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Stock Market Action Encouraging

(August 31, 2006)

Dear Subscribers and Readers,

In our last couple of commentaries, we had (hopefully) made our case that it is folly to rely on simplified models to explain both past and future movements in the stock market (the S&P 500), such as anticipated future earnings growth for the S&P 500, the NAHB Housing Index, the amount of auto sales growth for the last 12 months, and so forth.  I also discussed the historical relationship of housing prices vs. consumer spending, and why the historical correlation was most probably caused by a “third-party” variable such as rising income.  Moreover, based on the Bank of England study, the UK and Australian experience, and not to mention the declining growth in U.S. consumer credit over the last four years (growth which has been below nominal GDP growth during that time), and there is a strong likelihood that neither the stock market nor the U.S. economy will endure a recession simply because of the declining growth of housing prices and/or the rise in housing inventories.

One of our subscribers told me I was wrong and that I should “keep it simple.”  And here, I think I may have been slightly misunderstood.

I am not trying to make this overly complicated for our subscribers (even though the stock market is the most complex animal there is to model).  I was trying to point out the fact that many of the simple “models” or simple “leading indicators” that folks are using to “predict” the stock market just hasn't worked in the past (such as the NAHB Index in 1990/1991 and the advance or decline in S&P 500 earnings growth).  If these indicators have not historically worked, then why should we rely on them even though they may be “simple?”  Instead, I have always asked our subscribers to “plant your feet firmly on the ground” and to look at the true leading indicators of this market thus far – such as the Dow Utilities, the homebuilders, and the retailers.  I also asked our subscribers to keep track of breadth indicators – such as the NYSE A/D (operating companies only) line, new highs vs. new lows on the NASDAQ, as well as both the McClellan Oscillator and the Summation Index.  Finally to top it all off, I also asked our subscribers to keep track of sentiment on the markets – such as the AAII and the Investors Intelligence Surveys, the amount of mutual fund inflows/outflows (which is a good gauge of what retail investors are doing with their money), as well as short interest on both the NYSE and NASDAQ.  Many of these indicators have been telling me that retail investors have been capitulating – especially from U.S. large cap stocks – even as U.S. company buybacks are now the biggest in history and even as private equity funds have been snapping up U.S. corporations en masse.  This is one reason why I have been trying to dig for a bottom.  While the jury is still out (we will find out probably by the second week after the Labor Day Weekend as volume starts to make a come back), the action of the stock market over the last couple of weeks have definitely been encouraging.  Let me now illustrate.

In our August 20, 2006 commentary (“The Evolution of the Markets”), I had asked our subscribers to keep track of three indicators (in order of importance) – those being the Nasdaq Daily High-Low Differential Ratio, the Dow Jones Utility Average, and the U.S. Homebuilders ETF.  Since that commentary, all three indicators have performed well – with the former two “breaking out” of resistance and the latter one holding well halfway between its support at $30.10 (former low) and resistance $32.37 (former high).

The NASDAQ Daily High-Low Differential Ratio

Since mid-August, the NASDAQ Daily High-Low Differential Ratio (new highs minus new lows divided by total issues traded on a given day) has been vacillating near the zero line – that is, until yesterday.  As of Wednesday, August 30th at the close, this ratio closed at 2.28% (with 89 new highs and 17 new lows) – a high not seen since June 30th.  This is a very powerful “breakout” reading and should be heeded – especially given that this ratio has been mostly in negative territory since May 11th.

So Henry, what makes you think this is not just a one-day anomaly – especially since this indicator gave us a reading of 2.40% and then promptly reversed back to the downside?  That is a good question.  To argue for the case that this latest positive reading is now “for real,” I would like to turn to a longer-term and historically more reliable indicator of the NASDAQ new highs and new lows.  In this case, I would like to use the 10-day moving average of the NASDAQ High-Low Differential (please keep in mind that I am not using the ratio here).  Following is the 10-day moving average of the NASDAQ High-Low Differential vs. the NASDQ Composite courtesy of

Ten-day moving average of the NASDAQ High-Low Differential turning up (and now in positive territory) after being in a hugely oversold condition. Probability now suggests further upside in the NASDAQ Composite.

