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An Update of our Technical Indicators

(July 29, 2007)

Note: For those would like to learn more about Modern Portfolio Theory and the latest trends in the financial markets, please read our latest book review of Peter Bernstein's latest work, entitled “Capital Markets Evolving.

Dear Subscribers and Readers,

I hope all our subscribers have had a good weekend.  Again, I hope the “marketing piece” that we sent on Saturday morning was not too much of a bother.  In addition to being a marketing piece, the email also contained a quick update of the latest topics in our MarketThoughts discussion forum.  Our forum interface is easy to use and registration is free.  Please come and join us or ask a question whenever you get a chance – there are no dumb questions and chances are that other subscribers will also benefit from what you write.  MarketThoughts is meant to be an interactive experience.  I look forward to seeing you there.

Let us now begin our commentary by providing 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 July 29th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link).  While it would have worked out well if we had continue to hold our long position since May 8th, sold out and shorted last Monday, we had decided to exit our long position and remained neutral since that time, given the ample signs that were telling that this rally was getting tired.  Moreover, while we had wanted to initiate a 50% short position in our DJIA Timing System, the market did not “corporate” by rallying to a level (over 14,000) that was satisfactory for us to short.

The last point (waiting for a good entry point) needs some emphasis.  If this author had believed that we were entering a new bear market, then obviously I will have allowed some leeway, as a bear market will usually bail you out of a short position even if your timing was off.  As I have discussed over the last couple of months, we are currently only expecting a correction within a cyclical bull market (albeit a significant correction) – and because of this, we not only are more careful when it comes to shorting, but also are reluctant in shorting in the first place.  With the Dow Industrials having decline 4.2% in the latest week, it is now obviously too late to trade on the short side – and therefore, going forward, we will most likely look to get back on the long side instead.  Again, at this time, we are still not looking for a new bear market, unless one of the following occurs:

  1. The promise of significantly higher income and dividend taxes by whoever wins the next US Presidential election in 2008, along with a Congress willing to implement these higher taxation policies
  2. A trade policy mistake by Congress in dealing with China, along with a significant response from China
  3. If the Yen carry trade or Swiss carry trade unwinds in a violent way and ends, which we are not looking for at this time.  In all likelihood, such an event will most probably collapse the Korean consumer as well as the major Eastern European economies (not including Russia)

At this point – we will continue to wait for a more oversold position before getting in on the long side, as by the middle of next week, a secondary pillar of liquidity will also be removed – as insiders are typically not allowed to sell any shares during the two weeks (before and after) surrounding the reporting of its earnings numbers.  Given that the flood of earnings reports is in the midst of peaking, this means starting in early to mid August, there is a strong likelihood that insider selling will flood the market, as long as the stock market holds at current levels.  That is, I believe the stock market is still trading at a valuation that is attractive enough for insiders to sell – so unless the Dow Industrials or the S&P 500 sells off more than 5% on Monday, we will continue to stay neutral in our DJIA Timing System.

So Henry, don't you think the market is now severely oversold?  What kind of indicators are you looking at?

By some indicators (such as the value of the VIX relative to its levels over the last four years, the daily NYSE McClellan Oscillator reading, and the daily NYSE new lows vs. new highs), the market is now severely oversold, but in a liquidity squeeze/panic such as what we have been witnessing over the last week, this author prefers to see more of our technical indicators confirming this oversold condition before taking a position on the long side.  Let us now quickly go through each of these indicators, as there are a lot to cover.

Simple 200-day Moving Average

A quick glance on our MarketThoughts charts page will reveal that – despite last week's market swoon – the Dow Industrials and the S&P 500 is still trading at 4.1% and 1.7% above their 200-day moving averages, respectively.  For comparison purposes, both the Dow Industrials and the S&P 500 traded as low as 2% below their 200-day moving averages at the bottom during October 2005 and the summer correction of 2006.

