The Message of the NYSE A/D Line
(May 18, 2008)
Dear Subscribers and Readers,
One of the chief complaints of many investors who attend the annual Berkshire Hathaway meeting is the recurring and repetitive themes year after year. Sure, both Warren Buffett and Charlie Munger essentially say the same things every year, but alas, that is the purpose. For the majority of us who are vulnerable to losing discipline during times of great market dislocations (either on the upside or the downside), attending the Berkshire event is one way to reinforce that investing discipline, whether it is through value investing, following a trading system, or whatever. This is also one reason why I always – in addition to reading new books on investing and other interesting genres (such as modern history, biographies, quantitative finance, etc.) – go back and read the best books on investing/speculation at least once a year. Among others, this list includes: 1) Reminiscences of a Stock Operator, 2) The Intelligent Investor, 3) When Genius Failed…, 4) The Alchemy of Finance, 5) Buffett: The Making of an American Capitalist, and 6) The latest edition of the Ibbotson SBBI Yearbook. Obviously, there are always other must-reads depending on one's investing or trading style, but these books are on the top of my list. A complete “must-read” list is beyond the scope of this commentary, but I would start off by browsing our “Favorite Books” section. For those who would like to read more about quantitative finance or derivatives, I would begin with the “bible” in the derivative industry, the sixth edition of John Hull's “Options, Futures, and Other Derivatives.”
Let us now begin our commentary with a review of our 7 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 gain of 356.80 points as of last week at the close.
7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 1,271.80 points as of last week at the close.
As we have discussed in our prior commentaries and posts on the MarketThoughts.com discussion forum, a deleveraging environment, such as what we're currently experiencing and what we experienced during the late 1989 to early 1991 period, is generally not good for small capitalization companies. As of last Friday, the Russell 1000 was down 1.67% on a year-to-date basis, while the Russell 2000 was down 2.79%. Meanwhile, the Russell Microcap Index (consisting of the smallest 1,000 companies in the Russell 2000 and the next 1,000 smallest companies) was down a whooping 8.56%. Partly because of this, and partly because of the weakness in the financial and the health care sectors, breadth on both the NYSE and the NASDAQ Composite has been consistently weak in the recovery from the mid-March lows. This weakness in stock market breadth is evident in the following chart (courtesy of Decisionpoint.com) showing the action of the NYSE Common Stock Only A/D Line vs. the NYSE Composite over the last six months:
While many market commentators have continued to be concerned over the lack of strength in stock market breadth, subscribers should note that it is not surprising to see this in an environment that is still deleveraging, such as what occurred during the rally from the stock market lows of October 1990 (when the U.S. economy was still reeling from the junk bond era of the late 1980s and the S&L crisis of the early 1990s). The lack of breadth confirming the upswing in the U.S. stock market from the October 1990s lows can be seen in the following chart, also courtesy of Decisionpoint.com:
Interestingly, the NYSE A/D line actually topped out in August 1989 (not shown), even though the NYSE Composite and the Dow Industrials did not truly top out until July 1990. Rather, the topping out of the NYSE A/D line in August 1989 marked the peak of the LBO./junk bond boom (which culminated in the failed buyout of UAL in October 1989). More importantly, the action of the NYSE A/D line coming off the October 1990 bottom was very disappointing to those that had been paying attention to the NYSE A/D line at the time (after all, the lower highs in the NYSE A/D line had “foretold” the weakness in the U.S. stock market from during the July to October 1990 period). In fact, the NYSE A/D line did not best its June 1990 highs until December 1991. By that time, the NYSE Composite had already rallied over 40% from its October 1990 low, and was nearly 15% higher than its high in July 1990. Finally, by the time the NYSE A/D line had finally bested its all-time high (set in August 1989) in early 1993. the NYSE Composite had already rallied 50% from its October 1990 low. The bears who had been waiting for the NYSE A/D line to make a higher high had to wait for over three years and missed out on a huge 50% rally from the October 1990 lows.
