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Market Not Close to a Bottom

(June 10, 2007)

Dear Subscribers and Readers,

As we experience the full force of summer heat, my guess is that the bulls will also experience a tough summer this year.  As I have mentioned numerous times, both in our commentaries and in our discussion forum, there are many reasons for this – among them, liquidity, sentiment, and valuation reasons.  I will not list them here, as subscribers can always go back and read up on our commentaries over the last few weeks for a refresher.  Besides, the major purpose of this commentary is to discuss why – in my opinion – the correction that we experienced last week is most probably not significant enough for us to currently buy at these levels.

Now, let us continue our commentary.  First of all, following is an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on June 10th, we are neutral in our DJIA Timing System.  As I mentioned last week, we currently do not have any plans to go short in our DJIA Timing System – unless the Dow Industrials manage to rally to the 13,800 to 14,200 area.  We continued to hold this position.  While equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S. equities are now at its most expensive level since May 2006, despite the correction we witnessed last week.   Combined with the liquidity headwinds that we have previously discussed, stocks are definitely not too attractive at this point, especially as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase.  Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th.

In addition, we do not believe that the correction that we witnessed last week was significant enough for a tradable or buyable bottom.  Sure, we did get a Lowry's 90% downside day on Thursday.  Moreover, this was accompanied by the fact that:

  1. Declining volume on the New York Stock Exchange made up 92.5% of the sum of NYSE Advancing + Declining Volume

  2. Declining issues on the NYSE made up 90% of the sum of NYSE Advancing + Declining Volume

Because of this – the bulls would argue – the market is now oversold enough for a sustainable bottom going forward.  Looking at history, they are – for the most part – correct.  Following is a table showing the number of days we have had such high declining volume and issues from January 1987 to the represent:

Trading Days With over 92.5% Declining Volume & 90% Declining Issues (January 1987 to the Present)

Over the last 20 years, there have only been seven previous instances (excluding last Thursday) we have witnessed such dramatic downside breadth on the NYSE.  With the exception of the October 16, 1987 decline, prices effectively bottomed on that very day – and would rise significantly higher over the next three to six months.  Even including the October 16, 1987 decline, the 3-month and 6-month subsequent performance was 3.7% and 10.5%, respectively.

However, it is also interesting to note that the average daily decline of all those seven previous instances was 8.2%.  Excluding “Black Monday,” the average daily decline was still a high 5.8% - significantly overshadowing the 1.5% decline in the Dow Industrials that occurred last Thursday.

Moreover, the Dow Industrials is still sitting at 2.4% above its 50-day and 8.3% above its 200-day moving average.  The 8.3% reading, in particular, tells us that the market is actually closer to an overbought rather than an oversold level.  Moreover, this compares unfavorably with the late February to mid March decline earlier this year, when the Dow Industrials corrected to a level that was approximately 4% below its 50-day and 2% above its 200-day moving averages before continuing its rally.

In terms of relative valuations – especially because of the continuing rise in long-term bond yields (not just in the U.S. but all across the globe as well, including Japan) – the S&P 500 definitely did not decline very much in the latest decline.  This is evident in the latest reading in the Barnes Index.  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 May 2006 peak, the Barnes Index rose to a level of 67.60.  During the week prior – when the S&P 500 closed at an all-time high, the Barnes Index rose to a similar level.  As of last Friday at the close, however, the Barnes Index had only merely declined 1.2 points from the week prior – to a still relatively high reading of 66.00.  For comparison purposes, the Barnes Index declined a whooping 11.60 points to a reading of 52.40 on February 27, 2007.  Make no mistake: The correction of last week did not get us close to oversold territory.