The VIX, or Implied Volatility

While implied volatility (the VIX closed at 24.17 last Friday) is now at a four-year high, it is still relatively low compared to the readings we witnessed during the period from 1997 to 2002.  More importantly, while we did witness a 30% surge in the VIX over the last week, we did not get a daily surge in the VIX of over 25%.  The last time we had such a surge was February 27, 2007, and prior to that, May 30, 2006.  True, since January 1990, there have only been 14 instances when the daily reading of the VIX surged over 30% - but given the liquidity and sentiment changes we are now witnessing in the LBO market, I would definitely expect more from the VIX before the current panic bottoms out.

Actual Volatility in the Dow Industrials

As I have shown in previous commentaries, virtually every market decline that we have witnessed has usually ended with some kind of volatility spike.  Here at MarketThoughts, we usually like to calculate short-term volatility by taking a running 10-day volatility number and then annualizing that number.  As of Friday, volatility hit a level of 17.94%, the highest level since March 12, when it hit 19.36%.  Note that in the following chart, volatility has usually topped out (and hence, the market bottoming out) once it hits the 17.5% to 20.0% range over the last four years, with a maximum further decline of 200 points or so.

If we ignore the period from 1998 to 2002 and take a look at the 1994 to 1997 period, volatility has usually topped out in the 20% to 22.5% range, with the exception of the October 1997 period:

However, just like the October 1997, the October 1998 (not shown), and the 2001-to 2002 periods, the stock market is now in “panic mode” – as many investors are still trying to gauge the future market environment given the dramatic reversal in the buyout market and as – most likely – more hedge funds who had invested in CDOs are going to “come clean” in the coming weeks.  At the end of the last LBO boom on October 13, 1989 (when Japanese banks pulled funding for the UAL buyout) – the Dow Industrials declined more than 7% that day, and volatility spiked up to over 40%.  Moreover, even if volatility tops out in the 20% to 22.5% area, the Dow Industrials could still decline another 2% to 5% over the next few weeks.  Bottom line: At this point, actual volatility still isn't high enough for us to initiate a long position in our DJIA Timing System just yet.

The NYSE ARMS Index

As of last Friday at the close, the 10-day moving average of the NYSE ARMS Index “only” closed at a level of 1.29 – somewhat oversold but definitely nowhere near oversold compared to the readings we got in mid June (1.52) and mid July (1.40) of last year, not to mention the 20-year high reading of 2.8 (the highest since the October 1987 crash) that we got in early March of this year.  Until or unless this reading hits the 1.40 area, this author will not even think about going long just yet.

The NYSE McClellan Oscillator and Summation Index

While the daily NYSE McClellan Oscillator (ratio adjusted, so it is comparable to all time periods, going back to the 1920s) is now at a very oversold level (see following chart courtesy of Decisionpoint.com), the same still cannot be said for the NYSE Summation Index (ratio adjusted) – as it only closed at a level of -215.64 last Friday.  Relative to April 2005, October 2005, and June 2006, this reading is still more than 250 points away from a similar oversold level.

If we take these two readings and extend the chart back to the 1920s, we get the following picture, courtesy of Decisionpoint.com:

Interestingly, the daily reading of negative 100 or so suggests a very oversold level in the short-run – and while this can still run further (such as the readings we witnessed during the October 1987 crash and the trading week immediately after the September 11th attacks) – chances are that we will start bouncing tomorrow or Tuesday at the latest.  From a longer-term standpoint (i.e. the McClellan Summation Index), the reading of -215.64 is nowhere near an oversold level, especially when one compares this reading with readings we got during October 1987 (-1,600), October 1990 (-1,500), October 1998 (-1,500), and October 2002 (-1,500).  Again, this author would like to see a reading of at least -500 in the NYSE McClellan Summation Index (ratio adjusted) before we will initiate a long position in our DJIA Timing System.

Other technical indicators that do not indicate a severe oversold condition just yet includes the % of NYSE issues trading above its 200-day EMA, the 10-day running average of both NYSE and NASDAQ new highs vs. new lows, and the proximity of S&P 500 issues to their 52-week lows vs. 52-week highs.  Again, while some daily (i.e. very short-term) indicators are severely oversold, it is still too early to be thinking of a long position for any sustainable period of time, unless one is day-trading or is willing to flip his/her positions at a moment's notice.

