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Capitulation this Week?

(January 20, 2008)

Dear Subscribers and Readers,

No doubt this week has been difficult for many of you.  Believe me; the decline of last week had been tremendously frustrating for me as well.  Aside from doing some research this weekend, I also spent a lot of time working out and running – and of course, some time relaxing and hanging out with my fiancé as well.  More specifically, despite making a 1,326-point profit on our 50% short position that we had initiated in our DJIA Timing System on October 4, 2007 when we decided to cover our position on January 9th, we had also gone 50% long immaturely at the same time at a DJIA print of 12,630.   Subsequently, we watched the Dow Industrials decline day after day – taking out one oversold level after another.  However, as I have mentioned in my many commentaries, “ad hoc” emails, and posts in our discussion forum over the last 5 to 7 trading days, our technical indicators – such as the NYSE ARMS, new highs vs. new lows on both the NYSE and the NASDAQ Composite, the % of stocks below their 200-EMAs on both the NYSE and the NASDAQ, a Barnes Index reading below zero, etc, are now showing oversold levels not witnessed since the significant bottoms during October 1990, Fall 1998, September 2001, and October 2002.  All these bottoms have been a great time to buy – with half of these bottoms marking the beginning of a multi-year bull market in US stocks. 

Of course, there are also other factors telling me that we are not in a “full-blown” bear market just yet, but before I go on and discuss those factors, let us first update you on our six 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 on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a loss of 507.00 points as of Friday at the close.

Now that we have gotten this out of the way, so Henry, what are some of the other factors indicating that we are not in a “full-blown” bear market?  After all, didn't the US (along with the UK, Australia, and a large chunk of the Euro Zone) just experience a once-in-a-generation housing bubble, as well as a bubble in structured finance?  Shouldn't we wait on the sidelines for now until all the “excesses” have been cleansed out?

The answer to the last question, in general, is “yes.”  But as I have mentioned before, investment and commercial banks alike have already written down much of their questionable assets based on various structured finance indices (such as the ABX) that were not even available five years ago.  More importantly, these indices are now reflecting a significantly more dire situation than where either US residential real estate or housing prices are right now.  Could these derivative indices be right?  Sure, but should we witness any improvement in either these indices or simply a less pessimistic outcome in the US housing market over the next few months, then we could see some upside surprises in next quarter's round of earnings reports.  My main point is this: Because of the structure of the financial markets today, US investment and commercial banks are now writing down assets much quicker than in the last US housing downturn – especially during the S&L crisis in the early 1990s – such that all the “excesses” are now being cleaned out at a tremendous rate, and even better for us, they may have even overshoot on the downside.

As for the reasons why I don't believe we are in a full-blown bear market just yet, there are many reasons – so I would only list out some of them here, in no particular order:

  1. First of all, unlike the late 1990s technology bubble, the current bubble did not originate in the stock market – but rather, in the US residential housing market that was further aided by financial engineering and a loose monetary policy during 2003 to 2004.  Because of this, much of the retail speculation had focused on US housing, or more specifically, housing in California, Florida, Nevada, and Arizona.  To the extent there was retail speculation in the US stock market, it had centered on shares of homebuilding and mortgage companies.  In my humble opinion, the bubble in mortgage companies, and to a lesser extent, homebuilding companies, had already burst a long time ago and is close to being fully wounded down.  Because of this lack of retail speculation in the US stock market in recent years, valuations, in particular in the consumer discretionary, technology, health care, and consumer staples sectors, have never really gotten out of hand, unlike during the late 1990s bull market.

  2. While one could argue that many companies in the financial sector had over-inflated earnings due to the structured finance boom in recent years, subscribers should remember that any “crisis” that originates out of the financial sector – unlike the capital overspending and the aftermath in the technology sector during 2000 to 2002 – is usually easy to fix.  Whether the crisis was the S&L crisis during the early 1990s, the Russian/LTCM crises in 1998, or the current crisis in subprime – the easiest strategy has always been to inflate, inflate, and inflate.  Make no mistake: The Fed will continue to ease aggressively going forward.  It will also do everything in its power to make sure LIBOR stays at the Fed Funds rate.  From a fiscal standpoint, we have already seen what the Bush Administration and Congress is willing to do to prop up consumer spending this year.  Moreover, they have committed to agreeing on a solution by the State of the Union address on January 28th.  Not only that, the FDIC Chairman has publicly declared that if a market solution isn't enough to solve the subprime problem, the government will step in.  This is akin to the Federal government printing money and using it to soak up on the excess Cisco routers and Intel processors during the 2001 to 2002 debacle unwinding of the technology bubble.  Sure, many mediocre companies will still fail – but the overall stock market and the stronger companies will be propped up or “bailed out.”

