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Stock Market Breadth Continues to Improve

(October 15, 2006)

Dear Subscribers and Readers,

On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 – which is now 575.51 points in the black.  On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505.  That position is now 455.51 points in the black.  Real-time “special alert” emails were sent to our subscribers informing them of these changes.  Subscribers can refer to our DJIA Timing System page on our website for a complete history of our DJIA Timing System signals.

As of Sunday afternoon on October 15th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco (“Sysco – A Beneficiary of Lower Inflation”), etc.  We are also very bullish on good-quality, growth stocks – as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general).  Moreover, the breadth of the U.S. stock market has improved substantially over the past week, while many international, non-commodity based stock markets have also been performing strongly over the past week.  At this point, the stock market is very overbought on a short-term basis, but that is to be expected in the early stages of an extended rally.  While it may be tempting to take quick short-term profits here, I urge our readers not to get “cute” and to try to time this market on a short-term basis.  I assure you – no trader on the face of this Earth can do this successfully on a consistent basis – not Jesse Livermore, not Bernard Baruch, not George Soros, Stanley Druckenmiller, and not even Steve Cohen of SAC Capital – who have actually just recently sworn off short-term trading (effectively forever) in his fund.

Let us now get on with our commentary.  I would first like to start with: “What makes a good financial market newsletter writer?”  Obviously, a newsletter writer that makes you money in the long run, right?  For a newsletter that is not focused on individual stocks, the best service a writer could do is to write to his/her subscribers in “diary form.”  By that, I mean a style where the author communicates to his readers in the most candid way – not only documenting his current views, but also his mistakes and what would lead him to change his views, his fears, his thoughts, his conjectures, and his opinions.  In doing so, he needs to be clear that what he writes is usually merely an opinion – an opinion that is formed by studying (somewhat scientifically) history and what has changed in the financial markets in the last few years or in the last decade.  No matter how convinced you are, there is always a chance you could be wrong.  And given that there is always a buyer for every seller in the stock market (and vice versa), there is always a good chance that one can be wrong no matter what the conviction level is.

A good newsletter writer always does a “post-mortem” on his trades and calls on market direction – no matter whether they made or lost money.  In short, a newsletter writer should come up with analyses and writings such that his life depended on it.  It should be cold-bloodedly honest and accountable.  When the market goes against you, it makes no sense to be calling the market “irrational,” or if the stock market is rallying, “a sucker's rally.”  It does not do you or your subscribers any good (especially if they are paying subscribers).  That is a huge cop-out – and one that no newsletter subscriber should tolerate.

I am writing all this because I “have been there, done that.”  I know that most folks really do not care if a newsletter writer calls a GDP or a trade deficit number correctly (unless they are speculating on GDP futures).  What they want to know is: Is the stock market going up?  And if so, what kind of industries will perform well going forward?  Moreover, as an employee in corporate America, will my skills still be of value to my employer in the near future?  If not, what can I do now to start a business or to secure myself, and my family?  For folks who have been wrong on the stock market since mid-August and are now calling this rally a “sucker's rally,” it is truly a cop-out.  As I mentioned in our October 1, 2006 commentary, “This cannot be any further from the truth, as according to the ICI, U.S. equity mutual funds actually experienced an outflow of $3.7 billion in August. Moreover, from May to August of this year, the outflow of U.S. equity funds was $23.1 billion – representing the highest four-month outflow since a $71.4 billion outflow from July 2002 to October 2002.  In other words, the folks that have been propping up this stock market has been the private equity investors and the hedge funds (not retail investors) – and most likely, the suckers that [folks are] referring to were the folks selling stocks (similar to the folks who sold during July to October 2002), not the folks buying stocks!”  And for folks who are still doubting this view, we now have another piece of evidence: The number of management buyouts (MBOs) has been increasing at a blistering pace since the beginning of this year.  In other words, the ultimate insiders (even more so than private equity investors or even Warren Buffett) are leveraging their own balance sheets to buy out their own companies and to take them private.  Such buyouts are in an entirely different universe of its own. I definitely would not label these folks as "suckers" unless I happen to be Fed Chairman Ben Bernanke and am thinking of raising the Fed Funds rate by 75 basis points later on October 25th.