Moreover, there is no doubt that risk aversion among hedge funds and retail investors alike remains relatively low.  One reliable indicator of these “animal spirits” is the strength of the Yen carry trade.  Following is a chart showing the performance of the Yen against the Euro, Pound Sterling, the Australian Dollar, and the Canadian dollar from January 2, 2007 to last Friday:

Yen Cross Rate Performance (January 2 = 100) (January 2, 2007 to Present) - Major risk aversion during the late February to mid March decline! 2) So far, we haven't witnessed any similar risk aversion in the Yen carry trade just yet, despite the fact that Japanese 1Q GDP growth is greater than both U.S. and the Euro Zone. In fact, the AUD/Yen cross rate has gone on to make new highs.

As can be seen on the above chart, there is no doubt that risk aversion among investors today remains very low, as the Yen did not really rally in a significant way during last week's correction.  In fact, the Australian Dollar actually rose to a new high against the Yen last Friday!  Meanwhile, the Canadian Dollar-Yen cross rate remains at elevated levels, while the Euro and GBP-Yen cross rates are still vacillating near the highs.  The lack of risk aversion is especially apparently when one compares the action of the Yen over the last week to action during late February and early March – when the Yen rose anywhere from 6% to 8% against these same currencies during that period.  Given the lack of aversion we are witnessing in today's market, the chances of us having a tradable bottom at current levels remain low.

Note: As I am finalizing this commentary, news has just come out that the Reserve Bank of New Zealand has just intervened in the currency markets in order to keep the NZ$ from rising to high levels.  This piece of news is significant – as the Reserve Bank of New Zealand had not intervened in the currency markets since its currency stabilization fund was set up in 1990.  Combined with the revised 1Q Japanese GDP reading that was released earlier this evening, there is a real possibility we could see some sort of unwinding of the Yen carry trade during this summer.  Indeed, there is now discussion that the Bank of Japan could raise rates again as early as next month, instead of at the August meeting.  If so, this will not bode well for the world's equity markets this summer.

Before we go on with our discussion of the Dow Theory, I want to spend some time on the recent “full house sell signal” as mentioned by a Morgan Stanley analyst.  Subscribers who want some more details on the inputs of this latest sell signal on the MSCI Europe can read the BBC article.  While I have the original Morgan Stanley publication that discusses this latest signal – it, unfortunately, does not go into much detail on the inputs of their valuation, sentiment, and risk indicators.  It does, however, lists out the five previous “full house” sell signals – those being April 1981, September 1987, February 1990, May 1992, and April 2002.  On average, the subsequent three and six-month performance of the MSCI Europe was negative 13.0% and negative 15.2%, respectively.  With the exception of the three-month performance of the February 1990 signal (when it rose 5.5%), all of the subsequent three and six month performance numbers were negative, including the six-month performance (negative 6.8%) subsequent to the February 1990 signal.

In light of the latest “full house sell signal” from Morgan Stanley, I would at least be cautious here, especially given the deteriorating liquidity conditions (which their model does not appear to take into account, with the exception of bond yields) that we have been discussing over the last few weeks.

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 January 2005 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2005 to June 8, 2007) - Over the last week, both the Dow Industrials and the Dow Transports endured a significant correction from their all-time highs, with the former declining 243.72 points and the latter declining 206.01 points. Thursday's 5,034.91 close on the Dow Transports came within 0.58 points of violating its May 1st low. Again, please note that the Dow Transports all-time high close of 5,326.01 on June 1st came more than a month after the previous all-time high clos on April 25th and is thus still not an encouarging sign for the bulls, especially given the tremendous rise in bond yields over the last couple of months and the weakness in the Dow Utilities. As of May 8th, we have trimmed our 100% long position in our DJIA Timing System to a completely neutral position at a DJIA print of 13,299, and will most likely go short if the DJIA continues to move higher in the next couple of weeks. - preferably to the 13,800 to 14,200 area.

