is not catastrophic by any means.  In Bill Miller's case, I think there is still a chance for him to outperform the index by the end of this year, given the following:

  1. A 700 basis point underperformance of the S&P 500 does not necessarily translate into investor redemptions, especially if investors have gone through a similar experience before and especially if their confidence in the fund manager is unshaken.  For many fans of Bill Miller (and that should include most of his investors), this should just be a slight bump on the road.  Moreover, any higher-than-normal redemptions in the Legg Mason Value Trust fund should be minimal and should not have a significant impact on many of Miller's holdings, especially given that many of his holdings are very well-known, highly liquid, mega-cap names.

  2. The Legg Mason Value Trust Fund is not a hedge fund and nor a leveraged fund.  There are no potential market clearing or market dislocation issues should many of the fund's holdings continue to decline in the coming weeks.  Again, many of the fund's holdings are in the highly liquid, mega-cap names and thus should have no liquidity issues even in the off chance that Bill Miller is forced to dump those names (an added plus is that many of the companies in his holdings are buying back their own shares en masse).  Therefore, it is not in the interest of the hedge funds to short-sell or dump their holdings should they be holding the same stocks as the Legg Mason Value Trust.  The Legg Mason Value Trust is not Long-Term Capital Management.  It will not be forced to capitulate.

  3. As I have mentioned over the last couple of months, there is a very high probability that the U.S. domestic large-caps are set to overperform going forward (over the U.S. small and mid caps and nearly every other asset class in the world).  Bill Miller has the same idea (actually, I have already stolen a couple of ideas from him), and for those who have been thinking of buying a mutual fund to invest “for the long haul,” it may now be a good time to start establishing a position in the Legg Mason Value Trust Fund.

Let us now get on with our commentary.  In the realm of the stock market, it is still a battle being the bulls vs. the bears.  Not that it is not a battle every trading day, but as I have mentioned before, there are now two overriding extreme views – with one camp (e.g. TrimTabs) claiming that we are at the beginning stages of a major bull run (over 10% in the S&P 500 at least) while another camp claiming that we are now in the beginning stages of a bear market (e.g. Lowry).  Looking at corporate share buyback and cash acquisition information, and looking at mutual fund inflows/outflows data, one can see two distinct and contrasting trends: Corporations and private equity investors (who can be counted as insiders) have been snapping up the shares of Fortune 500 companies, while retail investors are actually in the midst of capitulating on domestic equities, especially the large caps which they were very fond of just over six years ago.  Bearish sentiment among retail investors is also being reflected in the very bearish readings we have witnessed in AAII and Investors Intelligence Surveys – with recent readings being in territory that that we haven't seen since early 2003 and even extending back to October 2002.  Insider bullishness is also evident in the most recent insider buying/selling information courtesy of Thomson Financial:

Insider buying/selling information for the week ending August 5,2006

Over the long-run, insider (mostly the Chairman, the executive team and the directors of the boards) selling always outnumber insider buying, given that many executives will inevitably diversify their holdings from their own company into “safer” investments, such as an equity or a fixed income mutual fund.  That being said, the latest monthly (July 2006) insider sell/buy (in terms of dollar amount) ratio of 3.86 is the lowest ratio this author has seen since we started tracking this ratio in January 2004 – suggesting that corporate insiders are bullish in their own shares a major way.

Ultimately, the investors with the most knowledge (the insiders) win, and that is especially true in the stock market – especially in this post Sarbanes-Oxley age where “material information” is difficult to come by.  In the short-run, technicals, and demand and supply rule.

So Henry, what kind of indicators are you now looking at to determine the market direction in the short-run (over the next few weeks) and during September to October?

First of all, let there be no mistake: I am still bullish on the U.S. domestic large-caps, given the valuations we are seeing in many of the world-renowned brand names and given the fact that so many investors have ignored these names over the last 12 months or so.  If anything, they are ripe for hedge fund (the macro funds especially) speculation – not to mention for investors who were previously speculating in real estate or the Middle East.  The latter is especially important, as U.S. large-caps have historically outperformed during periods of world uncertainty (the Israeli and Hizbollah conflict) and tightening world liquidity (which is also happening as I am typing this).  But in the next few months, anything can happen, and this author will now attempt to provide his views on the timeline I am envisioning.

