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Too Little, Too Late?

(December 2, 2007)

Dear Subscribers and Readers,

Now that Thanksgiving and post-Thanksgiving sales are over (although I do expect more discounting from retail stores over the next few weeks), it is time to get back to business.  As an aside, I will be leaving for Houston, Texas, on December 18th to visit my folks, relatives, and friends for a little bit over two weeks (and also to grab some year-end R&R).  While it is not likely that I will work my full MarketThoughts schedule while I am back in Houston, I will also try to work as hard as I can – given the recent volatility and day-to-day swings that we are currently witnessing in the stock and financial markets.  I will let you know more about my schedule as the day arrives.  Spending some time resting and relaxing will fully prepare us to tackle the markets in 2008 – and my guess is that it will be the toughest market to navigate since the early days of 2003.

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 584.28 points as of Friday at the close.

As of Sunday evening, December 2nd, we remain 50% short in our DJIA Timing System.  As we discussed in our mid-week commentary last week, the buying wave that we witnessed last week – especially Wednesday's rally (when the NYSE ARMS Index hit a hugely overbought daily reading of 0.32) – was most likely a result of the severe emotional swings of investors and traders alike, and does not signal a new bull market just yet.  Such hugely overbought daily readings in the NYSE ARMS Index usually only signal a new bull market after months of selling or after a severe crash in the stock market, such as the “buying waves” we witnessed in late 1987 and early 1988 (during the weeks after the October 1987 crash), or the reading we got on March 17, 2003 – after a three-year bear market in the Dow Industrials and the S&P 500.  At all other times, these readings tend to lead to more selling, or at the very least, a stagnant market going forward, such as August 10, 1987, September 22, 1987, October 16, 1989 (the day immediately after the 7% crash in the Dow Industrials on a failed LBO of UAL, and by extension, the end of the late 1980s bull market in leveraged buyouts), May 11, 1990, July 5, 2002, and January 2, 2003.  The two lone exceptions over the last 20 years were October 28, 1987 and June 15, 2006 – but even in both cases, the Dow Industrials would go on to retest its lows over the next two and four weeks, respectively.

There are also other reasons for our continued bearish stance, such as the following:

  1. According to Ned David Research, based on studies of 116 corrections since 1900, once the market falls 10%, there is an even chance of it declining 15% from its recent highs.  Based on the October 9th closing of the Dow Industrials, this would mean an even chance of the Dow Industrials falling to 12,040 over the next several weeks.  More ominously, the same study concluded that a further fall has usually been preceded by periods of high volatility, such as what we have been witnessing, suggesting that there are more than even odds that the Dow Industrials could not only retest its November 26th closing low but its March 5, 2007 closing low, when the Dow Industrials closed at 12,050.41 (note that the Dow Transportation Average had already closed below its March 2007 lows.  In fact, the Dow Transports hit a low not seen since September 2006 last Monday).

  2. TrimTabs, one of the most bullish publications (and who also “got it right” during the 2000 to 2002 bear market) over the last few years (including during the summer correction of 2006) has continued to be bearish on the US stock market, citing, among other factors, a) a decline in personal income growth, leading to less discretionary spending and less savings going into brokerage and retirement accounts, b) an IPO and secondary offering backlog totaling over $35 billion, one of the largest backlogs we have seen in this bull market, despite the fact that many large companies are choosing to list on other non-US exchanges, and c) a virtual freeze on cash acquisitions, given the recent LBO cancellations and lack of new LBO announcements (which is not surprising given the current credit crunch).

  3. For the first time since this bull market began in October 2002, the NYSE Common Stock Only Advance-Decline Line (please see below chart, courtesy of did not confirm the new highs in the Dow Industrials or the S&P 500 in early October.  As a matter of fact, the NYSE CSO A/D Line had already topped out in early July – three months prior to the most recent high.  A non-confirmation of the NYSE CSO A/D Line of a new high in either the Dow Industrials or the S&P 500 usually signals selectivity, or in other words, a lack of general buying power.  Over the last 50 years, such non-confirmations have always resulted in a correction in the Dow Industrials or the S&P 500 of 12 % or more – and sometimes, much more, such as during the 1973 to 1974 bear market or those fateful two months from late August to late October 1987.  In other words, this is a classic warning sign of, at the very least, a more severe-than-normal stock market correction.  If this were your typical “10% bull market correction,” then in all probability, there would not have been such a flagrant non-confirmation by the NYSE CSO A/D Line.

