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Markets Getting Overbought But Still Bullish

(April 26, 2007)

Dear Subscribers and Readers,

Important note: Unfortunately, I again need to embark on a quick business trip this weekend – of all places, to Quincy, Illinois.  For those who don't know much about the town, it is an old manufacturing town (right next to the Mississippi River) of less than 100,000.  Interestingly, I believe the population of the town has probably stayed the same over the last 100 years, and has most recently embarked on a steep decline due to the continuing exodus of manufacturing jobs outside of this country.  For those who are interested, I will try to get some photos taken while I am there.  Because of the fact that I will be traveling, I have again ask Bill Rempel – one of our regular guest commentators (the author of the blog – to write us a guest commentary for this weekend.  I apologize again to those who was looking for a full-blown commentary this weekend, but Bill is a very insightful guy so I am sure you will learn a lot from what he has to say!  Instead, I will attempt to write a more comprehensive commentary to be published next Thursday morning.  Going forward, I do not anticipate any business trips again over the next few months, so our subscribers can feel assured that I won't be missing any of my writings for the foreseeable future.

As I am writing this, the Dow Industrials closed at 8.71% above its 200 DMA, while the S&P 500 8.66% (you can review a history of these through our interactive charts page on  While these levels are not as stretched as they were during January 2004 (those readings got to nearly as high as 15%), they nonetheless are overbought relative to the levels we have seen over the last three years.  In our mid-week commentary last Thursday, one of the more important points that I stated was “…I am also told that net hedge fund exposure to equities rose to 59.2% from 56.5% last week.  Interestingly, the last time hedge fund exposure to the stock market was this high was immediately prior to the late February/early March sell-off in equities, when net hedge fund exposure touched a high of just slightly over 60%.  At the bottom of the last sell-off, net hedge fund exposure dropped to as low as 48%, but it has since bounced back as hedge funds rushed back into the global equities.  Could they be disappointed, once again? Indeed, if one chronicles the amount of net hedge fund exposure to equities since mid 2002, one would find that net hedge fund exposure has never gotten higher than 62% (it hit this level in early December 2004).  To the extent that hedge funds are now driving the direction of the global equity markets, this suggests that the short-term potential upside of the stock market is rather limited.”

In that mid-week commentary, I also discussed the overbought condition of many popular global market indices, such as the Australian All Ordinaries, the German DAX, the UK FTSE, the Hong Kong Hang Seng Index, the Tokyo Nikkei, and the Shanghai Composite.  Since that mid-week commentary, the performance of these indices has been as follows:

Australia: -0.7%

Germany: +0.8%

UK: +0.2%

Hong Kong: -1.2%

Japan: -2.4%

China: +3.7%

Note that the above performance numbers represented April 25th closes – and as of April 26th, these stock markets are up anywhere from 0.4% to 1.1% on the back of the continuing strength in the U.S. stock market.  In other words, the overbought conditions in the world's major stock markets still remain – all of which makes them very vulnerable to any surprising developments such as 1) the reversal of the Yen carry trade, 2) any surprising weakness in any of the major regional economies in the world, such as Japan, the Euro Zone, or the U.S., 3) a spike in oil prices, or 4) any surprising Central Bank rate hikes from the ECB, the Bank of England, the Bank of Japan, or the Federal Reserve.

Another indication of an overbought condition in the U.S. stock market is the relatively low NYSE ARMS Index readings we have been witnessing over the last few weeks.  As a matter of fact, the 21-day moving average of the NYSE ARMS Index touched a low of 0.941 on April 17th – a level not seen since the 0.920 reading on May 11, 2006 (and we all know what happened afterwards).  Following is a daily chart showing the 21 DMA and the 55 DMA of the NYSE ARMS Index vs. the Dow Industrials from May 2002 to the present:

21-Day & 55-Day ARMS Index vs. Daily Closes of DJIA (May 2002 to Present) - The 21 DMA of the NYSE ARMS Index has been consolidating in the 0.950 to 0.975 area over the last two weeks, suggesting a ST overbought condition. However, the 55 DMA is still at elevated levels, suggesting that the market hasn’t topped out yet.

What is encouraging for the bulls, however, is the fact that the 55-day moving average continues to remain at a very elevated level (primarily due to the 15.77 reading on February 27 and the 3.49 reading on March 13).  Given that a typical stock market rally does not top out until this reading has come down significantly relative to where it was at the last bottom, my guess is that the stock market most probably will not see a short-term/tradeable top until May 17th at the earliest.  In the meantime, we remain convinced that we most probably will not see a significant top in the stock market until July or August at the earliest.  In the meantime, the market can go much higher than anyone things – especially given that the shorts have been harping about a top in the market for weeks now.

Another encouraging sign for the bulls has been the relentless increase in short interest on both the NYSE and the NASDAQ.  To illustrate, let us know take a look at the NYSE Short Interest Ratio vs. the Dow Industrials from January 1994 to the present on the following weekly chart:

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present) - The latest NYSE SI ratio spiked higher from a reading of 6.1 to 7.4 in the latest month - the highest reading since the 7.5 reading during October 1996. More importantly, the 7.5 reading during October 1996 was folowed by a 12-month rally of approximately 35% in the Dow Industrials. The latest spike came on the heels of a continuing increase in NYSE short interest, accompanied by a slight drop in trading volume.

As mentioned on the above chart, the latest NYSE Short Interest Ratio just spiked higher from 6.1 to 7.4 in the latest month – a high not seen since October 1996.  More importantly, this high in October 1996 was followed by a 12-month rally of approximately 35%, and which did not end until the Asian Crisis came into full view in mid October 1997.

But skeptics may now ask: What about the proliferation of 120/20 and 130/30 strategies among institutional investors (these are basically just strategies where funds go both long and short but which try to maintain a 100% net long position)?  Aren't those strategies distorting the short interest numbers and potentially the margin numbers as well?

Yes, they are definitely “distorting” the short interest numbers to some degree (in that these funds are 100% bullish, but their holdings still show up in the short interest numbers), but according to a recent Pensions & Investments article, such strategies currently only have approximately $30 billion in assets.  Assuming 30% of those assets are used as collateral to short stocks, this only amounts to a short position of $10 billion overall – hardly a meaningful number that could cause a significant distortion in the short interest numbers.  Of course, we will continue to keep watch on the proliferation of such strategies going forward – as the popularity of these strategies may very well cause a distortion at some point.  For now, I believe we can safely ignore them.

In the meantime, I would recommend reading a recent post (dated April 24, 2007) by Geoffrey on our MarketThoughts discussion forum.  That post (and subsequent replies) provides an update on the Spanish housing market bubble – and may very well be the Achilles' heel for both the Euro and the Euro Zone economy going forward. 

For now, however, we remain 100% long in our DJIA Timing System, as we believe that the market's intermediate term trend remains up – given decent valuations (we probably won't significantly trim down our position until or unless the Barnes Index hits a level closer to 70 – it is currently at 60.40), decent breadth and volume, and relatively neutral sentiment.  The stock market also remains well supported by private equity buyouts and insider buying.  Sure, the market continues to remain overbought in the short-run, but the signs of a significant top (even on a short-term basis) are still not there yet.  Stay tuned for further updates.

Signing off,

Henry To, CFA

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