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Market Not Close to Capitulation Just Yet

(August 12, 2007)

Dear Subscribers and Readers,

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 August 12th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link).  Last week was an exciting week, if you will – as, for the first time since the trading day after September 11, 2001, most of the world's central banks had to make a point and inject a significant amount of liquidity into the financial markets.  On Thursday, the ECB injected close to US$130 billion into the Euro Zone's financial system by lending unlimited funds to the European money market at 4% – after overnight rates spiked to 4.7% as many investors panicked and cashed in their money market holdings.  On Friday, the ECB injected a further US$83 billion.  The Federal Reserve, Bank of Japan, and the Reserve Bank of Australia all injected certain amounts of liquidity during the last two trading days, with  the Federal Reserve intervening not once, twice, but three times on Friday by buying up a total of US$38 billion of mortgage-related securities in the open markets.  As late as Friday morning, the Fed Funds rate had spiked up to 6%, or 75 basis points more than the Fed's intended target.  If the world's central banks had not acted on Thursday and Friday, then there was a good chance that parts of the fixed income and most probably the equity markets would have broken down.

As I alluded to in our “ad hoc” commentary on Thursday evening, the latest hedge fund losses over the last few weeks did not just originate from the problems in the US subprime area, but also in the proliferation of quantitative market-neutral hedge funds and mutual funds over the last few years.  As we have also discussed in recent commentaries and in our postings on the MarketThoughts discussion forum, the popularity of these strategies (including the 120/20 and 130/30 strategies now being offered in 401(k) plans), had reached a crescendo over the last six months.  Given the declining “alpha opportunities” as a result of the increasing popularity of these strategies, many existing market-neutral funds had to increase their leverage in order to maintain adequate returns.  Sooner or later, this “alpha bubble” was sure to burst – and as what we have witnessed over the last few weeks – especially over the last week – it did, indeed, burst.  As a result of this and the increasing problems in the US subprime and alt-A markets, many hedge funds had to quickly unwind their positions – not just because these funds were overleveraged, but because of increasing volatility in the financial markets as well.  And now, the $64 billion question for our subscribers: Are the US and global equity markets now a “buy?”

In our weekend commentary two weeks ago (“An Update of our Technical Indicators”), I stated that I did not believe we are entering a new bear market, unless one or more 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)

I now want to add a fourth qualifier: If the current credit market woes spread to other asset-backed securities, such as those backed with auto loans, auto leases, and credit card debt, then we will most probably enter a new bear market.  Subprime and near subprime mortgage debt aside, any deterioration in the just-mentioned asset-backed securities will have severe repercussions for the average U.S. consumer, including higher auto loan and credit card rates all across the board.  At this point, the rise in spreads among junk bonds, emerging market bonds, mortgage securities, leveraged loan securities, and CMBS securities still have not spread into the auto loan and credit market markets – but if it does, then we will have to seriously rethink the possibility of a US recession in early 2008 (we will revisit this issue in a later commentary, if applicable).

For now, probability suggests that we're still in a cyclical bull market.  However, it is naïve to think that the last few years of excesses – including excesses in the US housing market, the US buyout market, and the global hedge fund market – can be corrected in a mere three weeks (both the Dow Industrials and the Dow Transports made all-time highs as recently as July 19th).  Make no mistake: This is also the first genuine financial crisis we have witnessed in the cyclical bull market that began in October 2002 – and thus unlike the unjustified “four-year low” and bird flu scares that we experienced during the summer last year, it is natural to expect more corrective action in the US and global equity stock markets over the next few weeks.  To put this in perspective: The Hong Kong Hang Seng Index can decline another 7% to 8% from its Friday close and still be above its uptrend line that stretches back to October 2005.

Moreover, there are still indicators out there which still do not suggest “capitulation” – or at the very least, a short-term, a tradable bottom.  Let us first take a look at the action of the Japanese Yen versus other popular “carry trade” currencies (these are the currencies that are popular with folks who borrow in Yen and choose to invest in other currencies, not including the New Zealand Dollar).  As our past commentaries have implied, it is natural to first look at the Yen carry trade for signs of capitulation, given that: 1) Speculative forex positions are, no doubt, the most liquid positions that any hedge fund or bank can liquidate in a financial crisis, and thus, it makes sense to look at the action of the Yen as a leading indicator of market capitulation,  2) In terms of measuring the Yen carry trade on either the purchasing power parity basis or in terms of the amount of Yen borrowed by investors or sent out by Japanese investors, the Yen has been getting very overstretched, i.e. close to its Fall 1998 levels, 3) Japanese retail investors, who have been the “main culprits” behind the Yen carry trade over the last 12 months, have historically (and still are) lousy market-timers.  Therefore, should the Yen dramatically increase, that would most likely mean that Japanese investors have capitulated and repatriated their money back home – signaling an imminent bottom in the global equity markets from a contrarian standpoint.

