Market Thoughts
Links | Sitemap | Search:   
  Home  > Commentary  > Archive  > Market Commentary  

Our Roadmap Ahead…

(March 4, 2007)

Dear Subscribers and Readers,

In today's world of instantaneous and constant communications and virtual 24-hour trading around the world, it never ceases to amaze me how things can change or unravel so quickly.  For the week, the Dow Industrials is down 4.2%, the Dow Transports 7.3, the NASDAQ Composite 5.8%, and the S&P 500 4.4%.  Moreover, the U.S. subprime industry continues to unravel – with New Century (NEW) reported that it is under federal investigation and Fremont announcing that it is exiting the subprime business at the close last Friday.  In after-hours trading on Friday, Novastar (Herb Greenberg's favorite bashing stock) declined below $7 a share, after closing at $8.48 the week before and $17.19 two Fridays ago.  The carnage continues…

Since I know our subscribers are pressed for time (especially in this kind of trading/investing environment), I want to cut to the chase and show you my favorite charts – but before I do that, let us first 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 729.10 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 609.10 points

While our two long signals from September of last year are still showing us gains – suffice it to say, I am definitely not happy with the recent losses suffered by our DJIA Timing System last week.  While most of the classic topping signs were not there (signs such as breadth divergences, significant mutual fund inflows from retail investors, overly high equity valuations relative to treasury and corporate bonds, and so forth) – there were some signs that the market was getting a little bit “frothy” – such as a high amount of margin debt, the record lows in the VIX, and so forth.  Even though the data suggests that most of the “forth” had been concentrated in the international and emerging markets, the contagion effects of a winding down of risk exposure from these markets, coupled with the meltdown in the subprime sector, was enough to send the U.S. stock markets reeling last week.

As I discussed in our mid-week commentary last Wednesday morning, I had this to say about the NYSE ARMS Index.  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.

And: 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.

I also mentioned that – despite the relatively tame decline last Tuesday in terms of percentage (it did not come close to being in the top 20 daily declines of all time in terms of percentage) – it was a panic nonetheless, as downside volume accounted for more than 99% of the sum of both advancing and downside volume (with record high volume to boot).  This has only occurred 21 times since records were kept from January 1, 1940 and onwards, with 13 of them occurring prior to 1950.  The last time this occurred was October 26, 1997 – which as I have mentioned before, is a day which coincided with speculators attacking the Hong Kong Dollar (during the midst of the Asian Crisis) the night before, as well as the day of the huge margin call that Victor Niederhoffer got - the one that caused him to close down his best-performing hedge fund and to sell his house and antiques.  For more clarity on why it qualified as a panic, please refer back to our mid-week commentary.

Back in 2000, a one-day NYSE ARMS Index reading of over 15 would have resulted in a crash in the Dow Industrials of more than 1,000 points (perhaps even close to 2,000 points).  The fact that the Dow Industrials “only” declined 416.02 points suggests that the market is getting a bid – even though those bids are still relatively reluctant at this point.  Indeed, as documented by TrimTabs, announced company buybacks and cash acquisitions hit a weekly record high of $67.7 billion, while new offerings remained below $5 billion.  Moreover, net insider selling virtually disappeared last week – totaling a mere $1.4 billion. Meanwhile, U.S. equity funds is estimated to have lost $4.9 billion last week.\ In the “old days” of the technology and telecom bubble, any mass stampede out of the stock market would have meant a retail investor outflow of over $10 billion on a weekly basis.  Combined with the fact that many technology companies were still selling shares during January to March 2000, and combined with the fact that company buybacks and cash acquisitions were virtually non-existent at the time – an intense selling day like the one we just had last Tuesday would surely have meant a decline of over 1,000 points on the Dow Industrials and most probably a similar amount (on an absolute basis) on the NASDAQ Composite as well.

But I digress.  One of the main points of the above argument is that the U.S. stock market is now severely oversold – at least in the short term anyway.  Subscribers and other readers should expect a significant bounce later this week.  A more important point, however, is this: Immediately prior to the end of a cyclical or secular bull market, two important things usually happen:

  1. IPOs and secondary offerings typically spike up, and speculation on the part of retail investors tends to be rampant.  Moreover, corporate buybacks and cash acquisitions usually disappear outright – as companies choose to invest in their own businesses and use their overvalued shares to acquire other companies instead.  As we have mentioned many times in our commentaries over the past 12 months or so, retail investors continue to shun domestic equities.  Given that corporate cash levels are still near all-time highs and given the decent valuations of many of the U.S. large cap brand names (such as PFE, CAT, IBM, MSFT, INTC, KO, etc.), there is every reason to believe that company buybacks will remain robust for the foreseeable future;

  2. Valuations – especially equity valuations in relation to U.S. Treasury and corporate bonds – tend to be very stretched towards the end of a bull market in stocks.  As of last Friday at the close, the Barnes Index (for an explanation of what this is, please refer back to our March 30, 2006 commentary) hit a level of 51.20 – down 12.80 for the week (on lower equity prices and lower bond yields).  The Barnes Index is now at its lowest level since late September of 2006.

