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Is the Latest Correction Over?

(March 29, 2007)

Dear Subscribers and Readers,

As they say, nothing comes easy in life – and the game of making money in the stock market is definitely one of the most difficult games in the world today.  Armed with the necessary statistics, access to company's annual reports, and/or weekly charts, one could probably have had a decent chance of beating the market if one was investing back in the 1950s and 1960s.  Today, however, with the advent of internet trading, over 9,000 hedge funds pondering short-term fluctuations, the increasing influence of the European Central Bank, the Bank of Japan, and the emerging market countries, it is almost next to impossible to keep up with everything.  In our last weekend's commentary, I stated that “over the long-run, I sincerely believe that the only way an individual investor can beat the professionals (including guys like Bill Miller, hedge funds, private equity funds, etc.) is to employ a buy-and-hold strategy and only buy on 1) valuations, and 2) fundamentals.  When buying individual stocks, capital preservation is the game, and buying based on valuations can cover a lot of mistakes.

Obviously, however, this author cannot throw up his hands and give up, since this is what you, our dear subscribers, pay me to do.  Day in and day out, I try to read as much as I can about the financial markets.  In addition, I also go back and brush up on my history, as well as keep track of the latest technical indicators.  Somehow, my brain synthesizes all these different variables and come up with a single view of what I believe the stock market will do – both in the short-run, and the longer-run.  If I get lucky, sometimes I may even get it right!

Jokes aside, the major market indices like the S&P 500, the Wilshire 5000, the MSCI EAFE, and the MSCI World Index are really very complex animals.  One cannot expect to use trend lines and Fibonacci Ratios in order to forecast where these indices are going.  Sure, sometimes it does work, but most of the time, it doesn't.  Curtis Faith, one of the original “Turtles” puts it (trend following) this way in one of his posts on the TradingBlox website:

  1. Indices are not normal speculative instruments in the sense that their price movement does not come primarily as a result of the trading in the instrument or it's underlying index. The price movement of an index is an accumulation of the price movements in the components stocks.

    Since the price action of the S&P 500 is an averaging of many other individual markets, it won't behave the same as a market whose price action is determined solely by that market. The price movements of the strong stocks that cause a rise in the index are diluted by the weak stocks that are down during this rise, and vice versa. This causes a dampening effect on trends.

  2. The indices more purely demonstrate price movements resulting from investor psychology than underlying fundamentals. Individual stocks may rise for certain reasons, but the "market", being an almost wholly psychological concept, rises because of human sentiment based much more purely on feelings rather than logic. While this is certainly true of all markets, it is more true of the indices than other individual markets.

That is also why – in the majority of cases – predicting where the S&P 500 will go using the aggregates earnings of the underlying components (on either a trailing or forward basis) is a futile exercise.  For example, buying U.S. Steel at a P/E of 15 is obviously different to buying MSFT at the same P/E.  When it comes to the stock market, it is important to look at everything possible.  Absolute is one factor, but so is relative valuation – not to mention financial flows, margin debt, short interest, retail investor sentiment, breadth and volume indicators, overbought/oversold indicators, and Central Bank policies of the Federal Reserve, the European Central Bank, Bank of Japan, and the People's Republic Bank of China.  The list just goes on and on.

Anyway, so much for this digression.  Also in last weekend's commentary, I stated: “In the short-run, the market is still relatively overbought – as both the Dow Industrials and the S&P 500 are still approximately 5% higher than their respective 200-day moving averages.  Given this short-term overbought condition, any further upside in the market during this upcoming week is probably not sustainable in nature, and should not be chased.  That being said, I am still bullish on the U.S. stock market in the longer-term, and after a brief consolidation phase (and hopefully more pessimistic sentiment readings and some kind of washout in margin debt levels), I expect the U.S. stock market to be higher three to six months from now.

As of Wednesday evening, March 28, 2007, I still stand by this belief.  The continuing rise in margin debt during February (especially after the market washout on February 27th) is still a concern, although that number is now relatively “stale” given that it was last updated four weeks ago.  At the same time, however, it is difficult to envision this number coming down significantly since four weeks ago, especially since the market has remained relatively strong after the February 27th decline.  For now, I would not be surprised to see one more washout and a retest of the 12,000 level in the Dow Industrials, but any further decline in the stock market over the next couple of weeks should be bought.  Readers should keep in mind that quarterly contributions for U.S. calendar year defined benefits pension plans are due on April 15th – which should serve to give the stock market a little boost during the week of April 9th to April 13th  (as most of that money tend to go towards purchasing equities).

