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Putting Things Into Proper Perspective

(September 23, 2007)

Dear Subscribers and Readers,

Let us begin our commentary by first providing 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 September 23rd, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link).  Given the relatively weak rally (both in breadth and in volume) we have witnessed since the mid August lows, there is a good chance we could see a retest in the major indices before we see a sustainable bottom in the U.S. stock market.  For those who prefer to stay long, our favorite stock selections are still those within the large cap (preferably mega cap) growth areas, as well as Asia ex. Japan and China.  Also, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last five weeks, there is a good chance that the Dow Industrials could to another all-time high over the next couple of weeks.  Should this occur, however, chances are that many other major market indices will not confirm this all-time high, such as the Dow Transports, the Dow Utilities, the S&P 400, the Russell 2000, the American Exchange Broker/Dealer, the Value Line Geometric, and the Philadelphia Semiconductor Indices.   Should the Dow Industrials make another all-time high – preferably in the 14,200 to 14,500 area, and should this be accompanied by weak breadth and divergences among many market indices, then there is a chance that we will establish an initial 50% short position in our DJIA Timing System.  As always, whenever we change signals in our DJIA Timing System, we will email all our subscribers on a real-time basis informing of the change.

Let us now get into the subject of our commentary.  Thanks to the modern age of instantaneous communications, video feeds over the internet, and the explosion of the blogosphere over the last few years – not only is news transmitted as rapidly as ever, but every piece of news is now also rapidly analyzed, interpreted, and communicated by professional investors, economists, and bloggers alike.  Getting a true edge no longer means having access to a Bloomberg terminal and a direct line to the NYSE.  For individual investors, trying to get a true edge in this day and age will require patience and focusing on the long-run, as opposed to short-term trading or trading based on emotions.  No doubt this is a difficult endeavor for both professionals and amateurs alike, as squeezing out our emotions – especially in a volatile market environment – is contrary to human nature.  The purpose of this weekend's commentary is to do just that – especially given the incredible events that had witnessed just last week, such as the 50 basis point cut in the Fed Funds rate, the Bank of England's bailout of Northern Rock (and implicitly the entire UK financial system by guaranteeing all deposits at Northern Rock), the Canadian dollar reaching parity with the U.S. Dollar, the ongoing contract talks between the UAW and GM, and the intense media focus on former Fed Chairman Alan Greenspan, whose biography “The Age of Turbulence” was released last Monday, and is now officially the number one best-selling book on both Amazon.com and Barnes & Noble.

As the title of our commentary suggests, the purpose of this commentary is to “put things into perspective.”  For starters, let us discuss the recent action of the Canadian Dollar. As many folks should know by now, the Canadian Dollar officially reached parity with the U.S. Dollar last Thursday – a level that has not been achieved since November 1976.  However, for folks who think that the Canadian dollar will go straight up from here and want to go long, I urge you to reconsider.  For one, the Canadian dollar is now highly overbought – it traded at US$0.95 as recently as early September and only US$0.93 in mid August.  The rapid appreciation in the Canadian Dollar has not only made the currency highly overbought on a short-term basis, but over a longer-term basis as well – as per the following chart showing the percentage deviation of the Canadian-U.S. Dollar exchange rate from its 200-day simple moving average from January 1978 to the present:

Daily CAD-USD Rate Percentage Deviation from its 200-Day Moving Average (January 1978 to Present) - 1) Plaza Accord is signed on September 22, 1985. However, the CAD would not bottom until February 1986 (when it hit US$0.69) - but from that level, the CAD would never look back until it hit $0.89 in November 1991. 2) CAD hits a major bottom at US$0.65, as crude oil declines to nearly US$10 a barrel. 3) Canadian dollar hits parity with the U.S. Dollar - something that it has not done since 1976. On a more immediate not, the CAD-USD exchange rate is now nearly 11% above its 200 DMA - making it the third most overbought level over the last 30 years, and only 2% below its record high deviation of nearly 13% in June 2003. 

As discussed on the above chart, the percentage deviation of the Canadian Dollar from its 200 DMA is now nearly 11%, making it the third most overbought level since January 1978, or just 2% below its record high deviation of nearly 13% in June 2003.  Even if one believes the Canadian Dollar will rise still further, it is now time for a breather.