  3. The change in investors' sentiment had been very dramatic since the beginning of the year.  Right before New Year's (and when we had already been short for nearly three months), everything was still “hunky dory” according to stock market analysts and economists alike – and now after a dismal unemployment number and a breakdown in the chart patterns, most if not all market analysts are now calling for a US recession and the end of the October 2002 to October 2007 bull market.  Given that the majority of these analysts and economists had not anticipated the current market decline last year, it doesn't make too much sense in betting on them now.

  4. As for basing your equity allocation based on “chart patterns” alone – I want to ask my subscribers this: Would you bet your life on a chart pattern, and if not, why would you bet your retirement portfolio on a chart pattern?  If one can call the beginning of a major bull or bear market simply by looking at moving average cross-overs, then there would be no market.  20 years ago, this would have been a useful endeavor – given that this kind of data was not easily available.  Nowadays – with a few simple mouse clicks, anyone can bring up a chart of the S&P 500, along with every technical tool one can dream of, for free.  That is not to say that this author doesn't look at charts.  However – to me – trading or making decisions based on chart patterns is only useful on the condition that: 1) Not many other analysts are observing the same patterns at the same time, and 2) The chart pattern is being confirmed by my other indicators, especially from a valuation and sentiment standpoint.  On both counts, the bearish case based on the current S&P chart pattern (and to a lesser extent, the bearish implications of the Nikkei chart pattern) does not pass much muster.

Moreover, subscribers should keep in mind that the “cash on the sidelines” is now approaching a level that has marked major bottoms in the past.  As mentioned in the Wall Street Journal over the weekend (and according to Morningstar), the cash levels of domestic equity mutual funds (mutual funds that have a general mandate to invest exclusively in US stocks) were at an average of 7.3% of assets as of December 31, 2007 – the highest year-end number since December 31, 2000.  Moreover, many of these funds (such as American Funds Fundamental Investors and Fidelity Magellan) have tried to “goose up” their returns over the last couple of years by “diversifying” into foreign stocks, even though their general mandate is to invest solely in domestic stocks.  In other words, not only are domestic equity mutual funds now heavily in cash, they are also underweight U.S. equities.  Barring a 1929 or a 1987 style panic out of the equity markets, domestic equity mutual funds not only have enough funds for redeeming investors, but also a substantial cash cushion to buy more domestic stocks should the market continue to decline.

Outside of mutual funds, there is another “cash on the sidelines” indicator that I want to discuss.  This indicator is one that I showed in last weekend's commentary, but which now I want to update.  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 of 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 January 2007 (updated with January 18th data for the month of January):

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to January 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 which 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 24.62% at the end of last week, due to the latest surge in money market fund assets and another decline in the S&P 500, and hitting a high not seen since March 2003 (and now over the level as of October 1990). Over the longer run, a reading such as this is on the very high side and should be supportive for stock prices over the next few years. That being said, that does not mean that this ratio cannot go higher - but chances are that the market will be higher for the rest of 2008.

As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 24.62% - a level that has not been seen since March 2003, and is now at a high level than where it was at the end of October 1990.  While this indicator is usually not a great short-term timing indicator, it is to be noted that this reading is now extremely high on a historical basis and should be supportive for stock prices not only for over the next few years, but over the next few months as well.  Even though the stock market can do anything over the short-run, my guess is that investors will capitulate this week – meaning we should get a good buying opportunity this week that will allow us to shift from a 50% long to a 100% long in our DJIA Timing System.

In our final “cash on the sidelines” analysis, I want to show you a chart that we haven't featured since our May 24, 2007 commentary.  The following monthly chart shows the level of cash in both cash and margin brokerage accounts (as compiled by the NYSE) versus the amount of margin debt in brokerage accounts, as well as relative to the Wilshire 5000 from January 1997 to December 2007:

Wilshire 5000 vs. Cash and Margin Debt Ratios (January 1997 to December 2007) - NYSE margin debt outstanding decreased nearly $21.5 billion in December, and $50.4 billion over the last six months - reflecting the largest six-month decrease in margin debt since May 2001. More importantly, cash levels as a ratio of margin debt is now at a low not seen since the month ending December 2002.

As of the end of December 2007, cash levels in both cash and margin accounts as a percentage of margin debt is was at its highest level since December 2002 – suggesting that we are now at or near a bottom.  Coupled with the sell-off we witnessed in the first two weeks of this month (there is no doubt that a significant amount of margin debt had been liquidated over the last two weeks), there is a good chance that this ratio is now at an all-time high (surpassing the record high at the end of September 2001), at least since records have been kept.   No matter how you look at it, we are now at or near the beginning of a substantial rally.

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 January 18, 2008) - For the week ending January 18, 2008, the Dow Industrials declined a whooping 507.00 points while the Dow Transports only declined 7.90 points. While the Dow Transports did not rise for the week - for all intents and purposes, the reluctance of the Dow Transports to decline further the week is a classific non-confirmation of the Dow Industrials by the Dow Transports on the downside. This non-confirmation is very important, given that the Dow Transports has been the leading index since this bull market began in October 2002. Again, this author is now bullish on the major US market indices, based on two overriding ideas: 1) The fact that we have seen a capitulation* in the US financials and consumer discretionary sectors, and 2) Our view that the Fed will adopt a more accommodating stance going forward. In the meantime, the technical damage is still with us. Moreover, the chance of one more low during the upcoming week still remains high. Bottom line: Subscribers should continue to be cautious, but this author would be looking to go 100% long in our DJIA Timing System sometime this week.