NYSE Common Stock Only A/D Lines 2003 to Present - NYSE Common Stock Only A/D Line had been contracting for nearly three months even as the Dow Industrials, NYSE Composite, and the S&P 500 made new all-time highs in early October.

Of course, the Dow Industrials and the S&P 500 could always retest or even surpass their highs until we see a more severe decline.  However, as last Wednesday's NYSE ARMS Index reading implies, there is a good chance that we would retest last Monday's lows over the next several weeks anyway, even if the stock market continues to make new highs going forward.  Given this, and given the other “evidence” that we had just pointed out, our strategy over the next several weeks would be this:

Scenario 1: Cover our 50% short position in our DJIA Timing System on a retest of last Monday's lows, should downside breadth (such as downside volume, new 52-week lows, or new lows in the NYSE CSO A/D Line) fail to make new lows on this retest.  This will be a positive divergence in terms of breadth, which is suggestive of a more sustainable rally going forward.

Scenario 2: Should the Dow Industrials or the S&P 500 move higher over the next several weeks, we will most likely leave our 50% short position in our DJIA Timing System “on the table.”  If we see a negative divergence in terms of weak breadth or a lower low in the NYSE CSO A/D line, there is a good chance we would shift to a fully (100%) short position in our DJIA Timing System.  Obviously, scenario 2 is still in flux, so subscribers should stay tuned.

Let us now discuss the main topic of this commentary.  The title “Too Little, Too Late?” is in reference to the government-brokered bailout (as opposed to a government-sponsored bailout, where taxpayer money is used) spearheaded by the Secretary of the Treasury, Hank Paulson.  The plan is still being hashed out as we speak, but if implemented (and if it is agreed upon by servicers and investors – which may be problematic since investors of these instruments are spread all across the world and involve all “classes” of investors), this would entail teaser rate extensions anywhere from 3 to 7 years for subprime borrowers of owner-occupied homes (i.e. no speculators allowed) who are 1) current with and can sustain their payments, and 2) who would not be able to afford the new payments if the teaser rate is reset.  At this point, it is still too early to assess how many subprime borrowers this would affect (many analysts stated last week that the FDIC's estimate of 1.2 million homeowners is too high), but there are obvious problems with this.  For example, as of last Friday, no trade group representing investors of mortgage-backed securities have stood up and supported the plan.  Even the lone agreement from the American Securitization Forum stated that “The one thing that will not change is there needs to be some kind of loan-by-loan analysis.”  The “loan-by-loan” analysis had been looked at and discarded already, as it was deemed too inefficient, and simply “too late” to the game.  Following is a few charts which should hopefully help our readers understand why.

The first chart shows the percentage of home equity of the nation's 110 million households as of December 31, 2006, courtesy of First American CoreLogic and Goldman Sachs:

Percentage of home equity of the nation's 110 million households as of December 31, 2006

While the latest OFHEO report shows modest rise in US housing prices during the third quarter on a year-over-year basis, two other reports, the National Association of Realtors (NAR) and the S&P/Case-Shiller Index are now signaling an approximate 5% in US median housing prices on a year-over-year basis (for those that are interested, the following publication covers the important differences between the construction of the OHHEO HPI and the Case-Shiller Index).  According to the OFHEO, the main differences between its HPI and the Case-Shiller Index are:

a. The S&P/Case-Shiller indexes only use purchase prices in index calibration, while the all-transactions HPI also includes refinance appraisals. OFHEO's purchase-only series is restricted to purchase prices, as are the S&P/Case-Shiller indexes.

b. OFHEO's valuation data are derived from conforming, conventional mortgages provided by Fannie Mae and Freddie Mac. The S&P/Case-Shiller indexes use information obtained from county assessor and recorder offices.

c. The S&P/Case-Shiller indexes are value-weighted, meaning that price trends for more expensive homes have greater influence on estimated price changes than other homes. OFHEO's index weights price trends equally for all properties.

d. The geographic coverage of the indexes differs. The S&P/Case-Shiller National Home Price Index, for example, does not have valuation data from 13 states. OFHEO's U.S. Index is calculated using data from all states.