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:

For the week ending July 27, 2007, the Dow Industrials declined by 585.61 points (4.0%) while the Dow Transports declined 320.45 points – capping off the worst performing weak for the U.S. stock market since October 2002.  Given the severe decline we have witnessed over the last six trading days, chances are that market should now at least begin a short-term bounce.  The key to a sustainable bounce, however, is good upside breadth and volume, and given what I have seen so far (a weak NYSE A/D line, Dow Utilities, and declining liquidity, not just in the LBO market but in the insider selling as well) chances are that bounce starting on Monday or Tuesday will not be sustainable.  For now, we will most probably maintain our neutral position in our DJIA Timing System, unless 1) we obtain more oversold readings in our technical indicators mentioned above, or 2) we see more of a loosening bias in the policies of the world's central banks, especially the Federal Reserve.  On the second point, however, we will most probably not see any hint of a Fed Funds rate cut (or an increase in the St. Louis Adjusted Monetary Base) unless we get a more drastic decline in the stock market, so don't hold your breadth just yet.

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 increased slightly from last week's 23.9% to 24.6% for the week ending July 27, 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:

In last weekend's commentary, I mentioned that “the four-week MA has moved in a very narrow range of 22.7% to 25.2% over the last 3 ½ months.  The $64 billion question now is: Which way will this resolve over the next few months?  Given that this reading has not been oversold since summer of last year, and given the tremendous rally we have seen since that time, my guess is that ultimately, this will resolve downward later this year – even if this indicator rises in the short-run.” 

While it is surprising to see this latest reading actually increase, subscribers should note that both the AAII and the Investors Intelligence survey readings were taken on Wednesday.  Therefore, neither the declines of Thursday or Friday would have been discounted into these readings just yet.  My sense is that the upcoming week's readings will be significantly lower – causing the four-week MA to break below its range of 22.7% to 25.2% over the last few months.  More importantly, we do not plan to go long the stock market again until his reading has gotten to a more oversold level, such as what we experienced during the April 2005 (8.5%), the October 2005 (11.6%), and the June 2006 (1.7%) bottoms.  For now, we will remain neutral in our DJIA Timing System.

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:

Over the last week, the 20-day moving average of the ISE Sentiment declined 2.7 points to 148.0, and after hitting a 14-month high of 152.9 as recently as last Monday.  Given the decline in the stock market last week, my guess is that the 20-day moving average has now turned down – a signaling that retail investors are now getting more pessimistic.  While such bearish sentiment is usually bullish for the stock market in the long-run, such a turn in retail sentiment is usually bearish to neutral for the stock market in the short-run.  More importantly, both the 20-day and the 50-day moving averages of the ISE Sentiment index is still nowhere close to being oversold.  Until or unless the 20-day moving average at least declines to a similar level we witnessed during June of last year (approximately 120), we will continue avoid a long position our DJIA Timing System.

Conclusion: There is no question that the short-term trend is now down, even should we see a bounce on Monday or Tuesday.  The question now is: When does the market become oversold enough for us to initiate a long position in our DJIA Timing System?  Judging from a review of our technical indicators on the US stock market, we are not holding our breadth just yet, especially since the easy liquidity environment we have witnessed in the last few years may now be in the midst of changing in front of our very eyes.  Again, while many of our indicators are now severely oversold in the short-run, they are nowhere near oversold just yet from an intermediate standpoint, including all our sentiment indicators.

In the meantime, subscribers who are willing or want to trade for a short-term bounce may want to buy the sectors that had exhibited relative strength last Friday, such as financials, REITs, and crude oil related stocks.  Over the longer-run, this author expects more money will flow into equities with stronger balance sheets – and in sectors that are less cyclical, such as stocks in the health care sector or specific stocks that have strong balance sheet and relatively stable earnings, such as UPS, DNA, JNJ, PEP, SPLS.  For subscribers who are interested, following is a recent chart compiled by Morgan Stanley showing various sectors/industries along with their free cash flow divided by their total debt:

Signing off,

Henry To, CFA

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