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Should We Even Pay Attention to Financial Stocks?

(November 18, 2007)

Dear Subscribers and Readers,

Note: Please participate in our latest poll.  The question is: What is the probability of a US recession in the near future?  According to the premier futures prediction market,, the probability of the US entering a recession sometime next year is now even at 50%.  As always, comments are welcome.

Also, for those who are thinking of buying the homebuilders at some point (even for a bounce), I urge you to read our latest conversations on the homebuilders in our discussion forum.

First of all, while I would be writing a mid-commentary this Thursday morning, I would like to wish our US subscribers in advance a great Thanksgiving.  While US stock market activity is usually muted during the days revolving around Thanksgiving, I would not be surprised if we see more action than usual this week – given the recent volatility and “dislocations” in the financial markets.  Let's face it - if I was a hedge fund manager or prop trader, I would certainly be paying attention to my Bloomberg terminal at my vacation house in the Hamptons, all the while cooking or frying my Thanksgiving turkey.

Also, while I will certainly be paying attention to the markets throughout the week, I would not be writing a “full-blown” commentary next weekend.  Rather, I would be writing an “ad hoc” commentary instead next Monday evening, as in all likelihood, there would not be much significant market action during the Friday after Thanksgiving Day anyway.  Things have been quite hectic for my lately, so I am going to take a short break.  Rest assured, I will come back stronger than ever during December and into 2008.

Let us begin our commentary by first providing an update on our four 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.

4th signal entered: 50% short position October 4, 2007 at 13,956, giving us a gain of 779.21 points as of Friday at the close.

As of Sunday evening, November 18th, we remain 50% short in our DJIA Timing System.  In last weekend's commentary, I stated: “Aside from the NYSE McClellan Summation Index, the NYSE ARMS Index, and the S&P 500's percentage deviation from its 200-day moving average, many of our technical indicators are now approaching a “fully oversold” status.  However, subscribers should keep in mind that during the midst of a panic, stock prices tend to experience their greatest declines towards the end of the panic (the most extreme case was October 19, 1987, when the Dow Industrials declined 22.6% (even though the market had already reached a highly oversold level the previous Friday), and would ultimately decline a further 7% on October 20th before reversing to close 6% higher than the previous day's close.”

We continue to stand by the above statement.  While the NYSE McClellan Summation Index has gotten more oversold since last weekend, Tuesday's tremendous rally has rendered some of our other indicators less oversold than where they were last weekend, including the NYSE ARMS Index and the S&P 500's percentage deviation from its 200-day moving average.  However, given our quick gains in our short position in our DJIA Timing System over the last few weeks, and given the current oversold conditions in the stock market, my current goal (which we initially discussed last week) is still to cover our short position in our DJIA Timing System should one of the following two conditions be met over the next few days:

  1. An intraday decline in the Dow Industrials of more than 400 points;

  2. An intraday NYSE ARMS Index reading of 2.5 or higher.

Should we decide to cover our 50% short position in our DJIA Timing System (to essentially go neutral), we will, as always, send a real-time email to our subscribers informing you of such a decision.  Note that the two previous conditions are merely “guide posts” at this point, and should not be construed as “set in stone.”  The shift in our position will not be official until an actual email goes out. 

Before we go on to the “gist” of our commentary and discuss the financial sector, I would like update our “MarketThoughts Global Diffusion Index” (MGDI) – which we last discussed in our October 7, 2007 commentary (“Global Economy Now Slowing Down”).  As we discussed in that commentary, given that as much as 50% of profits within the Dow Industrials and the S&P 500 is derived from outside of the US, we would never have gone short in our DJIA Timing System if we had believed that profit growth from outside the US would “make up” for an earnings slowdown or decline within the US.  In a way, this was what happened in the US during the second quarter, as virtually 100% of year-over-year profit growth came from outside of the US, while domestic earnings remained stagnant.  However, as we discussed in our October 7, 2007 commentary, there was a strong chance that much of the world's economy was slowing down as well, as implied by our MGDI indicator.  If that was the case, then chances were that earnings expectations for many US companies would be coming down for the foreseeable future as well.

