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A Quick Review of our Technical Indicators

(November 22, 2007)

Dear Subscribers and Readers,

First of all, I want to wish all our US subscribers a great Thanksgiving Holiday.  As Americans, there is a lot to “give thanks to” every year.  Despite this year's relative underperformance of the US stock market and the US Dollar Index, $99 oil, record airline delays, etc., it is important to remember that America still remains the world's wealthiest country, a country that is full of opportunities and respect for those that are persistent and that work hard.  It is interesting to note that while the maldistribution of both wealth and income is cited as a problem, folks typically forget the list of the top 1% of our population (or for that matter, the Forbes 400 list) turn over very quickly – certainly much more quickly than the list in Western Europe.

Secondly, I want to remind our subscribers that I will not be writing a “full-blown” commentary this weekend, given the lack of action in the markets over the next 36 hours or so.  Instead, I will most likely send out an “ad hoc” commentary with some updated thoughts or concerns about the financial markets.  We will then get back to our normal publishing schedule with a mid-week commentary next Thursday.  Again, I want to wish all our subscribers and your family a great Thanksgiving.

As of Thursday morning, November 22, 2007, we remain 50% short in our DJIA Timing System.  At this point – we will continue to wait for a more oversold position before turning neutral in our DJIA Timing System, but as I mentioned in our weekend commentary, we are now definitely getting there.  The big news yesterday was Mark Hulbert's article on the Dow Industrials' confirmation of the Dow Transports on the downside – citing, among other things, that 1) many of the popular Dow Theorists, including Richard Russell, are now bearish, and 2) that the signal should be heeded, given the record of this “mechanical methodology” (my words) of the Dow Theory, and given that many of their newsletter subscribers will probably be selling over the next couple of trading days in light of this signal.  Here is my response to Mark Hulbert's article on our discussion forum.  In essence, while I believe that the latest “Dow Theory Sell Signal” is still important, it is also very overrated.  Moreover, the article is simply incorrect on two major points regarding the Dow Theory.  For those that would like to read a complete but concise history of the Dow Theory, I urge you to go to our Dow Theory page on the MarketThoughts.com website.

As I mentioned in our last couple of commentaries, given our quick gains in our short position in our DJIA Timing System over the last few weeks, and given the oversold conditions in the stock market, our previous goal was to cover our short position in our DJIA Timing System should one of the following two conditions be met:

  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.

Given the continued sell-off in the stock market over the last few days, and given the Dow Industrials is now approaching its intraday August 16th low of 12,455.92, I am now revising the above conditions into one condition only: Should the Dow Industrials suffer an intraday decline of 250 points or more, we will cover our short position in our DJIA Timing System.  At that point, we will reevaluate our position, but given the current oversold conditions in the market, the relative strength in the Asian markets, and the prevailing pessimism among both Wall Streeters and Main Streeters alike, it is simply not prudent to remain short with the Dow Industrials approaching its August 16th low.  As I have mentioned before, given the current volatility in the stock markets, there is a good chance that our signals will become more frequent going forward – so don't be surprised if we either go long or go short again once we have turned neutral – it will all depend on the action of the stock market going forward.  For those who do not like to short, I would suggest simply sitting out on the sidelines and wait for a long signal from us before dipping your toes back into the markets again.

Let us now review some of our indicators in order to get an idea of the current oversold conditions in the US stock market.  By some indicators (such as the value of the VIX relative to its levels over the last four years, the daily NYSE McClellan Oscillator reading, and the daily NYSE new lows vs. new highs), the market is now severely oversold, but in a period of “forced selling” or high earnings uncertainty, this author prefers to see more of our technical indicators confirming this oversold condition before taking a position on the long side.  Let us now quickly go through each of these indicators.

Simple 200-day Moving Average

A quick glance on our MarketThoughts charts page will reveal that the Dow Industrials and the S&P 500 is now trading at 3.3% and 4.5% below their 200-day moving averages, respectively.  Such readings are consistent with the readings we experienced at the bottoms during October 2005 and the summer correction of 2006.  Another 250-point down day for the Dow Industrials down to the August 16th intraday low (presumably, such a sell-off would also mean short-term capitulation on the part of the subscribers who subscribe to the three “Dow Theory” newsletter that Mark Hulbert refers to in his latest article) would render this indicator “fully oversold,” at least in the context of a bull market correction.  While the chances of a one or two-year bear market have now increased given the latest market action, I am not inclined to bet on that just yet (even if I am to bet on this scenario, I would only go short again once this reading becomes more overbought).

