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Shifts in Market Behavior

(September 30, 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 30th, 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, and given the non-confirmation of the rally by the major stock markets in Europe and in Japan, 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.  As we mentioned in last week's commentary, 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 (note that Bill Miller is also now agreeing with us).  Also, given that much of the strength in the U.S. stock market has been focused on the Dow Industrials over the last six weeks, there is a good chance that the Dow Industrials could rise to another all-time high – perhaps as early as this week.  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 continuing 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 inform all our subscribers via email as soon as we make the change.

Let us now begin our commentary.  Late last week, I was fortunate enough to be able to listen to an institutional conference call held by Chuck Royce of Royce Funds – one of the best small cap mutual fund managers in the US today (over the last five years, one of the bigger funds that he manages – the Royce Value Trust fund – is ranked in the 1st percentile in the Morningstar small cap category and had outperformed the Russell 2000 by an annualized 8% over the same time period).  Despite the quick 30-minute call, he managed to cover a lot of ground.  Among other things he discussed were 1) the probability of a recession in the US is now very high and even though he does not believe there is much correlation between the economy and the stock market, he still believes that a larger correction (in the order of 15% to 20%) for small caps will occur in the foreseeable future, 2) the five-year performance of the Russell 2000 for the period ending in the 3Q 2007 will be one of the best five-year performance periods that we will ever witness in our lifetimes, 3) that rotation into large caps and growth stocks from small caps and value stocks have been evident for sometime now, but despite this rotation, he does not believe that any large cap outperformance from current levels will resemble the huge gap in performance that we witnessed during the late 1990s.

This rotation is obvious if one takes a look at the most recent performance of the different Russell style indices, as illustrated in the below table (note that the below performance represents total returns, i.e. capital appreciation plus dividends):

most recent performance of the different Russell style indices

During the third quarter, the best performing “style” was large gap growth, or more specifically “mega cap growth” – as the Russell Top 200 Growth Index returned 5.24% (seven out of the top ten names in this index are technology names.  They are, in market cap order, Microsoft, Cisco, Intel, Hewlett-Packard, IBM, Apple, and Google).  For comparison purposes, the Russell 1000 index returned only 1.98%, while the S&P 500 returned 2.03%.  As we move down the market cap spectrum and from growth to value, the 3-month returns continue to decline.  For example, while mid cap growth stocks (as represented by the Russell Mid Cap Growth index) returned a respectable 2.15% during the third quarter, the Russell Mid Cap Index returned -0.39%, and the Russell Mid Cap Value Index returned -3.55%.  The worst-performing style, not surprisingly, was the Russell 2000 Value Index, with a return of -6.26% during the third quarter.

The shift to large cap stocks, and in particular, large cap growth stocks, was inevitable, as we had discussed in our March 25, 2007 commentary (“Brand Name Large Caps Still a Buy”).  Not only had large caps been trading at a discount to small caps, but large cap growth stocks had been severely underperforming all styles since early 2000 (as you can see from the above table, the 7-year annualized return of the Russell Top 200 Growth Index is actually negative 4.07%!).  Moreover, given the current credit-constrained environment (an environment which should continue to linger at least through 2008), and given the current slowdown in the U.S economy – U.S. large caps, with its much more geographically diversified earnings stream – should experience higher earnings growth than U.S. small caps going forward.  As for value stocks, the majority of the underperformance during both the 3rd quarter and on a year-to-date basis was due to the severe underperformance of the financial sector – whose components make up about 30% of the various Russell value indices (versus about 10% for the Russell growth indices).

My current guess is that in general, large cap growth stocks will continue to overperform small caps and small cap value going forward.  This has more to do with the composition of the various “style indices” and the behavior of institutions as opposed to the fundamentals of the components of each individual index.  For example, as I can attest to given my institutional investment consulting day job, virtually none of our clients had been interested in large cap growth managers over the last few years.  On the other hand, allocations to small cap and small cap value stocks had continued to rise.  This represented a 180-degree shift from early 2000 – when small caps were regarded as “opportunistic” in nature and not part of a formal, long-term asset allocation for any respectable institutional investor, despite the fact that small caps had great fundamentals at the time.  As performance in large caps and large cap growth stocks perk up, institutions and high net worth individuals (not to mention foreign investors) will inevitable reallocate some of their assets into these asset classes – and given the size of these funds, what was a vicious cycle from early 2000 to early 2007 will turn into a virtuous cycle for large cap growth stocks, as the greater inflow of funds will lead to better relative performance, thus attracting even more funds.  While a significant amount of individual stock opportunities will stay in the small cap space, I believe picking the right small cap stocks will be more difficult going forward – especially within the financial sector.