That is not to say I am expecting a similar rally from the mid March 2008 lows. On the contrary – as the U.S. economy continues to deleverage – I expect the U.S. stock market to be relatively weak for the rest of this year. I also would not be surprised if we retest the mid January or mid March lows sometime this year. However, in the meantime, the trend of the U.S. stock market, in all likelihood, continues to be up.
In this author's opinion, much of the “overhang” on the U.S. stock market is mostly due to the strength in commodity prices, and not to the ongoing issues in the housing markets or the U.S. financial sector. That being said, I believe some short-term relief is on the way. While I don't believe the secular bull in commodity prices is over, we are now way overdue for a correction. For example, not a day goes without another prediction for a $150 or $200 oil price by the end of this year. In terms of sentiment and bullishness on crude oil prices, we are definitely in “euphoric” territory. Moreover, as I am typing this, we know that Iran has some 28 million barrels of sour crude oil sitting in tankers in the Persian Gulf (note that this is a very expensive way of storing oil as tanker charter rates are off the charts). Interestingly, Iran is still in the market for 90-day charters, suggesting that there is still an ongoing excess supply at least in Iran.
More importantly, the latest readings in our MarketThoughts Global Diffusion Index are calling for significant weakness in commodity prices over the next several months. We last discussed the MarketThoughts Global Diffusion Index (MGDI) in our December 9, 2007 commentary (“Global Economic Growth Continues to Disappoint”) – arguing that global economic growth will continue to slow down in the months ahead, as implied by the MGDI readings from last December. To recap, we first featured the MGDI in our May 30, 2005 commentary. For newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for 26 countries, the majority of which are in the Organization for Economic Co-operation and Development (OECD). Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages. More importantly, the MGDI has historically led or tracked the CRB Index and the CRB Energy Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI on three occasions – first by incorporating the leading indicator for the Chinese economy, second by dropping the one for Turkey, and third (which just occurred this month) by incorporating the leading indicator for the Brazilian economy. The first and third revisions are obvious; as China and Brazil are now significant drivers of global economic growth and have been over the last few years (China's contribution to global economic growth last year surpassed that of the US). The second revision is less obvious. While Turkey is by no means a small or marginal country, many of the readings over the last six months have been very unreliable (and have continued to be) – and so we have chosen to drop Turkey in our MGDI instead. This is rather unfortunate, but it is better to omit certain data points than to incorporate unreliable data. So what are the latest readings telling us?
Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the CRB Index and the YoY% change in the Dow Jones Industrial Average from March 1990 to March 2008 (the April readings will be updated and available on the OECD website in early June). In addition, all four of these indicators have been smoothed using their three-month moving averages:
Note the divergence of the year-over-year change in both the CRB Index and that of the MGDI (and its second derivative) since September of last year. Given the historical (positive) correlation with OECD (including China and Brazil) growth and the rise in commodity and energy prices since the fall of the Berlin Wall, there is no reason to expect this continued divergence. Moreover, given the latest decline in the “soft” commodities, and given the reluctance of the Bank of England and the European Central Bank to ease monetary policy in a meaningful manner (as well as the Fed's pause), my sense is that crude oil prices will correct meaningfully over the next several months. Again, as Jack Treynor discussed in his 2003 paper “A Theory of Inflation,” lower interest rates should eventually lead to lower oil and other commodity prices – to the extent that commodity price inflation is being caused by supply constraints. Why is this the case? Consider a present value or IRR study on a new drilling and development project in the deepwater parts of the Gulf of Mexico. If the planner decides that low interest rates are here to stay, then future projections of both crude oil prices and profits do not need to be as high to make the project feasible to executive management. In such a scenario, oil companies will choose to increase expenditures for exploration and drilling projects, which will in turn increase both reserves and production going forward. Furthermore, given that crude oil prices are now significantly over $100 a barrel, and given that many participants are now projecting demand to continue to grow steadily going forward, many participants – such as venture capitalists, private equity firms, and scientists – are now seriously devoting significant resources and time to the alternative energy sector.
