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The U.S. Stock Market – Where to From Here?

(February 28, 2007)

Dear Subscribers and Readers,

What a difference a day makes – I hope none of our readers got caught leveraged on the long side on Chinese ADRs over the last couple of days.  We had been discussing the ongoing developments in the Chinese stock market bubble for the last couple of months, and while I think this bull market in Chinese stocks can and will go on for the foreseeable future, I remain weary about investing in a country where P/Es are among the highest in the developing world (at over 25), and with questionable earnings to boot.  Moreover, given the meteoric 130% rise in the Shanghai Composite last year, a 9% daily decline is just your “par for the course” correction.

Of more questionable nature is the assertion that the 9% correction in the Shanghai market “spilled over” to the international developed markets and the U.S. stock market.  After all, the Chinese market is a closed market (only domestic citizens are allowed to invest in the market) and a small one at that.  Prior to yesterday's 9% decline, the market cap of all Chinese stocks was only $1.5 trillion – less than one-tenth the size of the market cap of the U.S.  Indeed, at the close of the market on Tuesday afternoon, the Hong Kong Hang Seng index was down slightly under 300 points and as late as noon ET, the Dow Industrials had only been down 100 points or so.  As the day wore on, the selling intensified, turning into a classic panic by 2pm to 2:15pm ET.

Unlike the May to July 2006 decline – when bonds and stocks both declined at the same time – bonds had been rallying during the latest stock market decline.  During the May to July 2006 decline, most investors were not worried about either a U.S. growth recession or an outright economic recession, but about run-away inflation (gold prices spiked and topped out at $725 an ounce or so in May 2006) and a Fed that may be overly aggressive in hiking rates.  There was also the prevalent psychology among investors of the “four-year low” later in the year – and many investors were spooked by this notion and decided to sell during the summer.

The latest decline – even though it was preceded by the 9% decline in Chinese shares – was also preceded by the meltdown of the subprime market and weak economic numbers (which is evident in our OECD indicators as well as in the ISM manufacturing numbers).  On Monday, the AMEX Broker/Dealer Index had declined 1.6% - a precursor to what was to come the next day.  Instead of an overly tight Fed due to runaway inflation concerns (as what was feared during the May to July 2006 decline), the latest decline smells of a “classic panic” and fear of a deflationary bust – culminating in a flight-to-quality scenario similar to what had occurred during the Russian and LTCM crises in 1998.

Let us first review the “carnage” in the Dow Industrials and the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to February 27, 2007) - Over the last two days, the Dow Industrials declined 431.24 points while the Dow Transports declined 295.17 points - turning your run-of-the-mill decline into a true classic rout.  We will reevaluate our signals in the upcoming days - but for now, we will remain 100% long in our DJIA Timing System as we believe this is only a hiccup within the context of an ongoing cyclical bull market.

The decline of both the Dow Industrials and the Dow Transports over the last two days (-3.4% and -5.7%) smelled of a true panic.  Sure, on a percentage basis, the latest decline is not even in the top 20 of all declines, but the downside breadth (95% declining volume) was there, and so was the volume on both the NYSE and NASDAQ.  In fact, the NYSE traded over 4 billion shares yesterday – a record high.  This record high volume even resulted in a computer glitch which prevented the Dow Industrials Average to reflect its true price for most of the afternoon.  The dominance of the bears and the panicking among the bulls yesterday is also reflected in the following table showing yesterday's decline among many of the more important U.S. indices:

February 27, 2007 Decline in Selected U.S. Indices
Index Percentage Decline
Dow Industrials (3.3%)
Dow Transports (3.4%)
Dow Utilities (2.9%)
NASAQ Composite (3.9%)
S&P 500 (3.5%)
S&P 400 (3.1%)
Russell 2000 (3.8%)
Philadelphia Bank Index (3.2%)
AMEX Broker/Dealer Index (4.4%)
Real Estate iShares (3.2%)
Philadelphia Semiconductor Index (3.1%)
AMEX Biotechnology Index (3.7%)
AMEX Pharmaceutical Index (2.5%)
AMEX Oil Index (3.5%)
Reuters/Jefferies CRB Index (7.0%)
Philadelphia Gold/Silver Index (0.6%)

However, a true indicator of “panic” is none other than the NYSE ARMS Index, or what they call the “TRIN.”  Subscribers who want a refresher of this index can do so on the education page of our website, but over the years, I have found the NYSE ARMS Index to be the most reliable as an overbought/oversold (mainly an oversold) indicator.  Indeed, the NYSE ARMS Index closed at an extremely oversold reading of 15.77 yesterday.  For comparison purposes, there has only been 34 instances since January 1940 when the NY ARMS/TRIN closed over 5.