In prior commentaries and in prior posts in our discussion forum, we discussed that unlike the May to July 2006 decline (when bond yields rose), this current decline (with bond yields declining) may be discounting a deflationary bust.  In a deflationary bust scenario, all bets are off.  Oversold indicators will get much more oversold, and many more companies and hedge funds will go bust before this is all over.  However, the deflationary bust scenario is very suspect – as 1) the ECRI Weekly Leading Index is still rising at a healthy rate, 2) Corporate cash levels remain historically high and 3) Foreign reserves held by the world's central banks are at very high levels – unlike the situation prior to the 1997 Asia Crisis and the 1998 Russia and Brazilian Crises.  Moreover, if we were really moving towards a deflationary bust or a “hard landing scenario,” corporate Baa spreads would now be blowing out.  So far, however, this hasn't been the case – as evident by the following monthly chart showing Baa spreads relative to ten-year U.S. Treasuries from January 1996 to March 2007 (with the latest March data taking into account the spread on last Thursday's close):

Yield Spreads of Moody's Baa Bonds over the Ten-Year U.S. Treasuries (January 1996 to March 2007) - 1) Spreads got to as high as 3.79% in October 2002 - right at the bottom of the last cyclical bear market! 2) The yield spread of the Moody's Baa bonds over the 10-year Treasuries is still at a relatively benign reading of 1.62% as of the close last Friday - which, interestingly, is actually lower than the 1.66% reading at the end of 2006. More importantly, Baa bond yields have actually declined four basis points since the end of 2006 (and a whopping 60 basis points since the end of June 2006) - evidence which supports the continuation of this cyclical bull market.

As mentioned on the above chart, the fact that Baa bond yields have actually declined four basis points since the end of 2006 (along with a whopping 60 basis points since the end of June 2006) suggests that equity prices remain relatively undervalued and that a deflationary bust/hard landing scenario is not in the offing.

Moreover, despite what many analysts or Federal Reserve officials are claiming, the odds of a deflationary bust/hard landing scenario remains relatively low – as being predicted by the futures market.  Given that a huge portion of the futures market is dominated by financial professionals, and given that they are putting their money where their mouths are, predictions made by futures contracts have historically been relatively reliable (for a background on the futures market and the predictive ability of its futures contracts, please refer to the following NY Times article) – at least much more reliable than predictions made by so-called experts.  Despite what the Fed says about a “50% chance of a recession” as predicted by the inverted yield curve, the traders trading on is currently only slapping a 22.9% chance of a recession in the U.S. in 2007, as shown by the following chart (courtesy of

Traders trading on is currently only slapping a 22.9% chance of a recession in the U.S. in 2007

Sure, the probability (as indicated by this particular futures contract) has gone up over the last few days – but a 22.9% chance of a recession remains comparatively low, especially given that this contract traded at a high of 35% during mid January earlier this year.

Meanwhile, as I am typing this, the Yen is again rallying across every major currency in the world.  Interestingly, however, the U.S. Dollar is doing relatively well, as the U.S. Dollar index is currently up 0.26 points – rising against all other major currencies with the exception of the Yen.  In fact, it is even rising against the Swiss Franc – another popular currency for the carry-traders.  Speaking of the Yen and the carry trade, there is no doubt that the latest decline in global equity markets is partially related to the covering of Yen short positions – and while the Australian Dollar and the British Pound have been the two most popular currencies for the Yen carry traders – the major currency that has been getting the most press has been the Euro, and specifically, its appreciation relative to the Yen over the last few years.  As I am typing this on Sunday evening, the Euro is down over 1.8% against the Japanese Yen.  However, based on its percentage deviation from its 50-day moving average, there is no question that the Euro-Yen cross rate is now very oversold, as shown by the following chart:

Euro-Yen Cross Rate vs. Percentage Deviation from its 50 DMA (February 1999 to Present) - The percentage deviation of the Euro Yen cross rate from its 50-day moving average hit a level of negative 3.49% on Sunday evening as I am typing this - the most oversold level since June 7, 2005. The Euro Yen cross rate should at least remain steady for the foreseeable future.

As shown on the above chart, the percentage deviation of the Euro Yen cross rate is now a whopping negative 3.49% below its 50-day moving average.  Based on historical precedent, the Euro-Yen cross rate should at least remain steady at current levels – even should the Euro enter a new bear market against the Yen here.  Moreover, the weakness of the Swiss Franc tonight is also giving carry traders a partial reprieve.  For the foreseeable future at least, the carry traders is looking like they will be left “off the hook” – no doubt, this will be supportive for equity prices in the days ahead.

In last week's commentary, we also briefly discussed the issue of global liquidity.  In a nutshell, I stated that global liquidity remains ample for now – and as long as current economic troubles within the U.S. remains contained within the subprime (and possibly the Alt-A) sector, this should continue to be the case going forward.  Speaking of liquidity, on a more immediate and domestic basis, I want to update our readers of a chart we initially posted in our January 14, 2007 commentary (“The Permanent Income Hypothesis”).  In that commentary, I stated that I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006.  At the time, his assertion was that based on this chart, he does not believe the rally in the U.S. stock market is close to “exhaustion” just yet, or in other words, a significant top.  Following is an update of that chart showing the ratio between U.S. money market assets (both retail and institutional) and the market capitalization of the S&P 500 from January 1981 to February 2007:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to February 2007) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio increased from 16.63% to 17.19% during February - the highest reading since September 2004. Given such high readings, the likelihood of a bear market from current levels is not overly high.