Moving on from the stock market, let us now discuss the foreign exchange markets – in particular, the U.S. Dollar Index.  In our last commentary on the US Dollar index on September 16, 2007 (“Tactical Trade on the U.S. Dollar?”), we wondered out loud whether a short-term buying point was approaching for the U.S. Dollar.  Based on the dollar's oversold conditions (based on its deviation from its 200 DMA), and based on the rate of accumulation of foreign reserves in the custody of the Federal Reserve, we determined that, while the dollar was getting oversold, it was still not a good time to go long the U.S. Dollar just yet.  There are two reasons for that.  Firstly, while the U.S. Dollar was very oversold relative to its readings over the last 9 months (it closed at 3.61% below its 200 DMA on September 14th), there have been cases over the last five years when the U.S. dollar has gotten much more oversold, such as during July 2002, May 2003, January 2004, and December 2004 – when the U.S. Dollar Index declined to as low as 8% to 10% below its 200 DMA.  Secondly, growth in foreign reserves held in the custody of the Federal Reserve had continued to increase exponentially over the last six months, signaling that there is still “too much U.S. Dollars” in the system.

So Henry, what do you think of the U.S. Dollar Index right now?

Again, we still stand by our original thesis – that over the longer-run, while most Asian currencies should out perform the U.S. Dollar (not only because of higher economic growth in Asia ex. Japan, but also because of the valuation differences from a purchasing power parity standpoint), things are not so clear in the Euro Zone, the UK, and Japan (collectively, the currencies of these three regions make up more than 80% of the U.S. Dollar Index).  I have discussed our many reasons before, but among them are: 1) deteriorating demographics, combined with the lack of a coherent immigration policy of young and enthusiastic talent with good education, 2) lack of structural reforms, 3) housing bust in Spain, along with the fact that both the UK and France's economic boom over the last few years have, in no small part, been helped by rising housing equity in both countries, 4) the fact that much of Euroland (especially Germany) is the marginal manufacturer in the world – and therefore, at the first sign of an economic slowdown, European exports will come to a screeching halt, and 5) a hugely overvalued currency from a power purchasing parity standpoint, as exemplified by the wave of UK tourists doing their Christmas shopping at Macy's during 2006.  More importantly, I also believe that both European and Japanese economic growth will be, at best mediocre going forward, and over the longer-run, less than that of the US.

In the short-run, I believe the U.S. Dollar should bounce sometime over the next couple of weeks, as the U.S. Dollar Index is now trading at 5.68% below its 200 DMA – an oversold level that we have not seen since May 2006. 

USD Index vs. Percentage Deviation from its 200 DMA (December 1985 to Present) - The percentage deviation of the USD Index from its 200 DMA hit a level of negative 5.68% last Friday. While this reading is definitely oversold relative to the readings we have seen over the last 18 months, it still does not compare favorably with oversold readings of years past. Moreover, the amount of foreign reserves in the custody of the Fed is still rising at a rapid pace, suggesting that there is still too many US dollars in the financial system. While I am still bullish on the USD against both the Euro and the GBP in the longer-run, I would not buy the USD until we get a more oversold reading - along with a confirmation of a higher shortgage of U.S. dollars in the market.

However, as mentioned on the above chart, and as mentioned in our September 16, 2007 commentary, the amount of foreign reserves held in the custody of the Federal Reserve is still increasing at a rapid, suggesting that there is still too much dollars in the financial system.  Before we decide to go long in the U.S. Dollar Index, we prefer to see either 1) the U.S. Dollar Index reach an even more oversold level, preferably selling at 8% to 12% below its 200 DMA, 2) at least a slowdown in the growth of foreign reserves held in the custody of the Fed – and preferably a decline, suggesting a higher demand for U.S. Dollars by foreign entities (or less of a supply from U.S. entities, such as less buying of foreign goods by U.S. consumers).  For now, we will continue to take a “wait and see” approach – as I believe that any potential long position will probably not occur until the November to December timeframe at the earliest.