For the week ending June 8, 2007, both the Dow Industrials and the Dow Transports retreated significantly from their all-time highs, with the former declining 243.72 points while the latter declined 206.01 points.  Again, given that the confirmation of the Dow Industrials on the upside by the Dow Transports came after more than a month, this latest confirmation during the week before last is really not that encouraging for the bulls.  For now, we will continue to maintain our completely neutral position in our DJIA Timing System and will probably initiate a 50% short position in our DJIA Timing System should the Dow Industrials hit the 13,800 to 14,200 area in the coming weeks – unless the Barnes Index stays below the 70 level or unless liquidity around the world starts to improve.  For now, my latest indicators tell me that liquidity conditions are continuing to deteriorate.

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 decreased slightly from last week's 25.2% to 24.4% for the week ending June 8, 2007, despite the correction that we witnessed last week.  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 June 8, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased slightly from 25.2% to 24.4%. Assuming that last week was the beginning of a new downtrend, it is definitely too early to look for a bottom here, given the mere 0.8% downtick in this indicator. For comparison purposes, the four-week MA of this indicator declined from 31.0% to 19.5% during the late February to mid March correction earlier this year.

Assuming that some kind of downtrend began last week, it is definitely too soon to be looking for a sustainable bottom at current levels, given that our sentiment indicators are still at relatively elevated levels.  Again, we will most likely not go long again unless these indicators again reach an oversold signal at least consistent with what we witnessed during the April 2005 and October 2005 corrections.  For now – should we witness some kind of spike (in the 3% to 5% range) over the next couple of weeks in this indicator, then we will probably initiate a short position in our DJIA Timing System as long as the Dow Industrials is trading in the 13,800 to 14,200 range and as long as the Barnes Index is at a reading > 70.

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:

ISE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA of the ISE Sentiment made a high of 137.8 last Monday and has declined to 130.4 as of last Friday. Meanwhile, the 50 DMA rose to as high as 130.3 last and closed at a reading of 128.2 as of last Friday. Even though the absolute readings in these two moving averages are still relatively low - given the latest run-up in the 20 DMA, my guess is that the market will most probably correct and continue to struggle throughout the summer. More importantly, we will need to see a significantly more oversold reading in this indicator before we will go long in our DJIA Timing System yet again.

While the 20-day moving average of the ISE Sentiment (at a current reading of 136.5) is still not close to overbought levels, its rally from a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) to 137.8 as of last Monday was definitely getting long in the tooth – and as such, a correction was definitely due.  Even though the 20-day MA has since declined to 130.4 as of last Friday, this reading is still somewhat elevated – and therefore, my best guess is that the market will continue to struggle throughout this summer.  Should this experience some kind of spike in the coming days, and should this be accompanied by a DJIA reading in the range of 13,800 to 14,200 and a Barnes Index reading of over 70, then we will most likely initiate a short position in our DJIA Timing System.  Moreover, unless the 20 DMA gets more oversold again, we will continue to avoid a long position our DJIA Timing System.

Conclusion: Assuming that a new downtrend began last week, there is plenty of evidence to suggest that we are still not close to a sustainable, buyable bottom in the U.S. and world markets just yet.  This is apparent not just in our valuation and technical indicators, but also in the pricing and sentiment indicators as well – not to mention the fact that investors' risk aversion remains low, as exemplified by the lack of a rise in the Yen against all the major carry trade currencies during the correction last week.  In addition, the latest “full house sell signal” from Morgan Stanley on the MSCI Europe is nothing to sneeze at, especially given its impressive track record over the last 25 years or so.

Finally, make no mistake – liquidity conditions continue to deteriorate all across the board – even as the commercial banks, hedge funds, and private equity funds continue to create and supply liquidity to the world's financial system.  All it takes now is one failed LBO, and the stock arbitrageurs will unwind their positions and probably carry the market along with it – similar to the aftermath of the failed buyout of UAL on October 13, 1989.  Combined with the “capitulation” of many mainstream market commentators, I am going to maintain that U.S. stock market investors will have a tough time during this summer.  At this point, we will thus stay completely neutral in our DJIA Timing System – and may actually even initiate a 50% short position in our DJIA Timing System should the right conditions materialize.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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