For the week ending January 18, 2008, the Dow Industrials declined a whooping 507.00 points while the Dow Transports only declined 7.90 points – creating a substantial non-confirmation in the process.  As I am finishing up this commentary, however, the S&P 500 futures are down 30 points.  Notwithstanding this decline, this non-confirmation of the Dow Industrials on the downside by the Dow Transports is a significant development, especially since the Dow Transports has been the leading index since this cyclical bull market began in October 2002.  Coupled with the severe oversold conditions in the U.S. stock market (and now the arguably the global stock market) my guess is that we are now or close to a bottom in the US stock market, even though there is a good chance we will see one more significant low sometime this week.   Should the market gap down when it opens for trading this Tuesday morning, there is a good chance we will shift to a 100% long position at that time.  Subscribers please stay tuned.

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 3.9% to -0.4% for the week ending January 18, 2008.   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 January 18, 2008, the four-week MA of the combined Bulls-Bears% Differentials declined a whooping 4.5% - from 3.9% to -0.4%. This reading is now severely oversold - in fact, it is even more oversold than the June 2006 low (when it reached 1.7%) and is now on par with readings last witnessed during April 2003. Moreover, the 10-weem MA (not shown) is now at 4.7% - representing the most oversold reading since late August 2006. Given the postive divergenc in the Dow Transports we witnessed at the end of last week, I expect the market to bottom out this week and to enjoy a substantial bounce over the next few weeks. At this point, we will stay 50% long in our DJIA Timing System, and most probably move to a 100% long position sometime this week.

With the reading at -0.4%, the four-week MA is now extremely oversold, and has now surpassed the hugely oversold readings that we got during June 2006, as well as early September and early December of last year.  In fact, this reading is now at its most oversold level since April 2003.  Given this and other factors we have previously discussed, I continue to be comfortable with a 50% long position in our DJIA Timing System, and will most probably go 100% long sometime this 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 143.4 on October 15th, the 20 DMA of the ISE Sentiment has declined to the 107.8 level, a level not seen since September 4th.  More importantly, both the 20 DMA and the 50 DMA are now severely oversold, and are consistent with levels achieved during various market bottoms over the last 18 months. Should the 50 DMA decline a couple of more points over the next few days, then the 50 DMA would be at a low not seen since November 2002. I continue to believe that there is little downside here. For now, we will stay 50% long in our DJIA TIming System, and look to go 100% long sometime this week.

With the 20-day moving average of the ISE Sentiment Index declining to 107.8 and the 50-day moving average to 112.4 in the latest week, the ISE Sentiment Index is now extremely oversold no matter how you look at it.  More importantly, the ISE Sentiment Index has now “sold off” to a level that is consistent with various market bottoms over the last 18 months, and are now on course to declining to levels not seen since November 2002.  Given the amount of “cash on the sidelines” that is now accumulating, and given the oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, I believe that we are now at or near a significant bottom in both the Dow Industrials and the S&P 500.  For now, we will stay with our 50% position in our DJIA Timing System, and most probably go 100% long sometime this week.

Conclusion: For our subscribers, I want you to keep this in mind: The only true advantage that one has is your investment horizon and in adopting a long-term view, since most of you do not need to report quarterly numbers to your investors and so have no pressure to outperform in the short-run.  If you sell out now, you will not only lose that only advantage, but would also fall prey to the mainstream media as well.  As I mentioned to a subscriber this weekend, this is how most investors lose money and/or underperform the S&P 500 over the long-run.  As for me, my “advantage” lies in the fact that I don't need to maneuver my way around all the “wiggles” and mini rallies/declines – and can either hold cash or stay in a long/short position for as long as I like (e.g. We stayed 100% long in our DJIA Timing System during the September 2006 to May 2007 period).  This is a luxury that hedge fund and mutual fund managers do not have.

Again, we will most likely shift from a 50% long position to a 100% long position in our DJIA Timing System sometime early this week.  Should the Dow Industrials gap down on Tuesday morning, we will most likely go long on Tuesday, although given Bank of America's earnings report on Tuesday morning, anything can happen.  For now, I continue to be bullish in certain US consumer discretionary and financial stocks (please see Rick Konrad's latest guest commentary for some suggestions on the consumer discretionary/retail side).  In terms of overseas markets, I am now bearish on most markets except for Japanese small caps (and most Japanese companies with a domestic focus) as well as Taiwanese shares.  Again, given the tremendous valuations (not to mention its hugely oversold condition) we are now seeing in the Japanese stock market, I think it is now time to start nibbling on Japanese equities.

Signing off,

Henry To, CFA

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