An Update on our Global Overbought/Oversold Model

Now, moving on, given that we have just approached the end of September, it is now time to update the readings of our “Global Overbought/Oversold Model” – a model that we first discussed in our August 2nd commentary.  As we mentioned in that commentary, the inner workings of this global overbought/oversold “model” are rather simplistic.  For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages.  Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998.  This way, we are comparing apples to apples and can control for country or region-specific volatility.  Following is our Global Overbought/Oversold Model as of the end of September 2007 (note that we have also added the CRB Total Return Index in this model since our August 2nd commentary):

Global Overbought/Oversold Model as of September 30, 2007

All the percentile rankings highlighted in yellow in the above table represent rankings below the 15th percentile, or one standard deviation.  That is, relative to the historical % deviations of the same country or region, the current % deviation is more oversold than 85% of its readings going back to December 1998.  Relative to the August readings, our global oversold/overbought model has gotten much less oversold, as countries all across the world bounced from their August lows.  However, Austria and Ireland still remain oversold – as both countries have been suffering disproportionately in the latest global credit crunch given the heavy weightings of the financial and construction sectors in these two countries.

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 28, 2007) - For the week ending September 28, 2007, both the Dow Industrials rose 75.44 points while the Dow Transports rose a mere 8.96 points. As can be seen on the above chart, and as we have mentioned over the last 2 1/2 months, 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 21% of the decline - leaving 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 28, 2007, the Dow Industrials rose 75.44 points while the Dow Transports rose a mere 8.96 points.  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 21% of its decline from July 19th.  More importantly, the Dow Transports is still more than 11% below its all-time high, and 1.7% below its most recent closing high on September 4th, even though the Dow Industrials is now 3.3% 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.

Aside from a non-confirmation of the Dow Industrials by the Dow Transports, we are now also seeing a non-confirmation in the Dow Jones Utility Index.  Historically (aside from the early 2000 peak), the Dow Utilities has led the overall stock market by 3 to 12 months.  Over the last 25 years, a non-confirmation of the Dow Industrials and the Dow Transports has usually not been a good sign, as exemplified by the January 1984 top (the Dow Utilities topped out in November 1983), the August 1987 top (the Dow Utilities topped out in January 1987), the July 1990 top (the Dow Utilities topped out in December 1989), the February 1994 top (the Dow Utilities topped out in September 1993), and most recently, right before the May 10, 2006 to mid June 2006 correction, when the Dow Utilities made a significant top over 7 months prior – during early October 2005.  Note that the Dow Utilities has not made an all-time high since mid-May, when it closed at 533.54 on May 16, 2007.  That was more than 4 ½ months ago.  Last Friday, the Dow Utilities closed at 501.54 – a level that is still a whooping 6% from its all-time high.  Should the Dow Utilities continue to remain weak going forward, this would be another red flag for the stock market bulls.

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 9.3% to 15.1% for the week ending September 28, 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 28, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 9.3% to 15.1% - the largest weekly uptick since late November 2005. The important question now is: Did the reading of a few weeks ago 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 three weeks ago. I also prefer to see this reading reach a more oversold levels than what we witnessed during mid August, 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 (in particular, the weakening signals coming out from the Euro Zone, the UK, and Japan), 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 115.0 on Friday. However, the subsequent bounce since the mid August lows has been weak and narrow in scope, and while the 20 DMA remains oversold, it has risen quite a bit over the last 5 weeks, and is actually now at its highest level since early August. 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 five weeks, the 20-day moving average of the ISE Sentiment rallied significantly – rising from 100.5 to 127.0 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 five 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 (such as the Dow Transports, the Dow Utilities, the American Exchange Broker/Dealer Index, the Russell 2000, and so forth), then there is a good chance that we will initiate a 50% short position in our DJIA Timing System.

Conclusion: The undercurrents that have been going on in the U.S. stock market over the last few quarters suggest a “sea change” – a sea change not based on investment fundamentals, per se, but most probably based on institutional behavior, as investment money started shifting from small caps to large caps, and from value to growth stocks.  Moreover, given the weakening credit and economic conditions around the world today, it now makes sense – from a style perspective – to invest in the mega-cap stocks instead, especially mega-cap growth stocks (such as Microsoft, IBM, Intel, etc.) where earnings have traditionally been more stable than most.   Finally, while the U.S. Dollar is still probably on a long-term downtrend relative to most Asian (excluding Japanese) currencies, the decline of the U.S. Dollar Index (collectively, the Euro, the Yen, and the British Pound make up more than 80% of the index) is probably now in its 9th inning.  Should the US Dollar Index reach a more oversold level (preferably closing at a level that is 8% to 12% below its 200 DMA), and should that be accompanied by a decline or a slowdown in the growth of foreign reserves held in the custody of the Federal Reserve, then it will be time to go long the U.S. Dollar Index in a big way.  For now, we remain in “wait and see” mode.

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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