The chart below shows the Yen cross rate performance (vs. the Euro, the British Pound, the Australian Dollar, and the Canadian Dollar) from January 2, 2007 to the present:

Yen Cross Rate Performance (January 2 = 100) (January 2, 2007 to Present) - Major risk aversion during the late February to mid March decline! 2) Sure, the Yen carry trade has corrected substantially since mid to late July, but so far, we still haven't witnessed any substantial risk aversion just yet, given that the % correction is still not as severe as the February to mid March decline trade and given that we are still only at a level similar to the early June levels.

As mentioned on the above chart, the most recent correction in the four popular Yen cross rates is still not severe enough as what we witnessed during the late February to mid March correction.  More importantly, these cross rates have only corrected to levels last seen during early June – definitely nowhere close to “capitulation” levels and a far cry to what we witnessed in Fall 1998, when the Yen – at one point – rose over 10% in a space of 24 hours!

The lack of an oversold condition in the various Yen cross rates (i.e. Yen carry trade) can also be witnessed in the percentage deviation of the Euro-Yen cross rate from its 200-day moving average, as shown in the daily chart below (from February 1999 to the present):

Euro-Yen vs. Percentage Deviation from its 200 DMA (February 1999 to Present) - 1) After a brief decline to the zero line during early March, the percentage deviation of the Euro-Yen cross rate from its 200-day moving average recovered strongly and had been trading between 4% to 6.5% from early April to late July, before correcting significantly over the last few weeks. Despite the latest corrrection, however, the Euro-Yen cross rate is still 1.88% above its 200 DMA - suggesting that there is still some downside to go before we can conclude that we have seen *capitulation.* 2) Not a very *impressive* correction in the grand scheme of things...

As can be seen on the above chart – even with the latest correction in the Euro-Yen cross rate, it is still trading at 1.88% above its 200 DMA as of last Friday.  As a minimum, this author would like to see this % deviation go back to the zero line (similar to what we achieved during the October 2005 and the early March 2007 bottoms) before we would think about initiating a long position in our DJIA Timing System.

Another speculation with plenty of liquidity is crude oil – a commodity that is used and prized all over the world – and one which we consume over 80 million barrels a day and has attracted a lot of long interest over the last few years.  Since the latest liquidity/credit crunch began, oil has declined from a high of over $78 a barrel to $71.60 at the end of last week, as can be seen in the daily chart (showing the daily spot price of crude oil as well as its percentage deviation from its 200 DMA) below:

Daily Spot Crude Oil vs Percentage Deviation from its 200-Day Moving Average (March 1983 to Present) - 1) George Soros made a substantial amount of money by shorting crude oil in late 1985/early 1986. Crude declines from over $31 in November 85 to just $11 by March 86. 2) Post *Gulf War 2* spike down - oil declines from $37 to $27 in just ten days. 3) Iraq invades Kuwait. 4) Oil peaks at $28 in December 96. Asia and Emerging market crisis hits in 97. Oil bottoms at $11 in December 98. 5) Over the last seven trading days, the spot price of WTI crude oil declined from over $78 to $71.60 at the close on Friday. In the grand scheme of things, however, what we have just witnessed cannot be categorized as a major correction just yet, as crude oil is still over 13% above its 200 DMA and still lingering near all-time highs.

While the latest one-week correction of about $7 a barrel has been relatively steep, it actually isn't much of a correction in the grand scheme of things – especially when compared to the action of crude oil prices over the last 25 years.  In the last global credit crunch (keep in mind, however, that this came after the Asian/Russian/LTCM crises), crude oil declined approximately 60% from peak to trough from December 1996 to December 1998.  Notwithstanding fears of a active hurricane season, the WTI spot price of crude oil is still lingering at near all-time highs, and is still 13% above its 200 DMA.  Before we can conclude that investors have capitulated, this author would like to see this percentage decline back to the zero line, or at the very least , a crude oil price of $68 (5% decline from current levels), or below.