So what are the latest readings telling us?  To recap, we first featured the MGDI in our May 30, 2005 commentary – with our last two updates coming in our September 9, 2007 and October 7, 2007 commentaries.  For our newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for the 25 countries in the Organization for Economic Co-operation and Development (OECD).  Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages.  More importantly, the MGDI has historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI on two occasions – first by incorporating the leading indicator for the Chinese economy, and second by dropping the one for Turkey.  The first revision is obvious; as China is now the fourth largest economy in the world and actually has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth this year is expected to surpass that of the US).  The second revision is less obvious.  While Turkey is by no means a small or marginal country, many of the readings over the last six months have been very unreliable – and so we have chosen to drop Turkey in our MGDI instead.  This is rather unfortunate, but it is better to omit certain data points than to incorporate unreliable data.

Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the CRB Index and the YoY% change in the Dow Jones Industrial Average from March 1990 to September 2007 (the October 2007 reading will be updated and available on the OECD website in early December).  In addition, all four of these indicators have been smoothed using their three-month moving averages:

MarketThoughts Global Diffusion Index (MGDI) vs. Changes in the CRB Index & the CRB Energy Index (March 1990 to September 2007) - 1) * All four indicators are smoothed by their three-month moving averages; CRB Index and DJIA data are as of October 30, 2007. 2) The deviation of the change in the Dow Jones Industrials and the CRB Index from the annual and the rate of change (second derviative) in the MGDI suggests that the U.S. stock and commodity markets should at least take a further *breather* before resuming its rally. More importantly, this weakening in the MGDI suggests that global economic growth should continue to weaken over the next three to six months.

As we discussed in our February 25, 2007 commentary, “The strength of the MGDI is essential to keeping our U.S. economic slowdown scenario alive – as a slowing global economy in the midst of a U.S. economic slowdown can mean many negative feedback loops around the world's economies which could in turn induce a classic U.S. economic recession.”  Ominously, as the above graph suggests, global economic growth (OECD + China - Turkey) has continued to decline since our last update on October 7, 2007 – suggesting that the chances of a U.S. recession has again risen ( is now predicting a 50% chance of a US recession sometime next year).  More specifically, the latest readings witnessed a wide dispersion in slowing economic growth among the OECD countries.  E.g. the year-over-year change in the OECD leading indicators in Germany, Luxembourg, and Spain turned negative for the first time, while the year-over-year change in the Japanese leading indicator plunged from -3.7% to -6.6% from August to September.  Even in South Korea – a country which has seen its stock market rise by 35% on a year-to-date basis – the year-over-year change in the OECD leading indicator declined from 6.2% in August to a mere 1.6% in September.

The weakness in the Euro Zone in particular (France's year-over-year change turned negative in August, and Italy's readings have been negative since August 2006) is not too surprising, given the tight monetary policy of the European Central Bank, as indicated by the Bank Credit Analyst's Monetary Conditions Index shown in the below chart:

Bank Credit Analyst's Monetary Conditions Index

As shown in the above chart, the Euro Zone's monetary policy – combined with its high exchange rate – is now the tightest in years and putting the brakes on the Euro Zone's economy in a dramatic way.  Given that many central banks in Asia are still in tightening mode (such as the People's Bank of China and the Bank of Korea), my guess is that global economic growth will continue to slow down going forward.

More importantly for now, a slowing global economy has nearly always meant a decline in commodity prices, and to a lesser extent, equity prices.  Given that the consensus view is that commodities (and gold) will continue to rise going forward as the Fed cut rates, there is a now a good chance that the commodity markets could actually surprise us and turn down instead over the next 3 to 6 months.  For us to become more bullish on commodity prices, both the Bank of England and the European Central Bank will need to change their policy stances – with the former easing as early as December and the latter at least shifting from a neutral to an easing bias.  Given the turmoil in the financial markets, and given the high dependence of the banking sector in the UK, I would not be surprised if this occurs – but my guess is that commodity prices will still need to correct from current levels before they can make a sustainable move higher.  We will see.

Let us now get to “the gist” of our commentary.  In previous commentaries and posts on our discussion forum, I had discussed the usefulness of both the Philadelphia Bank Index and the American Exchange Broker/Dealer Index as a leading indicator for the overall stock market (the S&P 500).  This is particularly true in the cyclical bull market that began in October 2002, as much of it revolved around a bull market in U.S. financial stocks – in particular the bull market in the hedge fund, structured finance, private equity, and homebuilding industries.  For example, if one had simply been tracking the AMEX Broker/Dealer Index over the last 18 months, one could've gotten ample “warning” and sold out prior to all the significant corrections over the last 18 months.  The following daily chart showing the AMEX Broker/Dealer Index and its relative strength vs. the S&P 500, courtesy of, illustrates this perfectly:

AMEX Broker/Dealer Index - Lower highs in the XBD even as the S&P 500 made all-time highs – a “warning signal” which preceded all the significant corrections in the S&P 500 over the last 18 months.