Crude oil prices are now also more than two standard deviations above its 200-day simple moving average – something that hasn't occurred since November 2007, and prior to that late August 2005, when Hurricane Katrina ravaged the Gulf of Mexico, resulting in a virtual shut-down of crude oil production in the region (nearly 1.5 million barrels a day). We are definitely due for some kind of correction here.
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:
For the week ending May 16, 2008, the Dow Industrials rose 240.92 points while the Dow Transports rose 174.98 points. While the Dow Industrials is still 8.3% away from its all-time closing high, the Dow Transports is now a mere 1.4% away. Moreover, the Dow Transports actually made a 10-month high last Thursday, when it was only 0.8% away from besting its all-time closing high – thus again confirming it as the stronger index over the Dow Industrials. Given the Dow Transports' role as a leading indicator of the broad market since October 2002, this strength in the Dow Transports is very encouraging, especially given another record high in crude oil prices last week. Moreover, with the latest decline in credit spreads across the world, and with further capital-raising within the global financial sector, it remains a dangerous time to stay short (unless one is selectively shorting small cap stocks), especially given the unprecedented amount of global investment-ready capital sitting on the sidelines. We will stay 100% long in our DJIA Timing System.
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 increased from last week's reading of 7.2% to 12.7% for the week ending May 16, 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:
While this sentiment is now getting overbought, it is still far from overbought conditions that we have experienced over the last four years. In other words, we are still not near “danger territory” just yet. However, should this sentiment indicator (and others that we track, such as the equity put/call ratio, the ISE Sentiment Index, etc.) get more overbought over the next few weeks, and should this be accompanied by a significant rise in the stock market on weak breadth or weak volume, then we will start to become more concerned. In the meantime, given the continued rise in this sentiment indicator from a historically oversold condition (by far the most important reversal signal in the stock market is when this indicator reverses from a very oversold situation), the line of least resistance remains up. Given the readings of this sentiment indicator, the relative strength in the Dow Transports, the implementation of the fiscal stimulus plan in the last week of April, as well as an essential guarantee by the Fed for most of the U.S. financial system, I continue to be comfortable with a 100% long position in our DJIA Timing System, and will most likely not par back until/unless we see the stock market or these sentiment indicators get overbought again, or should energy and general commodity prices continue to rise.
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. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. 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:
With both the 20-day and 50-day moving averages of the ISE Sentiment Index reversing from historic oversold readings and now in firmly established uptrends, probability suggests that the stock market should continue to rally for the foreseeable future. Despite this uptrend, we will continue to monitor this and other sentiment indicators for signs of an “over optimistic” market that may not be justifiable from a technical (weak volume, weak breadth, etc.) or fundamental basis (such as stubbornly high oil prices, etc.). In the meantime, given this reversal from a historically oversold condition of the stock market, the Fed “backstopping” the majority of the U.S. financial sector, the mailing out of the “fiscal stimulus” a few weeks ago, and the unprecedented amount of capital sitting on the sidelines, I continue to believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500. For now, we will stay with our 100% position in our DJIA Timing System.
Conclusion: While I am watching the action of the NYSE CSO A/D line very closely, I am still not overly concerned on the current lack of breadth on either the NYSE or the NASDAQ Composite just yet – given that small caps generally underperform in a deleveraging environment. However, should sentiment levels continue to rise, and should it be accompanied by a tremendous rally and relatively weak breadth in the stock market over the next couple of months, then we will most probably pare down our 100% long position in our DJIA Timing System. In the meantime, I expect crude oil prices to correct from current levels (which should help the Dow Industrials and the S&P 500), although the secular bull market in both energy and general commodity prices is still probably not over yet.
Again, we are still bullish on the U.S. stock market. Given that nearly 50% of all revenues within the S&P 500 components are derived from overseas markets, I continue to be comfortable with a long position our DJIA Timing System despite the fact that the U.S. economy is still in the midst of deleveraging. In the meantime, I will continue to be vigilant and inform our subscribers should we see a gathering storm that would impact the global equity markets, such as growing global discontent among the world's poor, renewed strength in the commodity markets, or the threat of a more vicious corporate or capital gains tax policy leading up to the U.S. Presidential election later this year.
Henry To, CFA