Another indicator, which has aided me immensely in calling for oversold bottoms since we began writing our commentaries, has been the NYSE ARMS index.  Following is a daily chart covering the 10-day and 21-day MA of the ARMS Index vs. the daily closes of the Dow Industrials from January 2003 to the present:

 10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - While we did our >3 daily reading and a 10-day MA reading of over 1.5 on August 3rd, the 21-day MA of the NYSE ARMS Index - which hit a high of 1.27 on the same day, is still not close to a severely oversold level yet, at least not when compared to the readings we got during late February and the Summer 2006 correction (when the 21-day MA peaked at 1.95 and 1.36, respectively). Normally, a 10-day MA reading of 1.5 would be high enough - but given the weak recovery we witnessed in the last few days, this author is betting that we will see more downside.

As mentioned in the above chart, while the >3 daily reading and a 10-day MA reading of over 1.5 on August 3rd would normally signal at least a short-term bottom, the quality of the subsequent rally has left much to be desired.  Because of the lack of breadth in the subsequent rally and no huge signs of capitulation just yet, this author is looking for more downside in the next couple of weeks, and probably won't initiate a long position in our DJIA Timing System until the 21-day moving average (which peaked at 1.27 on August 3rd) rises high – preferably to over the 1.35 level.

Before we go on and discuss the most recent action in the U.S. stock market via the Dow Theory – along with our most popular sentiment indicators – I would first like to go back and discuss whether the latest financial crisis is going to envelope the wider U.S. economy and to a lesser extent, the global economy.  As I have mentioned before, probability still suggests that the cyclical bull market in US and global equities still remain intact.  Moreover, corporate balance sheets are still close to the best we've seen in many years.  Corporate profit margins are also at 40-year highs – not to mention the fact that most of the countries in the global economy is also doing very well.  On a going-forward basis, however, things are less rosy.  Investment and money center banks in recent years have branched out to more speculative activities in recent years in order to goose up their profit margins and profits – such as moving into hedge and private equity funds – and there will no doubt be layoffs in the financial industry in the coming weeks.  More importantly, there is no good reason for the Fed to come in and “bail out” these folks – as the Federal Reserve's goal is to make monetary policy to the average Joe, not the hedge fund manager who made over a million dollars last year (besides getting laid off or having to close his/her hedge fund would be a good excuse to take a break), or the subprime borrower who is going to lose his/her house simply because his $15 an hour job can't support the mortgage payments on his $500,000 home.

However, there is good evidence that the latest liquidity crunch is starting to impact the average American.  If things continue as they are, then chances are that problems will start developing in the ABS market for auto loan/lease and credit card debt as well – and if that occurs, there is no doubt that the U.S. will head into a recession – most probably accompanied by significant downside in the S&P 500.  As a result, assuming that we witness more “seizure” in the markets ahead, I believe that the Fed will cut before the next scheduled meeting on September 18th – most probably before this month is over.  This will be followed by one more rate cut on September 18th – and then we will see the Fed stand pat for the rest of the year.

Keep in mind, however, that the above assumes that we will see more pain in the stock market over the next couple of weeks – something that I do anticipate will occur.  At this point, only a drastic worsening in the stock market and credit markets will make the Fed cut – as both the ECB and the Bank of England has made it clear that they are still in a tightening bias – and most likely, the Fed will not cut without some accompanying cuts by these two other central banks as well.  Moreover, as long as these three central banks are quick and decisive, there does not have to be a US recession, even in a worst-case scenario.  Five years ago, I would have slapped a higher probability of a recession occurring in the US in early 2008 – given what had just transpired over the last few months – and especially in the last couple of weeks.  However, it is always important to remind ourselves that – especially for US subscribers – not to remain so US-centric.  Not only does the American economy make up less of the global pie, it is important to keep in mind that global economic growth is still strong, and for the first time in a long time, both the countries in the Euro Zone (with the exception of Italy), and Asia (even Japan) has been outperforming the US in terms of economic growth over the two most recent quarters.  Assuming that crude oil prices will fall in any upcoming US slowdown, and assuming that export markets will remain open, U.S. GDP growth will most probably not dip into recessionary levels.  That is, besides having to watch US housing, the US consumer, and the US credit markets going forward, subscribers should also continue to watch the Euro Zone and Asia as well, with growing emphasis on the rapidly growing economies of China and India.  Subscribers please stay tuned.