I am looking at all kinds of indicators.  From the NYSE and NASDAQ McClellan Oscillators and Summation Indexes, the number of new highs vs. new lows on the NASDAQ, to relative strength of the homebuilders, and of course, the Dow Theory.

First of all, history has for the most part “shown” that the stock market typically rallies after a halt in a typical Fed hike campaign – only to see the rally die shortly afterwards (and even decline to new lows) as it slowly discounts a slowdown/recession in the U.S. economy.  This was the rule especially during the 1960s and 1970s.  The lone exception was the 1994 to early 1995 rate hike campaign, when the stock market took off at the end of 1994 without ever looking back – at least until the peak of the Asia Crisis in October 1997.

Following history, the market should at least have an upward bias until Labor Day Weekend – given that the Fed should pause at its meeting this coming Tuesday.  The strength of the upcoming rally (if any) should be used as a “barometer” to see if your long positions are worth holding.  This is the one and only way to determine if you should sell out your positions – how your stocks act after the initial rally.  As an aside, this is also the most effective way to determine if the stock market is a “sell” or “hold.”  When shorting the stock market, Jesse Livermore had always used this method to time his transactions.  Never, ever, try to sell at the top.

The NASDAQ Composite is also giving us signs of an impending rally, as exemplified by the following chart showing the daily NASDAQ High-Low Differential Ratios from January 2003 to the present.  The NASDAQ High-Low Differential Ratio is constructed by taking the difference between the number of daily new highs and the number of new lows on the NASDAQ Composite and dividing by the number of issues traded on the NASDAQ.  This ratio is especially important given that the NASDAQ Composite has been one of the weakest indices for most of this year:

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 2003 to August 4, 2006) - The NASDAQ High-Low Differential Ratio finally again touched positive territory last Friday - hitting 0.54% after having effectively been in negative territory since early July. The latest 'rally' in the NASDAQ High-Low Differential Ratio is the third attempt at a rally since the early May top. The $64 million question is: Will the current strength in the NASDAQ High-Low Differential Ratio be strong enough to rally the NASDAQ? It is certainly high time, given the severe oversold condition in this ratio. But if so, how long will the subsequent rally last? We will just have to see.

As mentioned in the above chart, the NASDAQ High-Low Differential Ratio finally touched positive territory last Friday – after having effectively been in negative territory since early July.  Again, this is the third time this ratio has made such an attempt.  Can anyone say “third time lucky?”  This is certainly the right time to rally as well, given the severe oversold condition in both the NASDAQ Composite and in the High-Low Differential Ratio and given that the Fed should pause at its meeting this coming Tuesday.  In my mind, the more relevant question to ask is: How long will this subsequent rally last?  Again, we will just have to reevaluate as new data comes in.  For the period from September to October, this author is being cautious, even though I am now long-term bullish on the U.S. domestic large-caps.

As I mentioned earlier, we are also currently keeping track of the NASDAQ McClellan Summation Index.  Following is a three-year chart showing the NASDAQ Composite vs. the NASDAQ McClellan Oscillator vs. the NASDAQ McClellan Summation Index:

NASDAQ Composite vs. the NASDAQ McClellan Oscillator vs. the NASDAQ McClellan Summation Index - The NASDAQ is certainly oversold given the oversold condition in the Summation Index.  But how long can the subsequent rally last, given that the Summation Index has been gradually weakening since January 2004?

As mentioned on the above chart, the NASDAQ Composite is certainly due for a rally – given the development of a “double bottom” in the NASDAQ McClellan Summation Index and given its hugely oversold condition.  At the same time, more detailed-oriented subscribers should be able to see this: The NASDAQ McClellan Summation Index actually topped out in January 2004 and has been gradually weakening since – even more so since August 2005.  The NASDAQ will have to give us some really strong rallies in order to “clean up” the technicals.  At this point, the author remains skeptical.  If the NASDAQ cannot rally significantly in the days leading up to the Labor Day Weekend, then we can actually see some fireworks (on the downside) in the September to October period.  Make no mistake, however, I am still long-term bullish on the semiconductors and many of the brand-name technology and internet companies such as Microsoft, eBay, Intel, and Yahoo! – but that does not mean they couldn't make lower lows during the September to October period should they technically remain weak over the next few weeks (even in the face of a $20 billion buyback scheme in MSFT due to happen on August 17th).