Also, prior to yesterday, there were only 24 instances when the NYSE ARMS Index closed over 6; 21 instances over 7; 20 instances over 8; 13 instances over 10, and 6 instances over 15.

The last time the NY ARMS/TRIN closed over 5 was on March 24, 2003, and prior to that March 10, 2003 (closing at 5.81 and 5.01, respectively). The highest reading over the last 10 years is the 10.2 reading we got on October 27, 1997, and yes, there were no >5 readings between that day in October 1997 and March 2003. And prior to that, you'd have to go back to October 26, 1987 (the Monday after Black Monday) to find another reading >5 (it closed at 12.11 on that day as investors who didn't get to sell on October 19th sold - making one of the biggest trading mistakes of their lives).

Also, it seems that most of the 6+ readings that I am getting occurred during World War II (during the fall of France and during 1943 when it seemed like the Allies were losing), the top in 1946, and during the early 1950s. Actually prior to the October 19, 1987 reading, the last time the TRIN closed over 6 (it closed at 30.76 on that day) was September 26, 1955 - the day of the Eisenhower heart attack.

Finally, the October 27, 1997 reading coincided with speculators attacking the Hong Kong Dollar (during the midst of the Asian Crisis) the night before, and it also coincided with the huge margin call that Victor Niederhoffer got - the one that caused him to close down his best-performing hedge fund.  On a 10-day moving average basis, the NYSE ARMS Index just hit a reading of 2.46 – the most oversold reading since October 30, 1987.  Following is a history of the 10-day moving average of the NYSE ARMS Index from January 1949 to the present (notice the one-day spike at the end caused by the extremely high reading yesterday):

10-Day Moving Average of the NYSE ARMS Index (January 1949 to Present)

Make no mistake – the selling yesterday was a “true panic” – at least among those that were selling yesterday.  This panic was also confirmed by the record volume on both the NYSE and the NASDAQ.

But Henry, yesterday's decline in the Dow Industrials did not even come close to the top 20 daily declines of all-time, so how could you call that a panic?

As I mentioned before, yesterday's decline was a panic among those that was trading – not among the general U.S. population that was evident in declines such as October 19, 1987 or during those fateful days of October 1929.  This makes sense, given two important reasons:

  1. The rally in the Dow Industrials from the bottom in July 2006 and up to last week had only resulted in an appreciation of the Dow Industrials of approximately 19%.  Ever since the inauguration of the Dow Industrials over 100 years ago, an appreciation of 22% over a nine-month period is actually relatively normal.  For comparison purposes: Over a similar period from late December 1986 to the top on August 23, 1987, the Dow Industrials had appreciated nearly 44%.  Coupled with the fact that interest rates were also rising at the same time, the U.S. stock market became overvalued very quickly during those fateful days of 1987.

  2. As I have mentioned before in several of our past commentaries, U.S. retail investors had been shunning U.S. domestic equities en masse over the last two years.  According to Trimtabs and ICI, out of $135.8 billion of all equity mutual fund inflows in 2005, only $31.2 billion flowed into domestic equities (the rest went to internationals).  In 2006, the numbers were even more lopsided, as only $12.1 billion flowed into domestic equities out of a total of $148.6 billion to all equity mutual funds.  In a typical bull market, monthly mutual fund inflows to domestic equities will typically range from $10 to $20 billion.

In other words, given the lack of enthusiasm over domestic equities on the part of retail investors over the last couple of years, there was no reason to expect a larger decline yesterday.  Therefore, yesterday's huge downside breadth – coupled with the record high volume – was sufficient to be classified as a panic. 

Make no mistake: This author's view on the U.S. stock market has not changed.  Despite the troubles in the subprime market and the recent weak economic numbers, I do not believe we are heading for a deflationary bust (or what some would call a “hard landing”).  Sure, there is a significant amount of leverage in our financial system today, but besides the volatility over the last week or so (which is bad), there is still sufficient liquidity (as I illustrated over our weekend commentary) in both our financial system and in corporate America to sustain a continuance of economic growth and a bull market in U.S. stocks.  Moreover, besides the subprime market, this author still has not seen a “blow out” in corporate bond or emerging market spreads – both of which are usually leading indicators of a U.S. hard landing.

And finally – unless we are heading towards a deflationary bust – the Barnes Index (courtesy of is now flashing a huge buy signal, as the current reading of 52.4 represents the most oversold reading since mid July of last year:

Barnes Index

As always, please email us with any suggestions and/or questions.

Signing off,

Henry To, CFA

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