Since we initially went 50% long in our DJIA Timing System on September 7th, we had argued and presented many pieces of “evidence” that this current rally is sustainable and that the stock market was making a significant bottom from July to mid-August.  The one missing factor was breadth – even though I had stated that it did not really matter since 1) We are now in a bull market for large caps, and 2) Initial rallies off of sustainable bottoms can sometimes be narrow in scope.  However, I also stated that while breadth “did not matter” early in the game, it is essential that breadth should improve at some point down the road.  And right on cue, the breadth of the U.S. stock market enjoyed a substantial improvement in the last week – not to mention the fact that many stock markets around the world (those that do no depend on commodities such as the Australian, the Canadian, the Russian, or the Arabian stock markets) have also been making new 52-week highs.

Following is a three-year chart courtesy of showing the action of the unweighted (or equal-weighted) S&P 500 vs. the S&P 500.  Please note that the action of the unweighted S&P 500 has been lagging the performance of the market-cap weighted (the true) S&P 500 until early last week, but has since made a new all-time high:

Weighted vs. Unweighted S&P 500 Index 3-Year

The fact that the unweighted S&P 500 has just made an all-time high suggests that the rally in the S&P 500 has not just been restricted to the mega-caps in the S&P 500.  Rather, it has been broad-based – as exemplified in the outperformance of the unweighted S&P 500 over the true S&P 500 ever since this cyclical bull market began in October 2002.   The significant improvement in U.S. stock market breadth can also be witnessed in last week's rally of 2.7% in the S&P 400, 3.0% in the S&P 600, 4.4% in the Philadelphia Semiconductor Index, 1.4% in the Dow Jones Utility Index, and 1.9% in the Dow Jones Transportation Index.  To top it all off, the number of new highs vs. new lows in the S&P 600 has also been making new rally highs, as shown by the following chart of the S&P 600 vs. the 10-day moving average of the new highs vs. new lows differential on the S&P 600 (again, courtesy of

S&P 600 Small-Cap New Highs and New Lows - Last week’s 3.0% rally in the S&P 600 went a long way in improving the breadth in the U.S. stock market... At the same time, the number of new highs vs. new lows in the S&P 600 also made a new rally high – confirming both the rally in the S&P 600 and the rally in the broader stock market...

As stated on the above chart – not only did the S&P 600 made a new rally high, but breadth in the S&P 600 improved substantially as well – thus confirming the latest rally in the broader stock market.  Note that we are also seeing similar improvements in breadth in both the S&P 400 and the NASDAQ Composite as well.

Moreover, according to the Bank Credit Analyst, we are also witnessing a broadening of the current stock market rally among international markets as well.  Quoting the BCA's October 12, 2006 commentary: “Our breadth measure for 36 major country markets has rebounded sharply in recent weeks, indicating that there is increasing participation in the equity rally. This reflects growing optimism that the U.S. economy will enjoy a soft landing and that inflationary pressures will diminish, judgments we concur with. Still, although breadth is improving, more growth-sensitive markets, industries and stocks are lagging as global economic growth moderates”.  Following is the chart showing a the BCA's world stock price index as well as the advance/decline for the 39 countries that the BCA keeps track of:

BCA's world stock price index and the advance/decline line

As mentioned by the Bank Credit Analyst, the countries that are lagging are those sensitive to growth, such as the Canadian, Australian, Brazilian, Russian, and the Middle Eastern stock markets.  Of course, there are always exceptions – and those are the Nikkei 225 (which makes sense as the Japanese monetary base as been experiencing the biggest plunges in history over the last six months), the South Korean stock market (actually, we are surprised that the South Korean stock market isn't weaker given the fact that the North Koreans have just tested a nuclear device), and the Taiwanese stock market (whose growth may be more correlated to the Philadelphia Semiconductor Index rather than the S&P 500).  Besides these three markets, however, many of the world's developed markets (and not-do-developed) have also be hitting new 52-week highs, as I will now show:

