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An Early 2007 Market Round Up

(January 11, 2007)

Dear Subscribers and Readers,

It has definitely been an exciting week so far – although the “excitement” had more or less been focused on the currency and commodity markets.  To sum up, many folks got whipsawed – but mostly those who are (or were) dollar bears or “peak oil” theorists.  Obviously, I want to devote a little bit of time to crude oil (I have already devoted a lot of ink to the U.S. dollar over the last couple of months) in this mid-week commentary, but since I have neglected the stock market for most of the last six weeks, I want to start off our commentary by discussing the U.S. stock market – and then onto the Japanese market.

Of course, there was a reason why we haven't devoted much ink to the equity markets recently.  Besides the fact that there was more of a trading/investing opportunity in both the currency and the commodity markets – the stock market – during late November and early December, were getting rather overbought on both a short-term and intermediate-term basis.  Since that time, breadth has continued to decline and demand for equities (especially from corporate insiders and private equity investors) have remained relatively weak.  It remains to be seen whether companies will come back into the market in droves to buy back their own shares (we wouldn't know this until after “earnings season”), or whether private equity investors will start utilizing their $160 billion “war chest” and unleash it onto the U.S. equity markets anytime soon.  For folks who want to buy stocks (hopefully not in energy, mining, or manufacturing), I would definitely wait until at least the first half of “earnings season” is over.

The lack of breadth and lack of demand for equities over the last four to six weeks is exemplified by the following chart showing the NYSE Composite Index vs. the NYSE Common Stock McClellan Oscillator and its corresponding Summation Index, courtesy of (note that this is a new chart available exclusively on

NYSE Common Stock Only McClellan Oscillator - The lack of breadth in recent weeks on the NYSE can be witnessed in the lower highs on the McClellan Oscillator and the peak in the Summation Index in late November.

As mentioned on the above chart, both the lack of breadth and the relatively low demand for equities in recent weeks can be witnessed in the lower highs of the NYSE McClellan Oscillator and the peak in the Summation Index in late November.  The most recent decline of the Summation Index from a level of over 800 to 330 at the close on Wednesday afternoon signals that breadth is continuing to get weaker – not stronger.  Going forward, the chances of a further correction in the stock market (especially for those stocks in established downward trends) are relatively high.  Again, for subscribers who are seeking to establish long positions, I highly recommend not doing so until at least a couple of week from now – or better yet, wait until earnings season is over.

In last weekend's commentary, I stated, “the market is most probably in the midst of a consolidation phase or a correction. Such a correction is definitely overdue, as bullish sentiment has turned higher in recent weeks (even though the market was in a consolidation phase) and as the market has not experienced a significant correction in over five months.”  A historically reliable sentiment indicator which is now telling us that the market is – at best – consolidating is the December 2006 Conference Board's Consumer Confidence reading.  Newer readers may not know this, but the Consumer Confidence Index has acted as a very reliable contrarian indicator from a historical standpoint.  While it has always been significantly better in calling bottoms during a bear market, it has also worked well in calling for significant tops during the 2000 to 2002 cyclical bear market – with its last successful contrarian signal coming on March 2002 at a Consumer Confidence reading of 110.7 and a DJIA print of 10,403.90.  During the subsequent four-and-a-half months, the DJIA declined more than 2,500 points.  Following is a monthly chart showing the Consumer Confidence Index vs. the Dow Industrials from January 1981 to December 2006:

Monthly Chart of Consumer Confidence vs. DJIA (January 1981 to December 2006) - After one of the biggest dips in history in October 2005 (which turned out to be a good buying opportunity), the Consumer Confidence Index bounced significantly from November to April 2006 - bringing us again to the top of the range at 109.6 (a high not seen since May 2002) we have experienced in this cyclical bull market. In retrospect, it was a good time to short. More importantly, Consumer Confidence just hit a relatively high level of 109.0. From a contrarian standpoint, this implies at least a pause in the bull market for now.

The last time the Consumer Confidence Index was this high was at the end of April 2006 – and we all know what happened afterwards.  The fact that this reading is now at a similar level to that of April 2006 and May 2002 suggests that subscribers who are thinking of initiating long positions in the stock market should be cautious for now, especially given the deteriorating breadth in the stock market as exemplified by the weakness in the NYSE McClellan Oscillator and Summation Index.

However, as I have been discussing over the last several months, I do not believe the U.S. stock market is close to a significant bull market top just yet.  The classic signs are not there.  In the short-run, the market is just working off an overbought condition incurred during the July to November 2006 run-up in prices.  A good timing indicator that has worked historically is the concept of “relative valuation” – a theme which I have been harping on for the last six months, including in our September 28, 2006 commentary.  As I stated in that commentary (and in previous commentaries), we have been utilizing the Barnes Index (please see our March 30, 2006 commentary for a description) as a measure of relative valuation between the two most important asset classes with money managers and investors today – that of 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 that the Barnes Index is still at a relatively low reading of 56.90 (it has come down during the last week given we are now in a new quarter and is thus using S&P 500 earnings), we are definitely not close to a significant top in the stock market just yet.  As a matter of fact, this author would not yet worry until the Barnes Index reaches a level of 80 or above.

As I have discussed before, any measure of relative valuations between stocks and bonds is very useful (historically, it has been a much better timing indicator than straight P/E ratios, for example) as long as 1) inflation does not get out of control, and 2) the U.S. economy does not enter into some kind of deflationary recession or depression.  More importantly, it can be argued that U.S. equities are also still undervalued relative to commodities, real estate, and even some emerging markets securities (such as India, for example).  This makes U.S. equities an especially attractive asset to hold at least for the foreseeable future – not only for domestic fund managers or retail investors, but for global investors as well (especially given that the U.S. dollar is undervalued on a purchasing power parity basis).

