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Market Overbought But Uptrend Remains Intact

(January 21, 2007)

Dear Subscribers and Readers,

As is described in the title of this commentary, the market remains “overbought” although the “uptrend remains intact.”  This has been the theme for at least a couple of months now – and has been a great lesson for folks who have been consistently calling a market top and had continued shorting into each new high.  As of Sunday afternoon on January 21, 2007, this theme remains in place, although the market has definitely gotten less overbought (in the short-term) over the last couple of weeks or so.  While there definitely are some danger signs, I do not believe the market is making an imminent top (although subscribers should remember that February is a seasonally weak month) just yet.

Before we continue with your commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,180.53 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,060.53 points

Some of our readers have specifically asked when we would exit our long positions in our DJIA Timing System – given the “profits” that we have made over the last four months or so.  My answer: The U.S. stock market remains in a cyclical bull market, and until we see signs of a significant top, we are not scaling back just yet.  Whether we will just scale back to a 50% long position or go short – this will depend on my future convictions.  For now, those convictions are firmly in place for a continued run in this bull market.  If, however, the Dow Industrials rallies 500 points within the next week or so (on weak breadth or weak volume), then we will scale back our long position to a 50% long position in our DJIA Timing System.  Readers please stay tuned.

As of Sunday afternoon on January 21, 2007, 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 (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel, GE, and American Express. We are also bullish on Yahoo, Amazon, and most other retailers as this author believes that “the death of the U.S. consumer” has been way overblown.  We also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials.  Moreover – judging by what we saw at the Consumer Electronics Show in Las Vegas a couple of weeks ago, there is a good chance we are now seeing a revival of Sony as a great global corporation (barring a global economic recession, the rest of this and the next decade will be known as the age of the emerging market consumer).  We also continued to be very bullish on good-quality and growth stocks in general.

In the short-run, the major stock market indices still look strong, although readers who are long individual stocks will definitely need to watch out given that earnings reporting season is now ramping up (many individual stocks – even Apple and IBM – can get hit even should the market indices continue to rally).  We are now probably at a stage where breadth in the stock market is narrowing – with the major indices being supported by a decreasing number of stocks as time goes on (such as during the April 1998 to January 2000 period).  I believe those stocks will be the blue chip, large caps such as what I had mentioned about – such as Home Depot, Wal-Mart, Microsoft, GE, etc.  As for the global stock market rally we have been witnessing over the last few years, I also believe that rally will narrow going forward – with the U.S. stock market being the stand-out.  I also believe that energy has made a good short-term bottom, and that while energy should continue to struggle this year, the secular energy bull should remain intact – as long as there is no significant breakthrough in battery or solar energy in the next few years.

Let us begin our “market overbought but uptrend remains intact” commentary by reviewing the most recent action of the Dow Industrials vs. its Advance-Decline line.  As subscribers may know, the A/D line has historically been a very reliable precursor of a significant top, although there have also been times when the A/D line and the actual index it represents topped out at the same time (although such instances are relatively rare).  However, there have also been times when the A/D line is too early in calling a top, such as the topping out of the NYSE A/D line in April 1998 – nearly a whole two years before a corresponding top in the major indices such as the DJIA, the NASDAQ Composite, and the S&P 500.

Without further ado, following is a three-year chart of the Dow Jones Industrial Average vs. the A/D line of the DJIA, courtesy of

Dow Jones Industrial Average vs. the A/D line of the DJIA - Note that during the formation of the two prior tops in the Dow Industrials, the DJIA A/D line actually had already topped out two to four months before the DJIA had topped out. As a matter of fact, the DJIA A/D line was actually higher in late December 2004 than it was in May 2006 – which in retrospect was a huge red flag for the Dow Industrials. Given that the DJIA A/D line is now at an all-time high, the chances of the DJIA itself making a top soon is relatively remote.