The VIX, or Implied Volatility

While implied volatility (the VIX closed at 26.84 yesterday) is now near a four-year high (it actually hit a four-year high of 31.09 on November 12th), it is still relatively low compared to the “peak readings” we witnessed during the period from 1997 to 2002.  More importantly, the VIX has since declined over 13% from its latest spike on November 12th, suggesting that there is probably one more spike before we can call this a short-term bottom.  My preferred scenario is to get another reading over 30 sometime over the next few trading days, but as I have mentioned before, we now have only one criterion for covering our short position in our DJIA Timing System: A 250-point or more decline in the Dow Industrials on an intraday basis.

The VIX vs. the DJIA (January 4, 1993 to Present) - On November 12th, the VIX hit its highest level (31.09) ever since March 2003, but it has since declined back to 26.84, which is still relatively low compared to the peak readings that we experienced from 1997 to 2002.

Actual Volatility in the Dow Industrials

As I have shown in previous commentaries, virtually every market decline that we have witnessed has usually ended with some kind of volatility spike.  Here at MarketThoughts, we usually like to calculate short-term volatility by taking a running 10-day volatility number and then annualizing that number.  As of yesterday, volatility hit a level of 20.14%.  Even though this reading is high over the last four years, it has actually already come down from the latest spike on November 13th, when volatility hit 25.13%, the highest level since April 4, 2003.  Note that in the following chart, volatility has usually topped out (and hence, the market bottoming out) once it hits the 17.5% to 20.0% range over the last four years, with a maximum further decline of 200 points or so.  Again, my preferred scenario is to see one more spike in the Dow's volatility, and by extension, another 250-point decline or more before covering our short position in our DJIA Timing System.

Running 10-Day and 21-Day Annualized Volatility of the DJIA vs. the DJIA (January 2003 to Present) - 1) Please note that since the summer of 2003, all declines in the Dow Jones Industrial Average have effectively halted when the running 10-day annualized volatility hits a level in the range of 17.5% to 20.0%. On November 13th, this reading hit a level of 25.13% - the highest level since April 4, 2003. 2) Moreover, every market decline has ended with a volatility spike (with arguably the exception of the May 2004 decline).

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

Running 10-Day and 21-Day Annualized Volatility of the DJIA vs. the DJIA (January 1994 to December 1997)

Subscribers, however, should remember that just like the October 1997, the October 1998 (not shown), and the 2001-to 2002 periods, the stock market is now in “panic mode” – as many investors are still trying to gauge the future market environment given the dramatic reversal in the buyout market and future earnings power of the financial and consumer discretionary sectors.  While investors are still bullish on technology, energy, and materials, this too, could change on a dime, especially if crude oil prices reverse (natural gas prices haven't been helping any) and if labor costs in the energy sector continue to escalate over the next 3 to 6 months.  At the end of the last LBO boom on October 13, 1989 (when Japanese banks pulled funding for the UAL buyout) – the Dow Industrials declined more than 7% that day, and volatility spiked up to over 40%.  Should we be entering a new bear market or a recession, then all bets are off.  Bottom line: At this point, while we are approaching a volatility level that is typically high enough for us to cover our short position in our DJIA Timing System, we are definitely not bold enough to go long just yet.

The NYSE McClellan Oscillator and Summation Index

While the daily NYSE McClellan Oscillator (ratio adjusted, so it is comparable to all time periods, going back to the 1920s) has been at a very oversold level since the beginning of this month (see following chart courtesy of Decisionpoint.com), the same still cannot be said for the NYSE Summation Index (ratio adjusted).  However, given the declines over the last couple of weeks, the NYSE Summation Index is also now approaching a very oversold level, a level that consistent with the readings during the April 2005, October 2005, June 2006, and August 2007 bottoms. 

NYSE McClellan Oscillator

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

NYSE McClellan Oscillator (Ratio Adjusted) 1927-Present

Interestingly, the August 2007 readings in the NYSE Summation Index of close to -1,000 was on par with the readings during the July 2002 bottom, when the NYSE Summation Index declined to slightly below the -1000 level.  More importantly, even this severely oversold reading in the NYSE Summation Index was not sufficient to sustain a stronger bull market rally, suggesting that something is definitely amiss here.  Such an “anomaly” is inconsistent with the history of this indicator, unless, of course, the NYSE Summation Index becomes even more oversold over the next few weeks.  This is the reason, dear readers, why we are still reluctant to go long here, as opposed to simply covering our existing short position in our DJIA Timing System.  For comparison purposes, this current reading is still not oversold if we compares this reading with readings we got during October 1987 (-1,600), October 1990 (-1,500), and October 1998 (-1,500).  A note: If, in the “off-chance,” that we get such an oversold reading, there is no doubt we will go fully long.

Other technical indicators that now indicate a severe oversold condition include the % of NYSE issues trading above its 200-day EMA, the 10-day running average of both NYSE and NASDAQ new highs vs. new lows, and the proximity of S&P 500 issues to their 52-week lows vs. 52-week highs.  We are definitely getting close.

Signing off,

Henry To, CFA

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