Furthermore, from a contrarian standpoint, it is important to note that the Commercials are now holding a record short position on the Canadian dollar futures contract (courtesy of the Commitment of Traders report and http://www.softwarenorth.net) – a short position that has not been this big since late July (after that record high short position in July, the Canadian dollar would go on to correct more than 2% over the next five weeks).:

Canadian Dollar - Net Commitments of Traders - Crude oil and natural gas exports in July actually down more than US$74 million on a year-over-year basis...

From a trade standpoint – while the Canadian trade balance still remains decidedly positive – it is important to note that during July of this year (August data hasn't been released yet), the total value of all crude oil and natural gas exports from the Canada to the US actually declined US$74 million on a year-over-year basis, despite the fact that the US dollar had continued to decline over the prior 12 months.  The following monthly chart (courtesy of Reuters EcoWin) shows the year-over-year change (in US$ terms) of Canadian crude oil and natural gas to the US from January 1996 to July 2007:

Year-over-year change in crude oil and natural gas exports (US$) monthly chart (January 1996 to July 2007) - Crude oil and natural gas exports in July actually down more than US$74 million on a year-over-year basis...

Finally, from a political standpoint, there are now loud political voices asking for the Bank of Canada to slash overnight rates by 50 basis points from the current rate of 4.50% to 4.00%.  Given the recent rapid rise of the Canadian Dollar over the US Dollar, chances are that the Bank of Canada will at least stand pat at its next meeting on October 16th.

Why we are thinking of going short in our DJIA Timing System

Now that we have (hopefully) put the recent rise in the Canadian Dollar in perspective, this author is also hoping to put the latest rally in the stock market in perspective as well.  From a technical standpoint, the latest rally from the market's mid-August lows had been less than spectacular from both a breadth and volume standpoint (this is also true from a Dow Theory standpoint, but we will get to that later in this commentary).  Some of the best work that attempts to measure the true buying power and selling pressure of the U.S. stock market has been done by Lowry's – but for those that do not subscribe to Lowry's – one can also easily see this in the relative weakness of many major indices, such as the Dow Transports, the Dow Utilities, the S&P 400, the Russell 2000, the American Exchange Broker/Dealer, the Value Line Geometric, and the Philadelphia Semiconductor Indices.  From a visual standpoint, the relative weakness in stock market breadth can be seen in the very weak A/D line of the Wilshire 5000 ever since its mid-August lows, as well as during last week when the Fed slashed both the discount and the Fed Funds rate by 50 basis points (following chart is courtesy of Decisionpoint.com):

Total Market Net Advances and Declines - Despite the immense rally in the Wilshire 5000 since mid August and during last week when the Fed cut by 50 bps, the Total Market A/D line is still very weak, and is significantly lower then where we were in late July – when the Wilshire was at similar levels.

Moreover, given the huge decrease in short interest over the last two months, it is not inconceivable to conclude that a significant part of the latest rally from the mid August lows was driven by short-covering.  The following monthly chart showing outstanding NYSE short interest vs. the Dow Industrials from November 15, 2000 to September 14, 20007 illustrates this perfectly:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to September 14, 2007) - For the month ending September 14, 2007, total short interest on the NYSE decreased 625 million shares to 11.47 billion shares - the greatest decrease on record, and coming off a 484 million share decline in short interest the previous month. My guess is that the latest decrease in short interest was due in no small part to deleveraging by long-short equity funds - but at the same time, it is not inconceivable that a significant part of this short-covering had also driven the rally over the last five weeks.

Note that the 484 million share decline for the month ending August 15, 2007 was probably driven entirely by deleveraging by long-short equity funds, given the severe losses experienced by these funds (including Jim Simon's Renaissance Technologies) during the first two weeks of August – and more importantly, given that the broader stock market actually declined during those two weeks.  However, the latest 625 million share decline in NYSE short interest cannot be explained by deleveraging along – given that there was no evidence of further deleveraging (in fact, the Goldman Sachs' $2 billion injection into its Global Equities Opportunities fund should have resulted in an increase in short interest after mid August, not further deleveraging).  Most likely, this 625 million-share decline in short interest was driven by pure short-covering – either from professional investors or hedge fund managers – suggesting that a significant chunk of the rally from its mid August lows was driven by short-covering.  As everyone and his neighbors should know, this sort of rally usually isn't sustainable – and thus, chances are that we will retest the mid August lows over the next few months.