As discussed in the above chart, the Dow Industrials A/D line is still making all-time highs as we speak – suggesting that the Dow Industrials Average is still nowhere close to making an all-time high.  Over the last few years, a significant top in the Dow Industrials has usually been preceded by the topping out of the DJIA A/D line by at least a couple of months.  Should the DJIA A/D line top out next week, this would probably mean a continuation of the rally of the Dow Industrials to at least mid to late March (for an earlier reference, the top of the Dow Industrials in January 2000 was preceded by a top in the DJIA A/D line in May 1999 – a lead time of eight months!).  Readers please stay tuned.

The second item on the list is relative valuations – a theme which I have been harping on for the last five to six months, including in our September 28, 2006 commentary and our November 26, 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 vs. the NYSE Composite from January 1970 to the present

The Barnes Index got as high as 67.60 in early May 2006, as we discussed in our May 7, 2006 commentary (“Playing the Probabilities”).  At the time, I stated: “In our past commentaries, I discussed that we will not enter the “dangerous zone” (the zone when cash/bonds start to become attractive relative to equities) until we hit the 65 to 70 level on the Barnes Index.  As of last Friday at the close, the Barnes Index finally entered the “dangerous zone” when it registered a reading of 67.60 … Of course, a huge decline isn't imminent here – especially given the fact that the market has gone on to make higher highs until the Barnes Index touch the 90 level (or even higher such as August 1987, April 1998, and January 2000) in 1981, 1983 and 1990.  But today's reading of 67.60 is consistent with the level made in the 1973 top, as well as the January 1980 top (which occurred in conjunction with the top in gold and silver prices).  One should at least expect a significant correction here – especially given the continuing rise in long bond yields and the fact that Fed still has at least one more Fed Funds rate hike to go on May 10th.”

In retrospect, we did manage to get our “significant correction” – and the Barnes Index has been instrumental in calling that.  As of last Friday at the close, however, the Barnes Index closed at 61.60 – still too far on the low side to be calling a significant top just yet.  Moreover, as a cyclical bull market matures, valuations have typically continued to rise – typically surprising everyone as it continues to rise, even the most bullish of traders.  Because of this, I would not be calling a top – even a short-term one – until the Barnes Index has reached a higher level than what we witnessed on May 7, 2006.  Instead of the 65 to 70 “dangerous zone” that we discussed earlier last year, I am now revising this “dangerous zone” to 70 to 75.  As for the ultimate top in this cyclical bull market, I would not be surprised if the Barnes Index rises to the 100 level (or over) before we see the death of this current bull market.

The third and final item (for this weekend's commentary anyway) reinforcing the view that the cyclical bull market isn't over yet is the NYSE Short Interest Ratio.  Without further ado, following is a weekly chart showing the NYSE Short Interest Ratio vs. the Dow Industrials from January 1994 to the present:

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present) - The latest NYSE SI ratio rose from an already high reading of 6.3 to 6.8 in the latest month. With this latest spike, the NYSE SI ratio is now at a high not seen since September 2006, and prior to that, July 1998 - suggesting the likelihood of higher equity prices ahead.

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.  This was true as recently as September 2006 – when the NYSE short interest ratio hit 7.0 – a level not seen since July 1998.  As mentioned above, the latest ratio of 6.8 is now at a high not seen since September 2006, and prior to that, July 1998.  Given the high short interest ratio, chances are that the market will continue its rally going forward – and the Dow Industrials should make a new all-time high over the next few weeks.

Not everything is rosy, however, and one thing that I am watching is the most recent underperformance of the small caps – as exemplified by the underperformance in both the S&P 600 and the .  Following is a chart of the S&P 500 vs. the S&P 500 Advance/Decline line, courtesy of

S&P 600 Small-Cap Advance/Decline line

As mentioned on the above chart, both the S&P 600 and the S&P 600 A/D line has failed to break above its previous highs.  Could this be the canary in the coal mine?  Probably – but readers should keep in mind that an index such as the S&P 600 could potentially underperform for months even should a large cap index such as the S&P 100 or the S&P 500 continue to rally to new all-time highs.  This has happened before, and will happen again.  For now, the underperformance of the S&P 600 is just another divergence we should have on the back of our mind as we continue to invest, trade, or watch the stock market.