What isn't obvious, however, is the $64 billion question for those who are looking to go long: Does the financial sector or the AMEX Broker/Dealer Index also lead the S&P 500 on the way up?  For example, immediately after the May 10 to June 15, 2006 correction, the relative strength of the XBD vs. the S&P 500 vacillated in a 2 ½ month trading range to early September, before finally breaking through in mid September.  However, as many of our subscribers should recall, the S&P 500 had already bottomed in mid June (with a successful retest in mid July) – and ultimately retrace its entire decline by mid September.  The relative strength of the XBD was a coincident indicator at best.

Another (more extreme) example is the action in the XBD vs. the S&P 500 during the Summer to Fall 1998 bear market, as shown in the following daily chart, courtesy of

Broker/Dealer Index - 1) Weakening relative strength of the XBD vs. the S&P 500 by mid August – which preceded a 14% slide in the S&P 500 over the next two weeks. 2) However, even though both the absolute value and the relative strength of the XBD made new lows over the next six weeks, the S&P 500 actually bottomed on August 31st – with a successful retest six weeks later.  The decline of the XBD turned out to be a false signal.

As shown on the above chart – while there was a relatively weak warning signal from the XBD before the S&P 500 plunged 14% in the last two weeks of August 1998 – the XBD did not turn to be a leading indicator for the stock market after the August 31st bottom.  As a matter of fact, the XBD would go on to decline a further 20% or so before bottoming with the surprise rate cut from the Federal Reserve on the afternoon of October 15th, while the stock market would merely vacillate before (successfully) retesting its August 31st lows on October 15th.

In other words, while the XBD (and to a lesser extent, the Philadelphia Bank Index) has been a very useful leading indicator of the stock market over the last 18 months, I would definitely not count on it as a leading indicator going forward, especially if it continues to make multi-month lows.  In fact, I would not be surprised if the XBD or the financial sector stays weak for months to come, even should the stock market makes a sustainable bottom and goes to make new highs early next year.  Remember: The financial sector merely acts as a “lubricant” for both the US and the global economy – that is one reason why we initially became bearish on the stock market in the first place, as the “lubricant” was breaking down and was thus creating clearing problems for companies and individuals alike.  However, it is also important to keep in mind that, over the long-run, what really matters is global corporate profits – and that ultimately depend more on workers' productivity, technological advances, geopolitics, and global employment levels than short-term fluctuations in Wall Street's investment banking profits or its short-term willingness to lend to companies or individuals.

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 November 16, 2007) - For the week ending November 16, 2007, the Dow Industrials rose 134.05 points while the Dow Transports declined 40.08 points. From a Dow Theory standpoint, all eyes are now on the DJIA's August 16th low of 12,845.78. More ominously, the Dow Transports actually again closed below its 2007 lows last Friday. As we have mentioned numerous times, over the last 3 months, the Dow Transports has persistently been the weaker index. For example, during its recovery from the mid August lows, the Dow Transports had only been able to retrace 42% of the decline at its peak, while the Dow Industrials subsequently made another all-time high. Moreover, the Dow Transports is now more than 16% below its all-time high. Given the recent action of the Dow Industrials and the broad market, it looks like that the Dow Industrials will continue to follow the Dow Transports down as well, which isn't surprising given that the Dow Transports has been the leading index since this bull market began in October 2002. Subscribers should continue to be cautious here.

For the week ending November 16, 2007, the Dow Industrials rose 134.05 points while the Dow Transports declined 40.08 points.  More ominously, the Dow Transports again made a new 2007 low, and is now more than 16% below its all-time high (vs. the Dow Industrials which is “only” 7% below its all-time high).  Given that the Dow Transports has nearly always a leading indicator since the cyclical bull market began in October 2002, subscribers should continue to be cautious with regards to both the Dow Industrials and the broader market.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators decreased slightly from last week's 19.7% to 15.1% for the week ending November 16, 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 November 16, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased from 19.7% to 15.1%. While the latest readings represented the biggest two-weey decline since mid August, subscribers should note that it is still too far away from its oversold readings in early September of this year, or June of last year, to be calling an intermediate bottom here. Moreover, given this reading had reached a multi-month peak just four weeks ago, my guess is that this reading - as well as the stock market - remains in a downtrend, for now. Again, I prefer to see this reading reach a more oversold level than its August to September readings before we shift to a neutral or long position, and as such, we will continue to remain 50% short in our DJIA Timing System.