Finally, from a time standpoint, the current cyclical bull market is getting long in the tooth.  While I am not stating that we are now entering into a bear market, subscribers should note that the S&P 500 hasn't experienced a rolling three month period with a return of less than negative 5% since the month ending February 28, 2003 – a streak of 54 months.  Even with the latest decline during late July to mid August, the S&P 500 still only experienced a return of negative 3.28% for the three months ending August 2007.  This is amazing considering that since November 1977 (by the way, note that the majority of this “study period” focused on the bull markets during the 1980s and 1990s) approximately 10% of all three-month rolling periods had experienced returns of less than negative 5% – with 43% of these rolling three-month periods experiencing returns of less than negative 10%.  The following histogram shows the distribution of the returns of all rolling three-month periods from November 1977 to August 2007 (note that these represent total monthly returns, not price returns, and thus include dividends paid on the S&P 500 components):

Distribution of S&P 500 Three-Month Rolling Returns (November 1977 to August 2007) - Just under 10% of all rolling three-month periods over the last 30 years achieved a returned of less than -5%.

Given the historical distribution over the last 30 years, we should now have already experienced five rolling three-month periods with returns of less than negative 5% in the S&P 500, with two of those experiencing returns of less than negative 10%.  However, as we all know, returns are not uniformly distributed by are, rather, in clusters.  For example, for the three-month rolling periods ending June, July, August, and September 2002, the S&P 500 experienced total returns of less than negative 10%, with one of those returning less than negative 15%.  No matter how you slice it or dice it, however, the 54-month streak is now getting long in the tooth – and is in fact, the highest consecutive streak over this 30-year period (the previous record streak was 51 months for the period ending July 1998). 

Given the above points – as well as the “schizophrenic nature” of the stock market over the last two weeks (it is amazing to hear so many folks stating that the stock market will only go up from here, thinking that the Fed's 50 bps cut in the Fed Funds rate would solve all the problems in the world) – there is still a good chance that the U.S. stock market will retest its mid-August lows.  Moreover, from a credit crunch standpoint, while the Fed's easing (along with the Bank of England's bailout of Northern Rock) has solved all immediate liquidity needs, subscribers should keep in mind that much of the excess that has occurred over the last 2 ½ years – such as subprime, the expansion of the hedge fund industry and risk-taking in general – was spurred on by the private sector, even as the Fed, the European Central Bank, and the Bank of England continued to rein in primary liquidity.  In other words, while both the Fed and the Bank of England can make money more easily available (and cheaper) – that does not mean the private/financial sector will need to necessarily borrow or “multiply” the money supply or make loans more easily available to their customers.  Finally, it can also be argued that the 50 basis point rate cut was actually bearish for the stock market, as this higher-than-expected cut may have come about because the Federal Reserve is seeing more headwinds for the U.S. economy than most Wall Street analysts or economists are seeing.  Again, should the Dow Industrials rally to an all-time high without a corresponding confirmation by NYSE breadth or other major indices such as the Dow Transports, the Dow Utilities, the S&P 500, the Russell 2000, the American Exchange Broker/Dealer Index, or the Philadelphia Semiconductor Index, then there is a good chance we will initiate a 50% short position in our DJIA Timing System, preferably at the 14,200 to 14,500 level.

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 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2006 to September 21, 2007) - For the week ending September 21, 2007, both the Dow Industrials and the Dow Transports rose - with the former rising 377.67 points and the latter 30.74 points. As can be seen on the above chart, while the Dow Industrials has nearly retraced all of its decline since its July 19th top, the Dow Transports has continued to struggle - and has only able to retrace 20% of the decline - rendering the index still more than 11% from its all-time high. This latest action is further evidence of what we have been seeing for weeks now: that the Dow Transports continues to exhibit relative weakness versus the Dow Industrials. 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 relative weakness of the Dow Transports during the last 2 1/2 months is not a very good sign for the market.