Also, according to the OFHEO, the Case-Shiller Index most probably overstated the recent decline in housing prices (since it excluded strong-performing States such as Idaho, Montana, and Wyoming).  However, by utilizing the same methodology that it uses to calculate its own HPI and by further extending that analysis to cover non-conventional mortgages and valuing the prices on a “market cap” instead of an equal weight basis, the OFHEO was able match closely the Case-Shiller indices in ten metropolitan areas for the 12-month period ending 1Q 2007:

Appreciation Rates (First Quarter 2006 - First Quarter 2007) for Ten Cities Covered by S&P/Case-Shiller Indexes: The Impact of Adjustments to OFHEO's Estimates

Interestingly, during the 12-month period ending 1Q 2007, the OFHEO by their estimation had overstated housing price appreciation in these ten metropolitan areas by an average of 300 basis points (simply take the average of column one minus column four).  Taking into account this discrepancy (where housing prices are equal-weighted and where price data is taken only from conventional loans), and given that the Case-Shiller readings excluded States that generally had stronger price performance (but which have a substantially lower housing stock, at least compared to California, Florida, Texas, and New York), it is not a stretch to imagine that US median housing prices probably declined 2% to 4% on a year-over-year basis for the period ending October 2007.  Given rising unemployment claims over the last 30 days – not to mention more adjustable mortgage resets – it is not a stretch to extrapolate this trend and assume a 3% or higher decline for US median housing prices by the end of this year.  Based on the prior chart from First American CoreLogic, this would mean an additional 2% of households (or 2.2 million households) would experience negative equity in their houses by the end of this year (generally, the principal of these folks who have little to no equity in their homes would not change much on a year-over-year basis) – on top of the 5.5 million households who already have negative equity.  A further 3% decline in US median housing prices would mean an additional 3 million households would experience negative equity – thus severely cramping discretionary consumer spending going forward.

Is it already too little, too late?  It is not surprising, given the above numbers, to see Secretary Paulson and other government officials scrambling here.  This is neither the time nor the place to argue about the “morality” or the philosophical issues of a government-brokered bailout.  However, even though the obstacles are not insurmountable, they are huge nonetheless.  Even if all the broad issues can be ironed out next week, time is running out, as the dollar amount of resets will spike over the next three months – peaking in March 2008.  In other words, unless they apply the rules retroactively, all the effort would have been for naught if they fail to implement this by the end of February 2008 (Secretary Paulson will most probably not be celebrating Christmas with his family this year), as outlined by the following chart courtesy of Goldman Sachs:

Subprime ARMs vs Pay-option ARMs

I will send you an “ad hoc” update either Monday or Tuesday evening showing the latest readings of our “Global Overbought/Oversold Model” since this commentary is getting too long already.  For now, 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 30, 2007) - For the week ending November 30, 2007, the Dow Industrials rose 390.84 points while the Dow Transports rose 210.22 points. At the close last Monday, the Dow Industrials closed below its August 16th closing low of 12,845.78. More ominously, the Dow Transports actually again closed at a low not seen since late September 2006 last Monday, and has continued to underperform the Dow Industrials in the latest week. 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 still more than 14% below its all-time high. While Wednesday's rally was definitely very impressive (both from a volume and a breadth standpoint) - the evidence still suggests that we haven't seen the bottom yet, given that the Dow Transports has been the leading index since this bull market began in October 2002. Subscribers should continue to be cautious.

