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When Will the Selling Stop?

(December 16, 2007)

Dear Subscribers and Readers,

As I mentioned in last weekend's commentary, I will be leaving for Houston, Texas, this Tuesday to visit my friends and family and will not be back in Los Angeles until January 3rd.   Most likely, you will be getting my “ad hoc” comments as opposed to my usual, verbose commentaries!  At this point, I cannot guarantee a “full blown” commentary next weekend (it is the weekend before Christmas, after all), but I will try to work as hard as I can – especially given the recent volatility and day-to-day swings in the stock and financial markets.  Note that this week's mid-week commentary will come from guest writer Rick Konrad, as usual.  I am definitely looking forward to spending some time on R&R – hopefully, this will fully prepare us to tackle the markets in 2008.  While I believe that 2008 will be the toughest market to navigate since the early days of 2003, I also believe that a great buying opportunity lies ahead in the US stock market.

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 616.15 points as of Friday at the close.

As of Sunday evening, December 16th, we remain 50% short in our DJIA Timing System.  As we discussed in our commentaries over the last three weeks, there are several reasons for our continued bearish stance, despite the impressive rally in the major market indices from the most recent bottom on November 26th.  These arguments remain in place.  For example, as we mentioned in our commentary two weeks ago, TrimTabs, one of the most bullish publications over the last few years (who also “got it right” during the 2000 to 2002 bear market, as well as catching 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).  This continues to hold true.  In addition, the technical picture has further deteriorated with the Lowrys 90% downside day that we witnessed last Tuesday.  To top if all off, the US (and most of the world's) stock market is still not oversold on any of our technical indicators – thus signaling there is further downside to go over the next several weeks.

So Henry, what technical indicators are you looking at?

I am looking at the “usual candidates” that I track on a daily basis.  These include: 1) the NYSE ARMS Index, 2) the NYSE Common Stock Only and “Classic” McClellan Oscillator and the Summation Index, 3) new highs vs. new lows on both the NYSE and the NASDAQ, 4) the percentage of stocks above their 20 EMAs, 50 EMAs, and 200 EMAs on both the NYSE and the NASDAQ, 5) the average stock on the S&P 500 relative to their 52-week high/low range, and 6) the Euro-Yen cross rate as a general indicator for the Japanese Yen carry trade.  At the same time, I am also continuing to trade our usual sentiment, liquidity, and global economic indicators.

As I said, none of our technical indicators is yet flashing a “very oversold” signal.  Given the weak upside breadth and volume that we witnessed during the post November 26th bounce, and given the strong downside breadth and volume last week, probability now favors more downside in the major market indices over the next several weeks.  So when will our technical indicators flash a “buy signal,” or at the very least, a signal to cover our 50% short position in our DJIA Timing System?

Let us start with the NYSE ARMS Index – an indicator that has aided me immensely in calling for oversold bottoms since we began writing our commentaries, has been the NYSE ARMS index.  Following is a daily chart showing the 10-day and 21-day MA of the ARMS Index vs. the daily closes of the Dow Industrials from January 2003 to the present:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - While we did get some very oversold readings in most other technical indicators during November, this was not confirmed by either the 10 DMA or the 21 DMA of the NYSE ARMS Index, which both hit a high of only 1.14 on November 26th. At the very least, I want to see a 10-day reading that is on par with the early to mid August readings, or around 1.5 before covering our short position and going long.

As of Friday at the close, the 10-day and the 21-day NYSE ARMS Index closed at 1.19 and 1.13, respectively.  This is still a far cry from the oversold readings that we got in early to mid August, let alone the immensely oversold readings we witnessed during late February and early March of this year – which represented the most oversold reading since during the October 1987 crash.  At the very least, I want to see a 10-day reading that is on par with the early to mid August readings, or approximately 1.5, before covering our 50% short position in our DJIA Timing System and potentially going long.

