The State of the U.S. Market
(January 8, 2008)
Dear Subscribers and Readers,
Given the decline in the major U.S. market indices earlier today, I would like to offer a few brief thoughts. Unless I see further developments that are worthy of another update, I am not anticipating writing tomorrow evening.
Firstly, the U.S. stock market is now severely oversold, based on many technical indicators that I track on a daily basis. For example, looking on our charts page alone, subscribers may notice that the Dow Industrials is now trading 5.83% below its 200-day moving average – a reading that has not been witnessed since March 2003. Should the Dow Industrials decline another 6% from its current level over the next couple of weeks, then based on this indicator, the Dow Industrials would be as oversold as it was at the March 2003 bottom (note, however, the Dow Industrials actually declined to as low as 20% below its 200 DMA on October 10, 2002).
Other technical indicators that I am currently looking at are: the NYSE ARMS Index, the McClellan Oscillator and Summation Index, the VIX, the percentage of stocks on the NYSE and the NASDAQ above their 200-day exponential moving averages, new highs vs. new lows on both the NYSE and the NASDAQ, and courtesy of Decisionpoint.com, the average value of the S&P 500 components relative to its 52-week low and 52-week high. Let us look at this indicator. According to Decisionpoint.com, this indicator is computed by tracking “each stock in a given market index and determines the location of its current price in relation to the 52-week high and 52-week low. We express this relationship using a scale of zero (at the 52-week low) to 100 (at the 52-week high). A stock in the middle of its 52-week range would get a "Rel to 52" value of 50. These charts show the average "Rel to 52" for all the stocks in the market index shown.” As shown on the following chart (again, courtesy of Decisionpoint.com), this indicator is flashing an oversold reading that is unprecedented (since records started being kept in 2001):
Note that the reading of 32 on this indicator implies an S&P 500 that is even more oversold than the significant bottoms during September 2001, July 2002, October 2002, and March 2003. More importantly, this was not the first “oversold” reading on this indicator. The first oversold reading came during the sell-off in August 2007 – meaning that the collective 52-week highs and 52-week lows on the S&P 500 have had more than four months to decline since that time. In other words, while a reading of 32 may not be as oversold if it had come early in the cycle (such as August of last year), a reading of 32 now definitely implies an S&P 500 that is severely oversold. This is the reason why we did not turn bullish or cover our short position back in mid August and late November. This reading that we just got today changes the game.
Moreover, the NYSE ARMS Index just registered another reading over 2.0 earlier today, putting the 10-day moving average at 1.84, the most oversold reading since early March 2007, and prior to that late March 2004. Note that with the exception of the March to September 1953 correction, the “Kennedy Crash” of 1962, the 1973 to 1974 bear market, and the 2000 to 2002 bear market, oversold readings like this don't occur very often. Following is the 10-day moving average of the NYSE ARMS Index from January 1949 to the present:
In fact, over the last 50 years (from January 1958 to today), there were only 41 such readings where the 10 DMA of the NYSE ARMS Index rose to over the 1.8 level, out of a total of 12,591 trading days (or 0.33% of all instances). Make no mistake: Either we will experience a huge bounce from current levels, or we crash. However, given the many positive divergences that I am currently seeing, my guess is that we will at least begin a tradable rally over the next few trading days.
More importantly, from an oversold standpoint, I had mentioned in last weekend's commentary that: Even should we cover our position, however, I most probably will not go long until (as we have mentioned before) I see more capitulation, such as 1) A high profile bankruptcy, whether it comes in the form of a domestic automaker, a national homebuilder, or a poorly-run bank that have originated a “generous” amount of subprime mortgages, 2) New highs in corporate bond, CMBS, and emerging market bond spreads, 3) Record high mutual fund redemptions on the part of retail investors, or 4) A dramatic decline in NYSE and NASD margin debt.
In trading earlier today, there were rumors of an imminent bankruptcy in Countrywide Financial, as well as an increased in selling pressure due to an announcement from AT&T indicating a substantial economic slowdown. While no major company filed for bankruptcy today, the heavy selling brought on by Countrywide's rumors and the AT&T “news” is most probably enough to signal “capitulation” for now – at least over the short-run.
Moreover, the internals of the market today were far from horrible, despite a 25-point decline in the S&P 500. We also witnessed a higher low on the McClellan Summation Indices, a lower high on the VIX, as well as a lack of confirmation from other major market indices around the world, such as the German DAX, the Hong Kong Hang Seng, the Singapore Strait Times, and most importantly, the London FTSE 100 Index – an index which is heavily weighted towards UK financials. Given the series of higher lows on the FTSE 100, my guess is that there is limited downside in the S&P 500 going forward (the only major index that is weaker than the S&P 500 is the Japanese Nikkei). From a liquidity standpoint, it is hard to see either the IPO calendar or insider selling ramp up over the next few weeks given the recent fall in equity prices – so from that standpoint, we are now not as bearish as we implied in our weekend commentary. Finally, quarterly contributions for defined benefits pension plans that are on a calendar year-based plan year (which is the majority) are due January 15th – indicating that liquidity on and after that date may actually be constructive for equities, at least for now.
We are now looking to cover our 50% short position in our DJIA Timing System (the ones which were initiated at DJIA 13,956) as soon as tomorrow – and most probably go 50% long as well. The combination of a severe oversold condition, significant positive divergences, and potential liquidity coming from defined benefits plans' quarterly contributions on January 15th is just too difficult to ignore. Moreover, as we alluded to in our November 11, 2007 commentary, should the S&P 500 decline to below the 1,375 level, then the chances of the Federal Reserve orchestrating an inter-meeting Fed Funds rate cut can no longer be ignored. Subscribers please stay tuned.
Henry To, CFA