Let us now discuss the most recent action in the U.S. stock market via 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 January 19, 2006) - For the week ending January 19th, the Dow Industrials rose 9 points while the Dow Transports rose 99 points. The Dow Industrials closed at near an all-time high for the week (after making a new all time-high on Monday), while the Dow Transports closed at a within 22 points of its November 16, 2006 high (the highest level since the top in May 2006). While this latest rally was strong and broad-based in nature, my guess is that it will only be sustainble in nature should the Dow Transports close above its November 16th high of 4,881.57 in the next week or so. Given that February is a seasonally weak month, however, subscribers should temper their bullishness.

For the week ending January 19, 2007, the Dow Industrials rose 9 points while the Dow Transports rose 99 points – with the latter now only 22 points away from its closing high of 4,881.57 on November 16, 2006.  Should the Dow Transports break above its November 16 high in the coming days, chances are that there will be more upside in both the Dow Industrials and the Dow Transports over the next few weeks.  For now, subscribers should hold off on making new purchases until at least earnings announcements are over.  We also continue to remain 100% long in our DJIA Timing System, as I believe that the market has still not made a significant top yet.  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 30.5% for the week ending January 19, 2007.  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 January 19, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 28.5% to 30.3% - the highest reading since the week ending January 20, 2006. Sentiment levels are now getting close to the extremes we have witnessed over the last few years - so it is now time for the bulls to be careful. In the meantime, however, the intermediate trend is still up but don't be surprised if we see a significant correction in the coming days given we have not experienced one in over five months.

As mentioned on the above chart, the four-week MA of this indicator has been rising consistently since early August – although it did dip slightly from mid November to mid December.  Subscribers should note that this reading is now approaching levels that are close to its bullish extremes over the last few years – so it is now time to be careful.  That being said, the uptrend still remains up for now – but don't be surprised if we see a significant correction in the coming days as the market “corrects” this rise in bullish sentiment (February is a seasonally week month, after all).

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) - More consolidation this week. After rising relentlessly from late September to mid November, the 20 DMA of the ISEE Sentiment pulled back from mid November to mid December and is now once again consolidating at around the 140 level. The fact that the 50 DMA has caught up with the 20 DMA is definitely a well-needed *rest,* and given that the ISE sentiment is not that overbought, suggests that stocks should continued to be purchased *on the dips* in general.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment has been rising relentlessly since late September (bottoming at 101.5), after dipping slightly from mid November to mid December, has been, and is still consolidating in the 140 area.  Meanwhile the 50-day moving average is also consolidating.  The latest pullback in both the 20-day and 50-day moving averages was definitely a well-needed rest for bullish sentiment – which is imperative in order for the rally to sustain itself.  Bottom line: While the average of the AAII, the Investors Intelligence, and the Market Vane's Bullish Consensus is signaling “overbought” and “be careful,” the ISE Sentiment index isn't confirming – and thus I believe the uptrend in the stock market remains intact.  We are still not close to exhaustion just yet.

Conclusion: Based on all the indicators I am currently watching (monetary, liquidity, fundamental, technical, valuation, etc.), the intermediate uptrend in the U.S. stock market remains intact.  Moreover, it is my contention that relative strength will shift to the U.S. stock market in 2007 – and specifically, U.S. large cap, brand names.  For folks who are considering cutting down on their equity allocation or just risk in general, I suggest you cut your exposure to both European and Emerging Market equities (in ten year's time, you probably will not be able to distinguish between the two anyway).  At the same time, however, subscribers should note that I am continually on the look-out for possible read flags, such as what we discussed above regarding the S&P 600 A/D line.  For now, we remain 100% long in our DJIA Timing System, although we may shift to a less bullish stance of 50% long should the Dow Industrials experience a quick rise to 13,000 or so (on weak breadth or weak volume) in the short-run.  Readers please stay tuned.

Signing off,

Henry To, CFA

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