Another sign calling for at least a short-term rally is the recent strength in the homebuilders.  Following is the daily chart of the S&P Homebuilder ETF.  As one can see, the XHB basically crashed in mid-June accompanied by very high volume and has since reversed – also accompanied by very high volume.

XHB (ST SPDR Homebuilders ETF) AMEX

Such a reversal (both magnitude in points and in volume) in the S&P Homebuilders ETF suggest that it is a legitimate reversal – and given that the homebuilders have been one of the leading industries ever since the beginning of this cyclical bull market, this is definitely a very encouraging sign.

Let us now discuss the Dow Theory.  Following is 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 August 4, 2006) - Over the last three weeks, the Dow Industrials rose 501 points while the Dow Transports declined 212 points - giving us the most significant non-confirmations in the two popular Dow indices in recent memory. There is now a good possibility that after four years of relative underperformance, the Dow Industrials is finally taking the upper hand over the Dow Transports and emerging as the clear leader - not just in the U.S. stock market but the global stock market as well. On the other hand, the underperformance of the Dow Transports is slightly disturbing - but this is to be expected, given the Dow Transports' huge overperformance since August 2004.

The Dow Transports have now declined five weeks in a row – going down 11.2% over the last five weeks.  At the same time, the Dow Industrials have actually risen over the last three weeks (501 points in all) – thus resulting in an upside non-confirmation of the Dow Industrials by the Dow Transports – giving us the most flagrant non-confirmation in the two popular Dow indices in recent memory.  Over the short-run, anything can happen, so this author would not be too concerned about this non-confirmation for now, especially since the Dow Transports should now rally given the severe short-term oversold condition in the index.  However, over the longer-run, this non-confirmation is definitely a red flag, especially since the Dow Transports has been a leading indicator of both the broad market and the Dow Industrials ever since this cyclical bull market began in October 2002.  Unless the Dow Transports rally back to its old highs before Labor Day Weekend, this author would tread very carefully during September and October.  But should there be a correction in the Dow Industrials over the next few weeks, this author will not hesitate shifting from a 50% long to a 100% long position in our DJIA Timing System.

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% six weeks ago to 4.9% in the latest week – signaling that both sentiment and the stock market have definitely reversed upwards.  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 bottomed (in late June) and has now reversed - with the four-week MA of the combined Bulls-Bears% Differentials increasing from 1.7% to 4.9% over the last six weeks. This is also suggestive of a rally over the next few weeks. But again, any signs of a further rally after Labor Day will depend on the strength of the rally over the next few weeks.

Conclusion: For those readers who are interested in my “trading strategy,” this author is currently looking for a rally following the August 8th Fed meeting and leading up to the Labor Day Weekend.  My view of the stock market post Labor Day should now be interpreted as “murky” – and a lot will depend on the strength of any rally after the Fed meeting this coming Tuesday.  We are now getting cautious for the period from September to October – not only because we are in the second year after a Presidential election year but also because of deteriorating technicals, the recent non-confirmation of the Dow Industrials by the Dow Transports, and the weakness of the NASDAQ McClellan Summation Index since early August 2005.  We are also very much overdue for a 10% correction in the Dow Industrials and the S&P 500.  Not to mention that despite so much effort (and hope) for a diplomatic solution, fighting is still as intensive as ever at the Lebanon-Israel border.

The above is my view of the markets over the next two to three months, and again, let there be no mistake: Over the long run, I am still bullish on the U.S. domestic large-caps.  Subscribers who had been interested in going long the large-caps at some point may now want to start nibbling on some of your favorite names – particularly strong, cashflow-rich large caps in both the semiconductor and the retailing industry. For now, this author is still bullish, but if the rally over the next few weeks (assuming there is one) is uncharacterically weak, then this author will not hesitate selling our 50% long position in our DJIA Timing System and going completely neutral or even short.   Subscribers please stay tuned.

Signing off,

Henry To, CFA

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