London Financial Times Index ($FTSE) 

Given the international nature of the FTSE and given its importance on the world's markets, it is imperative that any upside (or downside) in the S&P 500 is confirmed by a similar movement in the FTSE 100 (which represents approximately 80% of the total market cap on the London Stock Exchange).  Similar to the Dow Industrials vs. the Dow Transports, the FTSE 100 has at times led or followed the S&P 500, and this is telling me that the current rally in the S&P 500 is not a “sucker's rally.”

The next index is Hong Kong's Hang Seng Index.  The Hong Kong stock market is very important given that Hong Kong still represents the gateway to China today – and that any strengths or weaknesses in the Hang Seng index not only is a good representation of the Hong Kong economy, but the mainland Chinese economy as well:

Hong Kong Hang Seng ($HSI)

As shown on the above chart, the Hang Seng Index has also been making a new 52-week high.  Again, given the importance of the Hong Kong stock market (the Hang Seng represents approximately 70% of the total stock market cap traded on the Hong Kong Stock Exchange) and given its international nature, the fact that the Hang Seng Index is also confirming the S&P 500 on the upside is also a positive for the bulls.

Another important stock market benchmark is the DAX Index.  It is an index consisting of 30 largest German companies that are traded on the Frankfurt Stock Exchange.  The DAX index is also very important, as the Frankfurt Stock Exchange is ranked third in the world in terms of trading volume and sixth in terms of total market cap.  Just like the FTSE 100 and the Hang Seng Index, the DAX Index has also been making a new 52-week high over the last few days:

German DAX Composite ($DAX)

Other notable indices that are also making new 52-week highs include the Singapore Straits Times Index, the India BSE 30, the Shanghai Stock Exchange Composite, the Mexican Bolsa, the French CAC 40 Index, the Netherlands Amsterdam Exchange Index, and the Swiss Market Index.

For folks who are calling this a “sucker's rally” or that the market is being manipulated, I urge you to look at hard at the outperformance of the S&P 400 and the S&P 600 in the latest week, as well as the fact that most stock exchanges in the world today are making fresh 52-week highs.  Can the U.S. government, the Federal Reserve, Goldman Sachs, JP Morgan Chase, or Morgan Stanley manipulate all the major stock exchanges in the world?  Are the same “suckers” who are taking the S&P 500 to a new 52-week high also buying the Shanghai Composite, the Hang Seng Index, or the India BSE 30?  Can there even be so many “suckers” in the world?  Moreover, the fact that many of the world's “commodity markets” is underperforming confirms our scenario that we are now experiencing a deflationary boom, similar to what we had experienced during the late 1990s (but without the bubble valuations – for now).  Let me remind you (and myself) of one thing that I have said many times in our commentaries: Tops are inherently hard to call.  And by definition there can only be one top – and chances are that you are not going to be able to call it.  We are going to have to see much more investor optimism and divergences before I am even willing to hint of a top.  Again, while the U.S. market is short-term overbought and can correct any time, I would continue to hold the stocks that you fundamentally like as the intermediate trend definitely remains up for now.

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 October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to October 13, 2006) - For the week ending October 13, 2006, the Dow Industrials rose 110 points while the Dow Transports rose 88 points - the third consecutive week where both of the Dow indices have risen at the same time. More importantly, the Dow Transports again hit a multi-week high - as it hit a high of 4,657.87 last Friday - the highest close since July 19, 2006. While the two popular indices are now ST overbought, readers who are long should continue to hold on for now - and not try to be *cute* in timing any subsequent corrections - even though they are probably inevitable over the next few weeks.