Another indicator that does not yet suggest “capitulation” among retail and professional investors (mainly hedge funds) alike is the NYSE Common Stocks Only McClellan Oscillator and the McClellan Summation Index.  Following is a three-year daily chart showing the NYSE CSO McClellan Oscillator, the Summation Index, and the NYSE Composite, courtesy of

NYSE Common Stocks Only McClellan Oscillator

There are two strikes against the stock market bulls from the above chart.  First of all, the NYSE CSCO Summation Index – at a reading of -264.02, is still far above the oversold readings that we have gotten over the last three years.  Secondly, the NYSE CSO McClellan Oscillator has just turned below the zero line (now at -20.45) – confirming that the stock market is now again in a new downtrend.  At this point, I would most likely not cover our 50% short position in our DJIA Timing System (or potentially go 50% long) unless or until the McClellan Summation Index sells off to a reading below -500, or at least to a reading similar to the oversold readings that we have gotten over the last three years, such as April 2005, October 2005, June 2006, and August 2007.  As an aside, if the McClellan Summation Index sells off to a reading of -1,000 or below, then the stock market – per this indicator – would be as oversold as the stock market was during October 2002.  Such a reading would most likely take the Dow Industrials below 12,000.

I now want to move away from our usual technical indicators and discuss our “cash on the sidelines” indicator.  This indicator – the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 – had been particularly useful as a gauge how oversold the US stock market really is – as well as how sustainable a current rally may be.  I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006.  Following is an update of that chart (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to November 2007:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to November 2007) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash.  2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio rose to 21.63% at the end of November, due to the latest surge in money market fund assets, and hitting a high not seen since September 2003. Over the longer run, a reading of over 20% is on the high side and should be supportive for stock prices over the next 12 to 24 months. That being said, that does not mean that this ratio cannot go higher (it stood at 19.45% on August 31, 2001, right before the September 11th plunge) - but at some point in 2008, the market will present us with a great buying opportunity.

As of Friday at the close, the market cap of the S&P 500 is at a level similar to where it was on November 30th – and thus the above chart remains a good indicator, despite the sell-off we experienced last week.  Note that while the ratio between money market fund assets and the market cap of the S&P 500 is not a great timing indicator – what it does show is the amount of “fuel” for a sustainable stock market rally going forward.  Note that the November 30th ratio of 21.63% is now at its highest since September 2003.  Such a reading is relatively high on a historical basis and should be supportive for stock prices over the next 12 to 24 months.  However, over the short-run, the stock and financial markets can do anything.  For example, it is interesting to note that this ratio hit a high reading of 19.45% on August 31, 2001, and yet, this ratio continued to hit highs after highs as investors fled into money market assets in the midst of the September 11th attacks, the Enron scandal, the Worldcom, and Global Crossing bankruptcies, etc.  This ratio would ultimately not top out until September 30, 2002, when it hit a 20-year high reading of 27.69%.  Finally, subscribers should also note that money market fund assets have been growing at over 30% in recent weeks – a rate that is definitely not sustainable – especially since the Fed (despite slashing the Fed Funds rate by 100 bps over the last few months) remains relatively tight, as evident by the dismal growth of the St. Louis Adjusted Monetary Base over the last 12 months (in fact, the St. Louis Adjusted monetary base actually registered a decline from end of August to the present).  In other words, while it is likely that stock prices will be higher 12 to 24 months from now, it is not a given, and will highly depend on the viability of both the US and European financial sectors going forward.

A final chart I want to show is the following monthly chart, courtesy of Goldman Sachs, showing the market cap composition of the 10 sectors within the S&P 500 from January 1974 to November 2007:

Market cap composition of the 10 sectors within the S&P 500 from January 1974 to November 2007

Interestingly, after the most recent correction in the financials, the sector still makes up 19% of the S&P 500 as of the end of November – only 3% below its most recent peak of 22%.  Assuming that the bull market in financials did ultimately turn into a bubble (one can certainly argue this is the case, given the huge proliferation of new financial products over the last ten years, such as hedge funds, CDOs, CDSs, swaps, new “hedging products” such as weather and carbon derivatives, etc) there is still a further correction to go in the financials – even as the Fed continue to cut rates over the next several months.  Note that since the peak of the technology bubble, its percentage composition of the S&P 500 has halved, while the energy sector – despite its rise over the last few years, still makes up less than half of its peak in 1980, or 26%.  While I continue to believe that the global financial sector is in a structural bull market (this author tends to be more optimistic on the financial sector given my financial background), probability suggests that the financial sector will continue to be a tough sector to be in over the next 12 months.  Also, should Western Europe, Japan, and other major economies slow down dramatically over the next 3 to 6 months (as being indicated by the MGDI) – there is a good chance we will experience a correction in other sectors as well, such as industrials, materials, energy, and information technology.  Should this occur (or should the perception of this start to become common among retail investors), then all bets are off as to where the Dow Industrials or the S&P 500 would bottom out in the latest decline.

