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Relative Valuations and a Review of Two Sentiment Indicators

(September 28, 2006)

Dear Subscribers and Readers,

As of Wednesday evening, September 27, 2006, the Dow Industrials closed at 11,689.24 and is a mere 43.74 points away from its all-time closing high of 11,722.98 made on January 14, 2000.    For those who have been counting, it has been a little over six years and eight months.  For the stock market history buffs, this is the fourth longest time period between successive highs in the Dow Jones Industrial Average, as shown by the following chart:

 DJIA Study: Longest Time Periods Between Successive Highs

The longest time period between successive highs in the Dow Jones Industrials remains the time period after the 1929 stock market crash - which was followed by the Great Depression, World War II, and the post World War II recession of 1946 to 1949.  Barring a deflationary bust start tomorrow, it looks like that record will continue to hold for the time being.  Interestingly – if the Dow Industrials does not make a new high in the next three weeks, then it will move up one spot and displace the February 9, 1966 to November 10, 1972 period as the third longest time period without a successive high in the Dow Industrials.  Given the recent market action, even that record is most likely to hold – as this author believes that a closing high above the January 14, 2000 high is imminent over the next couple of weeks.

So Henry, when you mentioned “relative valuations” in your subject line, do you mean that valuations are now cheap – given that it has taken more than six years and eight months for the Dow Industrials to make a new high?

No, I do not mean that at all.  We all know that the P/E ratio of the broad market has come down significantly, but on a historical basis – as everyone and his neighbor now knows – P/Es are still relatively high in general.  However, looking at P/Es is really a useless exercise, as traditional valuation ratios have historically not been reliably timing indicators when it comes to timing the Dow Industrials or the S&P 500.  Moreover, as I mentioned in our July 9, 2006 commentary, 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.  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 July 6, 2006 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 54.40 (as shown in the above chart), we are definitely nowhere close to an imminent top in the stock market just yet – all the more so given that the December Fed Funds futures contract is now pricing in a 12% probability of a 25 basis point cut in the Fed funds rate by the December 12th Fed meeting and a 36% probability of a similar cut by the January 31, 2007 meeting.  This is significant, as any cut in the Fed Funds rate going forward will most likely cause the Barnes Index to decline still further.

Now that we have gotten the concept of relative valuation (and how it still looks bullish from that standpoint) out of the way, let us know discuss a couple of sentiment indicators which we have not discussed in a while.  First of all, readers who have still not read our latest weekend commentary should go and do so.  And while you are reading that commentary to refresh your memory, please pay special attention to both the increase in the NYSE Short Interest as well as the NYSE Short Interest ratio of 7.0 – the highest ratio since July 1998.  In that commentary, I concluded: “Note that since this cyclical bull market began in October 2002, a spike in the NYSE short interest ratio has always led to a subsequent rally in the stock market.  Given that the current short interest ratio of 7.0 is the highest we have seen since July 1998, chances are that the market will continue its rally going forward – and the Dow Industrials should make a new all-time high within the next few weeks.

This bearish sentiment on the outstanding shares on the NYSE is also being confirmed by the short interest on the NASDAQ – as just-released data shows that short interest on the NASDAQ has increased another 85.7 million shares to 7.35 billion shares – another record high.  In fact, short interest on the NASDAQ has now made all-time highs during six of the last seven months.  Following is the monthly chart showing the NASDAQ short interest vs. the value of the NASDAQ Composite from September 1999 to September 2006:

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to September 15, 2006) - Short interest on the NASDAQ rose 85.7 million shares in the latest month and is now at another record high of 7.35 billion shares. Short interest on the NASDAQ has now made all-time highs during six of the last seven months. The 12-month increase in short interest is now at 26.53% - 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.

Note that short interest on the NASDAQ has just literally exploded since the beginning of this year.  On a year-over-year basis, short interest on the NASDAQ has increased more than 26.5% - the highest annual rate of increase since September 2001.  As mentioned on the above chart: Unless we are now going to experience another tech or telecom bust – then chances are that we have already experienced a significant bottom in the NASDAQ and should now see higher prices going forward.  Moreover, the fact that short interest has continued to increase despite the rise of the NASDAQ Composite from mid August to mid September is definitely a very good sign from a sentiment standpoint.

And finally, I want to discuss the Rydex Cash Flow Ratio – a sentiment indicator I have previously but not consistently discussed.  Readers can learn more about how the Rydex Cash Flow Ratio is calculated and why it is useful at the website.  Suffice it to say, it has been a very reliable contrarian indicator in the past.  Following is a long-term chart of the Rydex Cash Flow Ratio vs. the S&P 500 from April 1999 to the present:

Note that the Rydex Cash Flow Ratio has consistently stayed at very oversold territory despite the rise of the S&P 500 since early July. This is definitely unprecedented. Well – not totally unprecedented. Note that the Rydex Cash Flow Ratio actually declined during the consolidation from June to August 2003 – ultimately leading to a further rally extending into early 2004.

As mentioned on the above chart, the Rydex Cash Flow Ratio has consistently stayed at a very oversold level of approximately 1.00 despite the rally we have seen in the S&P 500 over the last few months.  This is virtually unprecedented in the history of the Rydex Cash Flow Ratio (unless one takes into account the significant decline of this ratio during the June to August consolidation phase in the S&P 500 – which ultimately had bullish implications), and suggests 1) the Rydex Cash Flow Ratio has turned into a broken indicator, or 2) The rally in the S&P 500 should continue for the foreseeable future until the Rydex Cash Flow Ratio goes back to the 0.75 to 0.80 area.  Given our bullish views on U.S. equities and especially U.S. large caps and growth stocks, 2) is definitely our most preferred scenario – especially since there is no credible evidence that the Rydex Cash Flow Ratio has stopped working as a reliable contrarian indicator.

For now, a review of the Barnes Index, the NASDAQ short interest, and the Rydex Cash Flow Ratios suggests that the uptrend in the stock market remains intact – and that a new all-time high on the Dow Industrials is now imminent.  Readers please stay tuned.

Signing off,

Henry To, CFA

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