Bottom line: Even though the stock market may correct in the coming days, we will continue to hold our 100% long position in our DJIA Timing System.  In fact, any correction in the coming days may be used as a good opportunity to accumulate more U.S. equities.

The Nikkei

While I would really like to have some Japanese companies in my portfolio (let's face it, their equity markets are very attractive given that domestic interest rates are so absurdly low), I am still wary of the Japanese stock market (specially, large caps) in the short-run.  Moreover, since the end of the Bank of Japan's quantitative easing policy in March and the subsequent wounding down (which effectively ended a couple of months ago), there still has not been a “general washout” or “capitulation” of Japanese equity investors or even sentiment.  Given the historical correlation between the year-over-year rate of growth (or second derivative) in the Japanese monetary base (which is now very negative) and the year-over-year growth in the Nikkei (which was still at 6.9% at the end of December 2006), there is still a lot of downside risk for the Nikkei if the two indices converge to each other, as shown below:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to December 2006) - 1) Note that Japanese money growth has been plunging since the end of 2003 - with the latest Y-O-Y increase registering a highly negative reading of -20.0%. Such dismal growth will most likely mean a continuing consolidation in the Nikkei. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) has plunged since February 2006 - although it has definitely ticked up in the latest month.                

At this point (and keep in mind that my view may change over time), I am not willing to go long Japanese equities unless there is again decent monetary growth and unless the Nikkei plunges below 16,000 in the short-run.  I, for one, am not holding my breath.  This could be a multi-month process, especially since the Bank of Japan has had a dismal track record of making policy mistakes over the last 20 years.  Another policy mistake here and the number of Japanese youths who can be classified as the “lost generation” will increase substantially.

Crude Oil

To put it bluntly, crude oil prices have been crashing over the last few weeks – from a spot price of over $63 a barrel to slightly over $53 a barrel as I am writing this commentary.  In last weekend's commentary, I stated that I believe energy and other commodity prices will struggle in 2007 – even though I believe the long-term bull in energy and commodity prices remains intact.  However, energy in general was very oversold, and it has continued to get more oversold since Sunday evening.  I also posted a chart (showing the percentage of stocks in the Energy Select SPDR (XLE) that are above their 200, 50, and 20 EMAs, respectively) which illustrated this oversold condition (courtesy of  Following is an update:

Percent of Energy (XLE) Stocks Above Their 20/50/200-EMA

Over the last three trading sessions, energy stocks have gotten even more oversold – with the percentage of stocks above its 200 EMA declining from 40% on Sunday evening to 33.33% on Wednesday evening.  For folks that want to trade energy stocks here, now may be a good time to buy – especially stocks that are natural gas drillers or producers.  This author, however, is still waiting for an even more oversold condition (I want to see the percentage of stocks above its 200 EMA decline to below the 25% level) – which may or may not come.

More importantly, assuming the crude oil is now in a cyclical bear market, subscribers should keep in mind that oil prices can still fall a lot further, given:

  1. Continuing Central Bank tightening policies in the Euro Zone, China, and potentially Japan.  This should continue to have a depressing effect on global economic growth going forward.

  2. The concept of “Peak Oil” is rapidly losing popularity – starting with the announcement of the Chevron “Jack 2” discovery on September 6th.  If the true amount of reserves in the deep waters in the Gulf of Mexico comes in at the mid point of current estimates, then U.S. recoverable reserves would increase by 50%.  If one takes the potential of the Williston Basin into account, then the concept of “Peak Oil” really becomes a cruel joke (no pun intended).

  3. Continuing technological advances.  This has allowed Chevron to drill (and eventually to produce oil) in the deep waters of the Gulf of Mexico, and this has also allowed the USGS to boost the amount of recoverable reserves in the Williston Basin.  This has also allowed Canadian producers to produce and refine oil and tar sands economically.

  4. Marginal cost of production of oil today is approximately $40 a barrel.  Since the beginning of time in the oil industry, prices have always fallen back to its marginal cost of production at some point in time (natural gas is currently at this point right now, after falling more than 60% over the last 12 months).

As I am writing this commentary, however, crude oil is very oversold – with its spot price now 11% below its 50-day moving average.  As shown on the following chart, the price of oil has usually at least staged a short-term bounce after the spot price of oil has gotten over 10% below its 50-day moving average:

Daily Spot Crude Oil vs Percentage Deviation from its 50-Day Moving Average (March 1983 to Present) - As I am writing this, the spot price of crude oil is trading at approximately $53 a barrel and is 11% below its 50-day moving average. The $64 billion question is: How low is too low - given that we just experienced the biggest bull market in oil since the 1979 oil embargo?

That being said, there has also been times in the past when oil has continued to decline, such as the late 1985 to early 1986 period, the period immediately after the U.S. invasion of Iraq in 1991, the December 1996 to December 1998 period (Asian and subsequent emerging market crisis), the September 2000 to November 2001 period, and from March 12, 2003 to March 21, 2003 (when oil crashed $10 in just ten days).  Given that crude oil has just experienced the biggest bull market since the 1979 embargo, this author will most probably wait until we get an even more oversold condition in order to go long.  We will reevaluate this weekend, but for now, I am still favoring natural gas over crude oil.

Signing off,

Henry To, CFA

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