For the week ending September 21, 2007, the Dow Industrials rose by 377.67 points while the Dow Transports rose only 30.74 points, or just 0.64%, even as the Fed unexpectedly slashed both the discount and the Fed Funds rate by 50 basis points last Tuesday.  Also, as mentioned on the above chart, while the Dow Industrials has nearly retraced all of its decline since its July 19th top, the Dow Transports has continued to struggle, and has only been able to retrace just 20% of its decline from July 19th.  More importantly, the Dow Transports is still more than 11% below its all-time high, and 1.9% below its most recent closing high on September 4th, even though the Dow Industrials is now 2.8% higher than its September 4th high as of Friday at the close.   Given that the Dow Transports has nearly always been the stronger index – as well as a leading indicator – ever since the cyclical bull market began in October 2002, subscribers should continue to be cautious.

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 from last week's 4.9% to 9.3% for the week ending September 21, 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 September 21, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 4.9% to 9.3% - after coming off the most oversold reading since June 2006 two weeks ago. The important question now is: Did last week's reading represent a bottom - both for the reading and for the stock market? Usually, an answer can be found by studying the health of the subsequent rally of a typical market correction. Given the most recent breadth and volume numbers coming out of the market, however, this author believes that we have not seen the bottom yet, and that there is a good chance we will revisit the mid August lows - despite the immensely oversold reading we witnessed two weeks ago. At this point, I prefer to see this reading reach more oversold levels, as I did not see major capitulation during the mid August lows, and as such, we will continue to remain neutral in our DJIA Timing System.

Note that at its most oversold level on September 7th, the four-week MA was at its most oversold level since the week ending June 30, 2006.   However – given the weakening breadth of the U.S. stock market, the inevitable slowdown of the U.S. economy due to the lingering concerns over subprime resets and Alt-A loans, and the weakening global leading indicators that we mentioned in our September 9, 2007 commentary, I am still inclined to think that the U.S. stock market will retest its mid-August lows before embarking on a more sustainable path upwards.  Should the above indicator get more bullish over the next couple of weeks, and should this be accompanied by an all-time high in the Dow Industrials, and without a corresponding confirmation in breadth and in other major indices, then there is a good chance we will initiate a 50% short position 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 May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - Since hitting a 14-month high of 152.9 in late July, the 20 DMA of the ISE Sentiment fell to an extremely oversold level of 99.9 on August 28th, which, along with the late March lows, was the most oversold level since November 4, 2002. Meanwhile, the 50 DMA rose to a 5-month high reading of 140.9 on July 19th, before finishing at 118.3 on Friday. While the 20 DMA remains oversold, it has risen quite a bit over the last four weeks, and is actually now higher than the 50 DMA as of this writing. At this point - while the 50 DMA is now getting to a very oversold level - this author would like to see the 20 DMA spike down again before declaring *capitulation,* and so we will continue to remain neutral in our DJIA Timing System for the time being.

Over the last four weeks, the 20-day moving average of the ISE Sentiment rallied significantly – rising from 100.5 to 123.1 as of last Friday.  Indeed, while the absolute level of the 20-day moving average is suggesting that retail sentiment is still bearish (and thus bullish from a contrarian standpoint), the uptick over the last four weeks – despite the mediocre breadth and volume conditions in the market – suggests that the bottom is still not here just yet.  Moreover, should the 20-day moving average and the Dow Industrials continue to rally over the next couple of weeks, and should this be confirmed by our other sentiment indicators, relatively weak breadth, and lack of confirmation in other major market indices, then there is a good chance that we will initiate a 50% short position in our DJIA Timing System.

Conclusion: Given the many impact-making events that occurred during the last week, and given the recent “schizophrenic nature” of investors, it is easy for both professional and retail investors alike to lose sight of the proper perspective.  As I discussed before, the purpose of our commentary is to help our subscribers (and myself) restore a more proper perspective – especially when it comes to the recent appreciation in the Canadian Dollar and the recent rally in the U.S. stock market.  For our subscribers, we continue to urge you to be cautious in this environment – especially given that we are now witnessing the greatest headwind for the U.S. stock market and economy since the dark days of the Global Crossing and WorldCom bankruptcies in 2002.  More importantly, and from a contrarian standpoint, given that U.S. investors have not witnessed a 3-month rolling period where returns have been less than negative 5% for a record-breaking 54 months, it is normal for U.S. investors to have become complacent – and it is at these times when we should be at our most cautious. 

For now, we will also continue to remain neutral in our DJIA Timing System – but as we mentioned in this commentary, given the right circumstances, we will initiate a 50% short position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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