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A Potential Short in the Midst of a Bull Market?

(February 18, 2007)

Dear Subscribers and Readers,

I hope all our subscribers have had a good weekend.  The market certainly did – with the Dow Industrials rising 1.5% and the S&P 500 1.2% for the week.  More importantly, all three Dow indices (the Dow Industrials, the Dow Transports, and the Dow Utilities) all made all-time highs last Wednesday – the first such occurrence since March 17, 1998.  Excluding a similar signal in 1929 and the signal on March 17, 1998 (the reasoning behind this omission is discussed in this following post in our discussion forum), such a signal has often been a precursor for more stock market gains ahead.

Despite the continued and recent strength in the stock market, two of the weakest sectors within the stock market have been the semiconductor industry and the subprime lenders.  The semiconductor industry has always been a very cyclical industry, and the best time to buy semiconductor stocks (in general) has always been during times of high inventories and predictions of “doom & gloom.”  Moreover, I expect the adoption of Microsoft Vista to accelerate sometime later this year with the release of “Service Pack 1.”  Coupled with the commercialization of the “solid state hard drive” for ultra-mobile PCs and high-end laptops, I expect the demand for semiconductors to soar and for inventories to tighten later this year.  As for subprime lenders, it is definitely too early to say the industry has bottomed.  Sure, there has been a shakeout among the smaller subprime lenders as their credit lines were cut – but readers should keep in mind that this has occurred while both the U.S. and global economies are still awashed in liquidity.  Therefore, don't expect the Federal Reserve to come in and save these lenders (by cutting rates), unless there is a high probability the subprime lending industry would pose a risk to our financial system.  If anything, it now looks like that the major central banks are still continuing to tighten, as exemplified by the recent messages coming out from both the European Central Bank and the Bank of Japan.  At this point, however, I do not believe there will be any “spillover effects” from the troubles in the subprime industry.  That being said, I will continue to monitor developments in this industry and report back if my assessment changes.

Before we continue with the rest of our 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 1,382.57 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,262.57 points

Given the recent upside surprises in both the Euro Zone and Japan - not to mention the continued strength in the Nordic countries and in the majority of emerging markets around the world, chances are good that the U.S. stock market will continue to strengthen in the weeks and months ahead.  As of Sunday afternoon on February 18, 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 (Intel is now close to two generations ahead of AMD), 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 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.  We also continued to be very bullish on good-quality and growth stocks in general.  In terms of individual countries, we continue to be bullish on both the Taiwanese stock market and the Taiwanese dollar.

Our view that growth stocks should outperform value stocks going forward is also shared by the Bank Credit Analyst.  In a daily commentary last week, the BCA stated: “Generally, soft economic landings have led to a shift in investor preference toward growth. One reason is that as fear of recession and profit contraction ebbs, confidence in the durability of a long run economic expansion starts to build momentum. Under these conditions, analyst long-term (5-year) earnings forecasts have had a tendency to be ratcheted higher. In fact, a re-rating phase has already begun, as long-term profit forecasts have started to grind higher. Keep in mind that the last two major re-ratings in long-term forecasts have occurred well after both profit margins and profit growth had peaked, implying that an increase at the current phase of the business cycle would be well within historical norms. Inevitably, increased conviction in the long-run outlook has led to growth stocks to outperform value, and we expect a replay to unfold.”

Following is a chart courtesy of the Bank Credit Analyst showing the ratio of the performance of the S&P 500 Growth Index and the S&P 500 Value Index over the last 20 years:

Ratio of the performance of the S&P 500 Growth Index and the S&P 500 Value Index over the last 20 years

As shown on the above chart, value stocks in general have outperformed growth stocks over the last seven years.  In fact, relative performance of growth vs. value is now at its lowest since late 1994 (the last time the U.S. economy had a successful “soft landing), suggesting that it is only a matter of time before growth stocks outperform value stocks.  As stated by the above commentary from the Bank Credit Analyst, that time is probably now upon us.

But Henry, what could provide the “fuel” for a further upside in the stock market, especially a stock market that is conducive for a “re-rating” of growth stocks?  Isn't the bull market that began in October 2002 now “long in the tooth?”

I would attempt to answer the latter question first.  Yes, the bull market that began in October 2002 is now maturing.  But so was the market in early 1995 when it was emerging out of its “soft landing” in 1994, as the bull market that was to extend into early 1998 really began in October 1990.  As the above chart showed, the bull market in growth vs. value began in late 1994 – and it was not to end until early 2000.  While I am definitely not looking for a similar rise in growth stocks in the current cycle, I would not be surprised if growth stocks outperformed value stocks by a total of 20% to 30% over the next few years. 