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 December 14, 2007) - For the week ending December 14, 2007, both the Dow Industrials and the Dow Transports declined, with the former declining 285.73 and the latter 198.49 points. The bulls would argue that the latest decline is more of a reaction to the bounce we experience since November 26th, but given the mediocre breadth and volume during the latest bounce, I am inclined to believe that there is further downside to go over the next several weeks. As I mentioned before, the technical damage is severe - as at the November 26th close, the Dow Industrials closed below its August 16th closing low of 12,845.78 while the Dow Transports actually closed at a low not seen since late September 2006. Moreover, the Dow Transports is still 14% below its mid July highs. As we have mentioned over the last 4 months, the Dow Transports has persistently been the weaker index - this is all the more ominus 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 December 14, 2007, the Dow Industrials declined 285.73 points while the Dow Transports declined 198.49 points.  While both Dow indices are still up a sizable amount since the November 26th close, I believe the technical damage has already been done when the Dow Industrials closed below its August 16th close and the Dow Transports closed at a level not seen since September 2006 on November 26th.  Moreover, last week's decline in the major market indices was accompanied by a 90% downside day on Tuesday – and “impressive” downside breadth and volume for most of the week.  More ominously, the Dow Transports is still more than 14% below its mid July highs and remains the weaker index – and given that it has been the leading index since this 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 increases slightly from last week's 4.7% to 7.3% for the week ending December 14, 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 December 14, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 4.7% to 7.3%. From a sentiment standpoint, the market is still hugely oversold, so I would not be surprised if we see a bounce over the next couple of weeks. However, given that this reading had reached a multi-month peak just 8 weeks ago, and given the continued strong downside breadth and volume during the latest week, my guess is that this reading - as well as the stock market - will become more oversold over the next several months. At this point, short of a hugely oversold situation per the ARMS Index and other technical indicators, we will stay 50% short in our DJIA Timing System.

With the decline over the last few weeks, the four-week MA is now as oversold as it was during the summer 2006 and the late February/early March 2007 correction, despite the latest weekly bounce.  However, even though sentiment has now turned quite dark, subscribers should keep in mind that the sentiment indicators is mostly meant to be a secondary tool, as these surveys simply cannot take into account the action and sentiment of all US and global stock market investors.  Given the weak buying power leading up to the early October highs, and given the strong downside breadth and volume last week, chances are that we should at least see a retest of the November 26th lows, if not a further correction from those levels.  For now, we will stay with our 50% short position in our DJIA Timing System, and we will not consider covering unless we actually hit the November 26th lows.

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 115.6 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. However, given the strong downside breadth and volume that we witnessed since early October, and given the lack of an oversold condition in our other technical indicators, I believe there is further downside to go. At this point, this author will only go long (or cover our 50% short position in our DJIA TIming System) if the 50 DMA also becomes oversold as well - that is, decline to the 110.0 to 117.5 area. For now, we will stay 50% short in our DJIA TIming System.

With the decline of the 20-day moving average of the ISE Sentiment Index to the 115 level over the last several weeks, 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.  However, the 50 DMA is still not at a level that is consistent with oversold levels that we have witnessed in corrections over the last 15 months, and until we get that oversold reading, I will not cover our 50% short position in our DJIA Timing System just yet.

Conclusion: Given the weak rally off of the November 26th bottom, and given last week's strong downside breadth and volume in the US stock market, the weight of the evidence continues to suggest that we will at least retest the November 26th lows.  Moreover, I believe it is now too late for a “subprime bailout” plan that will meaningfully help these “homeowners” keep their homes going forward – short of a direct cash handout from the federal government (states everyone are cutting their spending – most notably, California with its projected $14 billion budget deficit).  As I mentioned in last week's commentary, it is now “too little, too late” as subprime resets are set to spike over the next three months – peaking during March 2008.  Moreover, I believe this “correction” in the financial and consumer discretionary sectors will eventually spread to the “strong sectors” as well – such as energy, industrials, and materials, given the significant slowdown that we are now witnessing in Western Europe and Japan as well.  For those subscribers who are looking to “bottom fish” various value stocks (such as Sears Holdings, Sprint, Citigroup, Freddie Mac, Home Depot, Dell, First Marblehead, Discover Holdings, 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. 

However, given the significant “cash on the sidelines” that we are seeing in both retail and institutional money market funds, I believe there will be a great buying opportunity sometime next year.  For now, we will also remain 50% short in our DJIA Timing System, but and we will most likely not cover until we have retested the November 26th lows.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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