While the ratio between money market fund assets and the market cap of the S&P 500 is probably not a great timing indicator – what it does show is the amount of “cushion” that we have in order to insure against a significant market decline.  Also, while this indicator is telling us that we are closer to the end of the bull market than the beginning of one, it is also telling us that we are not close to exhaustion just yet.  Based on historical experience, this author will not be too concerned about the end of the current bull market until this ratio hits a reading of 15% or below.  Finally, given that this ratio has just risen from 16.63% as of January 31, 2007 to 17.19% as of February 28, 2007 (the highest reading since September 2004), chances are that the equity markets will be ahead in the weeks and months ahead.  For the individual investor who is not leveraged and who is already long, a buy-and-hold strategy (instead of trading around the volatility) still makes the most sense.  For now, we will remain 100% long in our DJIA Timing System – although we reserve the right to trim our position should the technicals of the market deteriorate in the days ahead.

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 March 2, 2007) - Over the last week, the Dow Industrials declined 533.38 points while the Dow Transports declined 376.68 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 still believe this is only a hiccup within the context of an ongoing cyclical bull market.

For the week ending March 2, 2007, the Dow Industrials declined 533.38 points while the Dow Transports declined 376.68 points.  In retrospect, the weekly divergence of the Dow Industrials on the downside was a warning shot for the bulls – although there have been many cases of weekly divergences over the past couple of years where there were no significant consequences.  Given that all three of the Dow indices made simultaneous all-time highs as late two weeks ago, and given that the A/D line of the major stock market indices remains relatively healthy, this author will have to witness more deterioration of both breadth and other technical indicators before calling for a more substantial decline.  For now, we remain 100% long in our DJIA Timing System – and will continue to do so unless evidence suggests that we should trim down our position.

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 declined from last week's rally high of 31.0% to 28.8% for the week ending March 2, 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 March 2, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased from 31.0% to 28.8%. In last week's commentary, I stated that this reading - at the time - represented *the most optimistic reading in this indicator since late December 2005.* In retrospect, such an optimistic was definitely a warning sign, but subscribers should keep in mind that the intermediate trend still remains up, for now.

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.  As of last Friday, the four-week MA declined from a 12-month of 31.0% to 28.8% - a level that is still overbought.  Readers should keep in mind that sustainable bottoms have typically only occurred when this indicator is oversold –and right now, we are still at least a few weeks away form this occurring.  As indicated by the NYSE ARMS Index and other indicators I am tracking, however, this market is now very deeply oversold in the short-run, and should exhibit some kind of bounce this upcoming week.  After the inevitable bounce, we will reevaluate and decide on what to do with our positions in our DJIA Timing System from thereon.

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 of the ISE Sentiment plunged a whopping 10.8 points in the latest week - the biggest decline since the week ending June 23, 2006. Interestingly, the 20 DMA is now more than 10 points below the level on June 13, 2006 - when the S&P 500 made its bottom last year (at 1,223.68). The continued decline in the ISE Sentiment index reflected (and is still reflecting) pervasive pessimism among retail investors - even as the market held its ground and proceeded to rise non-stop from July onwards.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment plunged a whopping 10.8 points in the latest week – representing the biggest decline since the week ending June 23, 2006.   While the indices can certainly decline another 5% from current levels, the pessimistic readings coming out of the ISE Sentiment Index suggests pervasive pessimistic sentiment – signaling that the market is definitely a “buy” should this index (and the market) continue to decline going forward. 

Conclusion: This author continues to be long-term bullish on U.S. equities in general, especially U.S. large caps and large cap growth stocks.   Moreover, as indicated by the above charts and analyses, the market is now severely oversold in the short-run – and is thus ripe for a bounce at some point this week (as I am typing this however, the S&P 500 futures is down by more than 10 points).  In a world of rising volatility and risk aversion, the U.S. large cap brand names should expect to do relatively much better than either small caps or international/emerging market stocks going forward.  While there are certain sectors that we need to continue to keep an eye on (such as the U.S. subprime industry, the U.S. Alt-A industry, and the Indian stock market), things in general are still looking bright over the next six to nine months. 

We will continue to reevaluate our position in our DJIA Timing System, and will send out a real-time email alert to our subscribers should we decide to trim our long position in our DJIA Timing System during the upcoming week.  For now, the market is severely oversold.  Whether we will sell on the inevitable bounce will depend on new information – such as technicals, liquidity, mutual fund inflows/outflows, sentiment, and so forth.  For now, we remain 100% long in our DJIA Timing System.

Signing off,

Henry To, CFA

Article Tools

Subscribe to this FREE commentary

Discuss this page

E-mail this page to your friends

Printer-friendly version of this page

  Copyright © 2010 MarketThoughts LLC. | Privacy Policy | Terms & Conditions