Moreover, in previous commentaries, I had discussed that based on our indicators such as 1) the amount of money market funds vs. the S&P 500 market cap, 2) equity and equity mutual fund holdings as a percentage of total household assets, 3) mutual fund inflows/outflows data per, 4) short interest outstanding on the NYSE and the NASDAQ, 5) relative valuations of U.S. equities vs. U.S. bonds, international stocks, real estate, and commodities, and so forth – this current bull market in U.S. stocks is still not close to a top just yet.  The potential long-term bullishness inherent in these indicators is also being confirmed in our most popular sentiment indicators – those being the American Association of Individual Investors (AAII) and the Investors Intelligence Surveys.  I have not covered them on an individual basis since our October 8, 2006 commentary (rather, these two indicators have been combined with the Market Vanes Bullish Consensus to come up with a combined indicator) so I want to provide a quick update.  However, instead of providing the reader with weekly readings, I want to show both surveys on a 52-week moving average basis in order to smooth out any spikes or “seasonal effects” (along with giving the reader a longer-term perspective).  In essence, the readings of these two surveys suggest that the premise that there are “too many bulls out there” is a false premise.  Let us first start with the American Association of Individual Investors (AAII) Survey.  During the latest week, the 52-week moving average of the Bulls-Bears% Differential increased from 4.9% to 5.2%.  While this reading is the highest reading since early December of last year, it is more important to note that this only represents a small bounce from a low of 4.3% achieved during late December/early January – a low which had represented the most oversold reading since June 2003.  Following is the 52-week MA of the AAII survey vs. the weekly closes of the Dow Industrials from July 1988 to the present:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (July 1988 to Present) - The 52-week moving average of the AAII Bulls-Bears% Differential touched a low of 4.3% in late December/early January (the most oversold level since June 2003) and is currently still at a relatively oversold reading of 5.2%.

As mentioned on the above chart, the 52-week MA of the AAII Bulls-Bears% Differential most recently hit a low not seen since June 2003.  Moreover – excluding the spike lower in the latter parts of 2002 and early parts of 2003, the 52-week MA of the AAII Bulls-Bears% Differential is at its most oversold level since March 1995 – and we know what happened afterwards.

As for the 52-week MA of the Investors Intelligence Bulls-Bears% Differential – it is definitely not as oversold as the AAII survey on a historical basis – but please note that during early October of last year, it hit a low not seen since July 2003, as illustrated by the following weekly chart:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (November 1970 to Present) - The 52-week moving average of the AAII Bulls-Bears% Differential touched a low of 17.9% in early October 2006 (the most oversold level since July 2003), and is currently still at a relatively oversold level of 18.9%.

While the 52-week MA of the Investors Intelligence Bulls-Bears% Differential has since bounced to a level of 18.9%, subscribers should keep in mind that this is only a relatively minor bounce – and in fact, if we exclude the readings over the last few months, the latest reading of the 52-week MA still represents the most oversold reading since August 2003.  Again, while the Investors Intelligence Survey isn't as oversold as the 52-week MA of the AAII survey, the fact that it is now giving us a reading which is still oversold is definitely encouraging for the bulls and for our “growth stock scenario” going forward.  The “conjecture” by the permabears suggesting that “there are too many bulls out there” just does not hold water.

Let us now get to the gist of our commentary and discuss the one potential sector that bears could short at some point this year, although I do have to make one thing clear before I do so: This should be construed as a recommendation on our part.  I know, I know – most of our subscribers are financially sophisticated but I just want to reiterate this anyway: Shorting is not for everyone – and in fact, shorting at the tail-end of a bull market is especially dangerous, as by definition, a bull market does not end until most of the bears have been squeezed out of their short positions or pulled in to the long side of the market.  This is what happened in the final “blow-off” rallies in 1929, 1965/1966, 1968/1969, the Nifty Fifty market during 1971/1972, 1987, 1999/early 2000, the gold/silver markets in late 1979/January 1980, and so forth.  Ironically, astute traders who trade on the short side usually do quite well during the “meat” of the bull market advance – as during the “meat” of the bull market, the stock market usually undergoes several corrections as it climbs a “wall of worry.”  As the bull market comes to an end, however, this is usually not the case.  In the final phase of the bull market, these same astute traders who have profited from shorting during most of the bull market will be driven out – as retail investors rush in and as stocks subsequently “blows off” to the upside.  Sure, these astute traders may have timed the end of the multi-year bull market or certain individual stocks to the month – but as folks who traded the NASDAQ in late 1999/early 2000 or the gold market in late 1979/January 1980 could attest, one could literally get wiped out even if one is just a few weeks off in his or her timing.  For illustrative purposes, gold actually climbed from $550 an ounce to more than $850 an ounce in a span of three weeks while it was topping out in January 1980.  Ditto the NASDAQ – which more than doubled from August 1999 to March 2000.  Many professional short sellers were wiped out during the final advance of the NASDAQ in late 1999 to early 2000.