As the above chart shows, the ten-day moving average has been turning up since late July and has just recently crossed into positive territory – something that it has not been able to do since late May.  Given that this indicator was in such oversold territory as late as last month, probability now suggests further upside in the NASDAQ Composite for the foreseeable future. 

The Dow Utilities

In our August 20th commentary, I stated that: “Historically, the Dow Utilities has led the overall stock market by 3 to 12 months.  During the first half of 2006, I stated that the underperformance of the Dow Utilities was also a red flag for the stock market, as it had topped out in early October 2005 and actually put in a lower high in late January 2006.  The Dow Utilities continued to underperform going into early May – which in retrospect was a great warning sign to stock market bulls…”  I also stated that a close above 440 in the Dow Utilities “is the key for a more bullish stock market scenario right up ahead…”  Since that commentary, the Dow Utilities has managed to close above the 440 level on three separate occasions – on August 22nd, August 28th, and August 29th.  Following is a weekly chart of the Dow Utilities courtesy of

The Dow Utility Average finally surpasses its last bull market high – officially extending the life of this current cyclical bull market.

As mentioned on the above chart, the Dow Utilities has finally convincingly closed above the last bull market in early October – thus “officially” extending the life of this cyclical bull market just a little bit further.  Moreover, based on both PPO and the timeframe, the Dow Utilities is still nowhere near an overbought level just yet.

The Homebuilders ETF

Again, in our August 20th commentary, I stated: “As this author has discussed in our commentaries for many months now, the homebuilding sector has been one of the leading indicators of the current cyclical bull market.  We cited the homebuilders as a “red flag” for the stock market when many of the homebuilding stocks topped out in late March and early April – even as many of the gurus and the mainstream media was still bullish on the stock market.”  However, the action of the homebuilders since its July lows have been very encouraging – see the following daily chart of the XHB courtesy of for further clarification:

XHB (ST SPDR Homebuilders ETF) AMEX

As shown on the above chart, the XHB has put in a series of high lows since late July – ending with $30.10 last week.  The XHB closed at $31.15 today and is bumping up against resistance at the 50-day moving average of $31.64.  Immediately above the 50-day moving average is another resistance level – its most recent high at $32.37.  Should the XHB rise above $32.37 anytime soon (even on an intraday basis), then this will confirm the bullish movements in both the NASDAQ High-Low Differential Ratio and in the Dow Jones Utility Average.

Finally, both the NYSE and the NASDAQ short interest numbers (as of the settlement date of August 15, 2006) recently jumped to all-time highs – suggesting that there is a huge prevalence of bearish sentiment across the U.S. stock markets:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to August 15, 2006) - For the month ending August 15, 2006, total short interest on the NYSE increased 340 million shares to 9.64 billion shares - the third consecutive month that it has made a new all-time high and only 360 million shares short of a 10 billion share short interest. Moreover, the 12-month rate of increase of 12.3% represents the greatest rate of increase since May 15, 2005 - suggesting that the market has or is in the midst of making a significant bottom.

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to August 15, 2006) - Short interest on the NASDAQ rose 128 million shares in the latest month and is now at another record high of 7.27 billion shares. Short interest on the NASDAQ has now made all-time highs during five of the last six months. The 12-month increase in short interest is now at 24.85% - the highest reading since the 34.27% reading in September 2001. Unless we are going to have another tech bust (which is not likely), then there is a good chance we have already reached a sustainable bottom on the NASDAQ Composite.

In a sustained bear market, rising short interest numbers are not too much of a concern for the bears.  But until that has been substantiated (for now, the uptrend still holds), then the skyrocketing short interest numbers on both the NYSE and NASDAQ are bullish for the stock market – in that the shorted shares on both the NYSE and the NASDAQ will provide “fuel” for the bulls to take the market higher going forward.  And while some readers have stated that much of the action over the last two weeks has been due to short-covering, we definitely wouldn't know until late September.  For now, any speculation of a short-covering induced rally in the last two weeks is mere speculation and should not be taken as fact.

Signing off,

Henry To, CFA

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