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 August 10, 2007) - For the week ending August 10, 2007, both the Dow Industrials and the Dow Transports bounced - with the former rising 57.63 points and the latter rising 87.92 points. This is to be expected, as both indices had just declined for three consecutive weeks - with one of those weeks being the worst week since October 2002. Note that the Dow Transports has nearly always been the stronger index over the last few years - as it has always led the Dow Industrials on the upside and had also risen more than the Dow Industrials during that period. As such, the inability for the Dow Transports to retrace its recent decline as much as the Dow Industrials is not a very good sign. At the very least, it signals a change in leadership from more speculative into less speculative, and more blue-chip type of stocks.

For the week ending August 10, 2007, the Dow Industrials rose by 57.63 points while the Dow Transports rose 87.92 points – a weakish bounce (confirmed by the weak breadth in the U.S., stock market) especially in light of the magnitude of the decline that we witnessed over the prior three weeks.  In our comments from two weeks ago, I stated: “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.”  Again, given this not-very-inspiring bounce in the markets last week, this author will have to conclude that there is more downside in the days ahead – confirmed by the fact that our technical/sentiment indicators are still not at severely oversold levels 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 decreased significantly from last week's 21.5% to 18.4% for the week ending August 10, 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 August 10, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased significantly from 21.5% to 18.4%. While this reading is starting to get oversold, keep in mind we're still far away from the oversold readings that we witnessed during the bottom of the last three significant corrections - those being the April 2005, October 2005, and June 2006 bottoms. The story here remains the same, however: Until these readings reach more oversold levels - perferably to levels last seen in June 2006, there is still no major capitulation, and as such, we will continue to remain neutral in our DJIA Timing System.

In our commentary from three weeks ago, 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.”  Since then, this reading has ticked down, but my guess is that we haven't seen the bottom yet in this indicator.  More importantly, the four-week MA in this reading is still not at a very oversold level yet, and until we get this oversold reading, such as what we experienced during the April 2005 (8.5%), the October 2005 (11.6%), and the June 2006 (1.7%) bottoms, we continue to 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:

ISE Sentiment vs. S&P 500 (November 1, 2002 to Present) - Since hitting a 14-month high of 152.9 in late July, the 20 DMA of the ISE Sentiment readings has literally gone into freefall. Meanwhile, the 50 DMA rose to a 5-month high reading of 140.9 on July 19th, before finishing at 130.3 on Friday. Even though the 20 DMA is now severely oversold, this author would like to see a reading similar to the September 2006 and March 2007 levels before declaring a tradeable bottom. Moreover, the 50 DMA is still not to close to very oversold levels, and thus it will most likely take at least a couple of weeks before we are comfortable enough to go long in our DJIA Timing System yet again.

Over the last week, the 20-day moving average of the ISE Sentiment declined a whooping 18.7 points to 115.9, and after just hitting a 14-month high of 152.9 as recently as late July.  While the freefall in the 20-day moving average is suggesting that retail sentiment has turned very bearish in the short-run (and therefore bullish from a contrarian standpoint), it is still not pessimistic enough – especially when compared to the lows we witnessed during the September 2006 and early March 2007 lows.  Moreover, the 50-day moving average is still not close to being oversold, and chances are that we will need at least a couple of more weeks to see an oversold reading in the 50-day moving average.  Until or unless the 50-day moving average decline to a similar level we witnessed during recent bottoms (approximately 120), we will continue avoid a long position our DJIA Timing System.

Conclusion: Given the lack of a “severely oversold” condition in the Yen carry trade currencies, crude oil, and in our favorite sentiment indicators, my guess is that the stock market has still not capitulated, just yet.  Moreover, while some of the unwinding is due to the liquidation of market-neutral hedge funds (as opposed to long-only funds) – it is probably not a safe bet to assume that this won't have an adverse impact on the world's stock markets.  Sure, market neutral strategies should have a zero correlation with the MSCI World and the S&P 500 indices, but the latest liquidity crunch/increased volatility means that banks, hedge funds, and private equity funds alike are all paring back their risk in general.  A decrease in folks' risk  budgets will mean less of an allocation to riskier assets going forward, such as a long position in foreign equities, REITs, etc. 

At this point, I still do not advocate any long position in the stock market – even if it is just for a short-term bounce.  While scalping for short-term bounces can be a profitable endeavor during the beginning stages of a decline, it is not going to be very profitable towards the end of a decline, as markets tend to accelerate downwards as it approaches a bottom.  Over the next several weeks, I will most probably write more on long ideas in preparation for the inevitable rally.  For now, we will just take it one day at a time, and be glad that we have not been caught in the latest downdraft.

Signing off,

Henry To, CFA

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