If I can emphasize this any stronger, I will.  That being said – one sector which I have mentioned quite often during the last couple of weeks, U.S. REITs – is still looking very overvalued to me and is probably a short at some point.  For subscribers who want to join our discussion on REITs, you can do so in the following thread of our discussion forum.  Also, quoting a recent Bloomberg article:

The last time REIT dividend yields fell as far below Treasury yields was during the seven years that started in November 1978. Bond yields soared as Federal Reserve Chairman Paul Volcker increased the central bank's target interest rate to 20 percent in 1980 to combat soaring inflation.

The NAREIT index underperformed the S&P 500 during that span by 33 percentage points.

REITs in Asia and Europe also have reached records as asset prices in Japan rebounded and countries from the U.K. to Germany and Pakistan follow the U.S. in introducing property trusts.

The Bloomberg Asia REIT Index climbed 34 percent in the past 12 months and five of the 10 biggest gains were from Japan.

Finally, following is a monthly chart showing the FTSE NAREIT Total Return Index vs. its percentage deviation from its 12-month moving average from December 1971 to January 2007:

As can be seen on the above chart, as of the end of January 2007, the NAREIT All REIT index was trading at nearly 20% above its 12-month moving average – a level which more or less has implied a subsequent correction in the past.  Since the end of January, U.S. REITs have risen another 1.2%, as implied by the iShares Dow Jones U.S. Real Estate Index (IYR).

While I am definitely watching U.S. REITs very closely, and while they are definitely very overbought and very overvalued, I still do not see a major top just yet.  At this point, I most probably won't short U.S. REITs (either via the IYR or the Dow Jones Real Estate Index futures contract that will start trading this Tuesday) unless one of the following occurs: 1) A blowoff in the U.S. stock market and a further run-up in U.S. REIT prices (another 10% to 20% over the next few months), or 2) a collapse of REIT prices in either Western Europe or Japan.  For now, liquidity is still ample and the demand for REITs is still in place.  Readers please stay tuned.

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:

For the week ending February 16, 2007, the Dow Industrials rose 186.74 points while the Dow Transports rose 186.52 points.  Again, the big news last week – at least from a Dow Theory standpoint – was the simultaneous all-time highs achieved on all three of the Dow indices.  More often than not, such a “three-way confirmation” is usually a precursor for higher prices going forward, especially given the current undervaluation in U.S. equity prices relative to U.S. bonds and almost every other major asset class around the world today (with the exception of Taiwanese and a few “Emerging Asia” markets).

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 28.8% for the week ending February 16, 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:

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.  While last week's reading of 28.8% is still uncomfortably high, readers should note that this is due more to the Market Vane's Bullish Consensus readings more than anything else – and is not being confirmed by other sentiment readings such as the Rydex Cash Flow Ratio or the ISE Sentiment Indices.

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:

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, is now again declining.  This latest decline is encouraging for the stock market bulls, as it allows the stock market to work off some of its short-term overbought conditions.  Again, there is no guarantee that the stock market won't endure a correction from current levels, but the outlook for equities is bright for the weeks and months ahead.

Conclusion: This author continues to be bullish on growth stocks vs. value stocks – as well as U.S. equities in general.  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.  For now, we remain 100% long in our DJIA Timing System.

However, it is to be noted here that the speculative fever in the U.S. (and global) REIT market may be now peaking – although it is too soon to tell when the impending top will come (it may come this Tuesday or it may come later in the year).  The Dow Jones Real Estate Index iShares (IYR) is going to be a short at some point this year, but again, subscribers should keep in mind that timing a top in any market is near impossible.  This is made all the more difficult since markets that are in the midst of topping out nearly always “blows off” to the upside before doing so.  Not only should buyers be wary of the current bull market in REITs, but short-sellers as well.

Signing off,

Henry To, CFA

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