Again, while the stock market is still vulnerable in the short-run, things are still looking bright in the longer-run, as valuations and interest rates (despite what Chairman Bernanke said yesterday) are still conducive for a further rally in stocks over the next three to six months.  Let us first look at relative valuations.  As I stated 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

At the most recent peak, the Barnes Index rose to a high of 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 yesterday at the close, however, the Barnes Index closed at 57.20 – still too far on the low side to be calling a significant top just yet.

Finally, the most recent rise in both NYSE and NASDAQ short interest suggests that there is still further upside in stocks.  Let us first take a look at the absolute increase and outstanding short interest on the NYSE.  Following is a monthly chart showing the NYSE Short Interest vs. the Dow Industrials from November 15, 2000 to March 15, 2007:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to March 15, 2007) - For the month ending March 15, 2007, total short interest on the NYSE increased 915 million shares to 10.51 billion shares. The monthly increase represented the greatest monthly increase on record while the 10.51 billion shares outstanding short interest also represented an all-time high. Moreover, the latest 12-month increase in short interest just hit a high of 27.5% - a high which hasn't been witnessed since November 2002. Chances are that more shorts will need to cover their positions before we will see a significant top in the stock market.

As mentioned on the above chart, both the monthly increase and the total amount of outstanding short interest on the NYSE hit a record high for the monthly period ending March 15, 2007 – with total short interest rising a whopping 915 million shares to 10.51 billion shares.  Moreover, the latest 12-month increase in short interest just hit a high of 27,5% - a high which hasn't been witnessed since November 2002.  While short interest numbers are not a good timing indicator, the fact that short interest is increasing so quickly (and the fact that it has just hit a record high on the NYSE) suggests that the long-term outlook of the stock market remains benign.

Moreover, readers should keep in mind that – unlike the bull market during the late 1990s – we are still currently experiencing “float shrink,” mainly because of the huge amount of company buybacks.  That is, this latest increase in short interest should be taken much more seriously than if had occurred during a time of huge IPOS and secondary offerings.  For those that like to look at short interest as a ratio of trading volume, following is a 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 declined from a reading of 6.2 to 6.1 in the latest month. Despite the latest surge in volume, the rise in NYSE outstanding short interest was sufficient enough to maintain a somewhat pessimistic reading on the NYSE Short Interest Ratio. Chances are that the market will not top out until we witness a significant covering of shares that have been shorted on both the NYSE and the NASDAQ.

Despite the recent surge in volume, the NYSE Short Interest Ratio remains elevated – declining only 0.1 to hit a level of 6.1 in the latest reading.  Given that this reading remains elevated, chances are that the market will not top out until we see the NYSE Short Interest Ratio decline to a level below 5 or less.

In the meantime, the latest spike in the NYSE short interest is also being “confirmed” by a similar spike in the total amount of short interest on the NASDAQ.  Following is a monthly chart showing NASDAQ Short Interest vs. the value of the NASDAQ Composite from September 15, 1999 to March 15, 2007:

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to March 15, 2007) - Short interest on the NASDAQ rose a dramatic 850 million shares in the latest month (a record) and is now at 7.89 billion shares - a record high. The 12-month increase in short interest is now at 27.34% - a rate of increase not witnessed since September 2001. In the short-run, the amount of short interest outstanding is a horrible timing indicator, but over the longer-run, such an increase in short interest is bullish for the stock market, especially since this also confirms the record high short interest on the NYSE.

For the monthly period ending March 15, 2007, short interest on the NASDAQ rose a whopping 850 million shares to a new record high of 7.89 billion shares.  Meanwhile, the 12-month increase in short interest just hit a high of 27.34% - a rate of increase not witnessed since September 2001.  Again, in the short-run, the looking at both the increase and the absolute amount of short interest is a horrible timing indicator, but over the longer-run, such an increase in short interest is bullish for the stock market, especially since we are seeing such spikes on both the NYSE and the NASDAQ.

Signing off,

Henry To, CFA

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