Note that the latest decline in the four-week MA is mostly due to the latest decline in the AAII bulls-bears differential and the Mark Vane's Bullish Consensus readings.  More importantly, however, even with the latest decline, the four-week MA is still higher than its most recent bottom on September 7th (when it reached 2.6%), signaling that sentiment has not turned “pitch dark” just yet.  Given the current downtrend in the stock market, as well as the continuing weakness in the US financials and consumer discretionary sectors, the inevitable slowdown of the U.S. and UK economy due to the lingering concerns over subprime resets and Alt-A loans, the deteriorating credit conditions as exemplified by the continuing blowout of credit spreads (corporate bond and CMBX credit spreads made a new high again last week), and the weakening global leading indicators as evident in the MGDI, (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 at least retest its mid-August lows before embarking on a more sustainable path upwards.  Given that this sentiment indicator is still not at an oversold level, we will stay with our 50% short position in our DJIA Timing System for now, but again, we will not hesitate to cover our short position and go neutral should the opportunity present itself during the upcoming week.

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 3-month high of 144.3 on October 29th, the 20 DMA of the ISE Sentiment has since declined to 130.4 at the close last Friday. More ominously, the 20 DMA also just crossed below its 50 DMA last Monday - signaling that the 20 DMA is now in a confirmed downtrend. Given that the ISE Sentiment is still nowhere close to *fully oversold* levels, and given that the stock market still remains in a downtrend, this author believes that the 20 DMA (and thus the the stock market) will need to decline further before we can claim *capitulation,* and so we will continue to remain 50% short in our DJIA Timing System for the time being.

With the latest weekly decline of the 20-day moving average of the ISE Sentiment Index from 135.4 to 130.4, , and with it closing below the 50 DMA last Monday, the 20 DMA is now officially in a downtrend.  More importantly, the absolute levels of both the 20-day and the 50-day moving averages are still suggesting that retail sentiment is not oversold, thus signaling further downside in the US stock market.  While we will not hesitate to cover our short position in our DJIA Timing System should we experience: 1) A 400-point intraday decline in the Dow Industrials, or 2) An intraday reading of 2.5 or over on the NYSE ARMS Index, we will most likely not go long in our DJIA Timing System again until both the 20 and the 50-day moving averages are again at oversold levels.

Conclusion: While the market can definitely turn on a dime, especially with the Thanksgiving holiday approaching, my sense is that we are not at a sustainable bottom yet, given that the market is still at least a few percentage points away from being “fully oversold,” and given that both the Federal Reserve and the ECB has still not adopted more of an easing bias, just yet.  As we mentioned in previous commentaries, we continue to believe that the chance of a preemptive ease by the Fed is still relatively low, and that it will involve a further decline in the S&P 500 to below 1,400 before we will even consider such a scenario.  Moreover, as we move into 2008, this chance will continue to get smaller, given the generally higher “hawkishness” of the 2008 FOMC voting members versus the 2007 voting members.

As we move forward into December and 2008, my sense is that volatility will be here to stay, at least until the second quarter of 2008.  There are several implications: 1) A buy-and-hold strategy will continue to be frustrating, unless your definition of “buy-and-hold” means buying and holding for a few months, at the most, 2) There is a good chance that the signals in our DJIA Timing System will be more frequent, especially if we believe that the Dow Industrials will stay in a trading range for the foreseeable future (the jury is still out here), 3) at some point, we may see a general washout in the market that we haven't seen since the beginning of this bull market, as more traders and retail investors are “weeded out” of the stock market because of the upcoming whiplashes and volatility, and 4) A long strategy purely based on momentum or relative strength may not work as well as it has over the last five years.

As for the US Dollar Index, I still want to see another spike down in the U.S. Dollar Index before I would consider a long position in the US Dollar Index.  Moreover, this will need to be accompanied by a continued slowdown in the foreign reserves growth rate over the next four to six weeks.  We will continue to update our readers on the U.S. Dollar Index, but my guess is that there will be a buying point sometime in the next three to six weeks.

For now, we will also remain 50% short in our DJIA Timing System, but will not hesitate to cover and stay neutral in our DJIA Timing System should the right conditions emerge in the upcoming week.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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