For the week ending October 13, 2006, the Dow Industrials rose 110 points while the Dow Transports rose 88 points.  While the Dow Industrials rose yet further above its prior all-time high made on January 14, 2000, the action in the Dow Transports continues to be very encouraging as well – as its high of 4,657.87 last Friday represented the highest close since July 19, 2006.  For the bears who had been pointing out to the weakness in the Dow Transports as “evidence” that this rally was not sustainable, the most recent strength of the Dow Transports is thus a red flag (and thus encouraging for the bulls).  The rally in the Dow Transports, the Dow Utilities, the S&P 400, S&P 600, and the Philadelphia Semiconductor Index last week suggests this rally still has further to go (not to mention the fact that most of the world's stock market indices have also been making new 52-week highs).  Therefore, we remain 100% long in our DJIA Timing System.  Readers please stay tuned.

I will now continue our 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% in late June to 22.1% for the week ending October 13, 2006.  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) - For the week ending October 13, 2006, the four-week MA of the combined Bulls-Bears% Differentials rose from 20.4% to 22.1% - resuming its upward trend after the first decline since early August last week. Given that the four-week MA has is still on an upward trend and given that it is not overbought yet, readers may now want to look for higher prices here - and the market most probably won't endure a significant correction until this indicator gets overbought again.

During the week before last, the four-week MA of this indicator actually experienced a dip from 21.4% to 20.4%.  As this author contended last week, however, it most likely just represented a “well-needed” rest – as this indicator had been rising relentlessly since its bottom in late June (aside from a slight dip in early August).  It now looks like that the four-week MA will continue its rise in the upcoming weeks – given that this indicator is still not at a very overbought level and thus there is a good chance that the market will maintain its most recent trend of higher prices at least until this indicator gets overbought. 

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISEE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA hit its lowest reading since late October 2002 on September 15 and has since reversed and has even risen above the 50 DMA - suggesting that the market has bottomed and that the trend continues to be up.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment reversed back to the upside during the week before last (from 101.5 to 108.2) and has risen further to 115.5 in the latest week.  Meanwhile the 50-day moving average also reversed on the upside from an extremely oversold level of 109.1 to 110.5.  The fact that the shorter-term moving average has reversed back to the upside and has now crossed above the 50-day MA suggests that the market has already bottomed and is preparing itself for a further up move over the next few months.

Conclusion: In last weekend's commentary, I had stated that:

As of last Friday at the close, the breadth of the market is no longer a red flag – given the improvement in breadth on the NASDAQ Composite and given the huge rally in the Dow Transports last week.  Moreover, both the S&P 400 and S&P 600 are still in a solid uptrend.  The only red flag is the Philadelphia Semiconductor Index, as it actually closed down slightly last week.  However, this author believes that semiconductors are a good buy on purely a fundamental basis – no matter what the technicals are currently saying.  To me, there is no question that the Philadelphia Semiconductor Index would close above 500 at some point over the next few months.  Based on this assumption, this author will continue to remain fully-invested in both U.S. large caps and U.S. growth stocks.

The further rise in the U.S. mid and small caps, along with the Philadelphia Semiconductor Index and many of the world's stock market indices suggests that breadth is continuing to improve – not just locally but across much of the world as well (with the exception of the commodity-based stock market indices).  Again, we remain 100% long in our DJIA Timing System and has no intention of shifting to a less bullish stance anytime soon (unless we quickly hit DJIA 12,500 in the next five to ten trading days).

And finally, for those who still want to be calling tops in the current stock market, here is a useful quote from Sir John Templeton:

Bull markets are born on pessimism; grow on skepticism; mature on optimism; and die on euphoria.

Whether we are now in the “skepticism” or “optimism” stage is debatable (I would say we are closer to the former), but we are definitely not in the “euphoria” stage at this point – at least not for U.S. stocks.

Signing off,

Henry To, CFA

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