For the week ending November 30, 2007, the Dow Industrials rose 390.84 points while the Dow Transports rose 210.22 points.  While last Wednesday's rally was definitely very impressive, the fact that the Dow Industrials closed below its August 16th close last Monday has now clouded the technical picture, in terms of whether we will enjoy a sustainable rally going forward.  More ominously, the Dow Transports again made a new 2007 low last Monday (when it closed at a low not seen since September 2006) and has continued to remain week despite the latest rally.   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 from last week's 11.4% to 5.4% for the week ending November 30, 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 30, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased from 11.4% to 5.4%. From a sentiment standpoint, the market is now hugely oversold, and as such, I would not be surprised if the major indices continue to rally over the next couple of weeks or so. However, given that this reading had reached a multi-month peak just six weeks ago, and given the dismal breadth of the rally since the August lows, my guess is that this reading - as well as the stock market - will become more oversold over the next several months. However, should the market retest its lows in the upcoming week on weak downside breadth, we will cover our 50% short position in our DJIA Timing System and go completely neutral.

With the latest decline, the four-week MA is now as oversold as it was during the summer 2006 and the late February/early March 2007 correction.  However, even though sentiment has now turned quite dark, it is to be noted that the use of sentiment indicators is mostly meant to be a secondary tool, as these surveys simply cannot take into account the action of US and global stock market investors alike.  Given the weak buying power leading up to the early October highs, and given that most of the rally last week was centered on the heavily oversold and technically weak financial and consumer discretionary sectors, and the “knee-jerk” optimism surrounding the government-brokered “subprime bailout plan,” probability still calls for at least a retest of last Monday's low, if not a further correction from those levels.  For now, we will stay with our 50% short position in our DJIA Timing System, but again, we will not hesitate to cover our short position and go neutral should the market retest its lows but without corresponding downside breadth or volume.

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 declined to 117.6 at the close last Friday. The 20 DMA is now very oversold and is also at a level consistent with various market bottoms over the last 18 months. As such, I believe there is a good chance that we could see a tradeable rally develop over the next couple of weeks. Whether any upcoming rally will be sustainable will depend on the breadth and volume of any such rally, and given the weak demand we have witnessed since mid August, my guess at this point is a *no.* However, should the market retest its lows in the upcoming week on weak downside breadth, we will cover our 50% short position in our DJIA Timing System and go completely neutral.

With the latest weekly decline of the 20-day moving average of the ISE Sentiment Index from 128.7 to 117.6, the 20 DMA of the ISE Sentiment Index is now very oversold.  More importantly, the absolute level of the 20 DMA is now at a level that is consistent with various market bottoms over the last 18 months.  This, along with our other sentiment indicators, suggest the potential of a meaningful bounce over the next few months (although not before a possible retest of last Monday's lows over the next several weeks), especially if both upside volume and breadth remains decent going forward.  However, given the evidence I am seeing today, I do not believe we will see meaningful new highs in either the Dow Industrials or the S&P 500 until/unless we experience a more severe correction going forward.

Conclusion: The weight of the evidence suggests that we will at least see a retest of last Monday's lows over the next several weeks, with a high possibility of a more severe correction going forward – a correction that could potentially take us down to the early March 2007 lows in both the Dow Industrials and the Dow Transports.  Moreover, unless the “subprime bailout” plan can be implemented over the next three months, my sense is that it will not matter much going forward, unless the terms of the plan can be retroactively applied to those who have already defaulted or stopped making the higher payments that have reset.  For those subscribers who are looking to “bottom fish” various value stocks (such as Sears Holdings, Sprint, Citigroup, Freddie Mac, Home Depot, Dell, etc.), I would not do so here until we have at least seen a retest on a positive divergence in breadth, since technically weak stocks such as these tend to be the last stocks to bottom in any major correction.  Again, my sense going into 2008 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 believe that we will see one more spike down in the U.S. Dollar Index – and I would not consider a long position in the US Dollar Index until this occurs.  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 before the end of this year.

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 next several weeks.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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