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Is Our Short-Term Scenario Busted?

(August 10, 2006)

Dear Subscribers and Readers,

Wow – I guess too many folks were expecting a rally after the Fed pause on Tuesday afternoon.  In more normal times, two days of action are definitely not enough to prove any scenario wrong – but it is certainly discouraging given that the market failed to rally despite Cisco beating estimates and experiencing a one-day rise of 14% (and despite a daily equity put/call ratio of 0.91 on Tuesday – the most oversold daily reading since mid-April 2005).

While the earnings report from AIG showed that the company beat estimates in the latest quarter, the after-hours action in AIG is certainly not encouraging, as it was down 0.75% in after-hours trading at the close.  And don't look for help from the company going forward either, as earnings are down 29% on a year-over-year basis due mainly to margins being squeezed in Japan and Taiwan.

Now, readers may recall that this author based his short-term bullish scenario over the weekend partially on the strength of the homebuilders.  In our weekend commentary, I stated: “Another sign calling for at least a short-term rally is the recent strength in the homebuilders …  As one can see [in the most recent daily action], the XHB basically crashed in mid-June accompanied by very high volume and has since reversed – also accompanied by very high volume.  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.”

The action of the homebuilders had been very encouraging from late July until recently (in fact, just the last two days).  Following is the most recent daily chart of the S&P Homebuilders ETF courtesy of Stockcharts.com:

XHB (ST SPDR Homebuilders ETF) AMEX - The XHB experienced a one-day reversal last Friday – and was further confirmed by the two down days on Tuesday and yesterday – both days accompanied by high volume.

As mentioned on the above chart of the S&P Homebuilder ETF, homebuilders experienced a one-day reversal last Friday.  At the time, this author was still optimistic – as the homebuilders were very overbought on a short-term basis and thus were due for a correction.  However, last Friday's reversal has since been confirmed by the declines of Tuesday and Wednesday, and given that these two down days were accompanied by high volume, there is a good chance that homebuilders have reversed and may head to lower levels from here.  Yesterday's decline of the homebuilders was caused by a bleak outlook from Toll Brothers.  Quoting from the Forbes article: “Based on the relatively solid state of the U.S. economy, Chairman and CEO Robert Toll expected some housing-market aches--but not this much quarterly pain. In a statement, the eponymous chief explained, "It appears that the current housing slowdown...is somewhat unique: It is the first downturn in the 40 years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors."”  Given that many homebuilder CEOs are still very optimistic about their businesses, there is a good chance that future outlooks from homebuilders CEOs for the rest of 2006 will be further ratcheted down.

Again, since the action of the homebuilders has been a leading indicator of the broad market, today's decline is very ominous.  In the meantime, the Dow Transports has been downright dismal, as it further declined 2.9% yesterday (mostly due to the most recent price war initiated by United Airlines).  For the week, the Dow Transports is down 4.9%.  Since the May 9th top, the Dow Transports is down a whopping 16.7%.  Since the Dow Transports has been a leading index for the cyclical bull market that began in October 2002, we definitely need to respect this down action in the Dow Transports and give the bears the benefit of the doubt.

Another positive scenario (for the short-run) that this author had been looking for was the reversal of the NASDAQ Composite – given that the daily High-Low Differential Ratio of the NASDAQ Composite finally moved to positive territory (at 0.54%) last Friday – after having been negative territory effectively since early July.  It also represented the third time at such a try ever since early May:

Daily High-Low Differential Ratio of the Nasdaq vs. the Nasdaq (January 2003 to August 9, 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. At the time, I said that this may be 'third time lucky' and that this was 'certainly the right time to rally.' The market did not comply, however, and this ratio again slipped back to negative territory on Monday and actually closed at a highly negative value of minus 4.09% yesterday.

This author had been anticipating that the third attempt to remain in positive territory would be sustainable – especially given the highly oversold condition of the NASDAQ Composite and of the NASDAQ Daily High-Low Differential Ratio.  Alas, this was not to be – as the ratio promptly slipped back into negative territory this Monday and actually closed at a highly negative value of minus 4.09% yesterday.  Judging by the most recent action in the NASDAQ and given that the NASDAQ Composite is not “fully oversold” yet (I will provide some targets this weekend), this author will have to conclude that the breaching of the 2,000 level on the NASDAQ Composite is inevitable at some point.

And finally, the relative strength of the Retail HOLDRS (RTH) vs. the S&P 500 just touched a new low at the close yesterday – touching a level not seen since early January 2003.  Given that the relative strength of the RTH vs. the S&P 500 has been a leading indicator of the broad market (from two to eight weeks) since the beginning of this cyclical bull market in October 2002, this most recent dip of the relative strength of the RTH is definitely very ominous:

Relative Strength (Weekly Chart) of the Retail HOLDRs vs. the S&P 500 (May 2001 to Present) - At Wednesday at the close, the relative strength of the RTH vs. the S&P 500 sank to a level not seen since January 2003. This is a worrying sign, as the weakness of the RTH in January 2003 was a foreshadowing of the decline in February and March 2003. At the same time, it may be wise to start looking at retail stocks once again.

Unfortunately – even though insider buying, corporate share buybacks, cash acquisitions, and valuations are still giving us very bullish signals, these are all longer-term indicators.  In the short-run, technicals rule – and they are currently not painting a pretty picture.  To make matters worse, we are still not that oversold in many of the major indices (e.g. Dow Industrials and the S&P 500) – nor are we seeing oversold readings in many of our technical indicators such as the NYSE McClellan Summation Index, the VIX, the ARMS Index, or the 10-day equity put/call ratios.  We are seeing bullish signals from our most popular sentiment indicators, such as the AAII and Investors Intelligence Surveys, but readers should remember this: Stock market crashes tend to happen when these surveys are oversold – and right now (or the next two to eight weeks) is as good a time as any.

And given all the talk of inflation, it is interesting to note that deflation is now becoming more common once again – as exemplified by the round of airfare price cuts today and the continuing decline in homebuilder new orders.  As I have mentioned before, China briefly exported some inflation in 2005 (based on Hong Kong re-export prices) but since the end of 2005, China has been again exporting deflation.  More importantly, Japan is now also exporting deflation in spades – as many Japanese firms have ramped up their capital spending both last year and this year YTD at the expense of profit margins.  Over the long-run, this author will avoid investing in cyclical companies, such as auto manufacturers, airliners, mining companies, and so forth.  Instead, we will look to invest in companies that will benefit from the continued consumer good deflation being exported from China and Japan – such as Wal-Mart, Best Buy, and other retailers, as well as companies that have sustainable high margins such as Dell, Microsoft, Intel, and eBay.

Because of the horrible technicals and the still-tightening central banks, this author is currently planning to shift from a 50% long position in our DJIA Timing System (established at DJIA 10,770 on July 18th) to a completely neutral position sometime soon.  At this point, there is no reason to just sit and wait for a better exit point – given that the Dow Industrials could be many points lower next week.  We will provide more price targets and what indicators to watch for in this weekend's commentary.  Over the long-run, this author is still bullish on the U.S. domestic large-caps, but in the short-run, readers should continue to expect weakness in U.S. equities in general.  Readers please stay tuned.

Signing off,

Henry To, CFA

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