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Looking for a Short-Term Correction

(August 30, 2009)

Dear Subscribers and Readers,

Let us begin our commentary by reviewing our 9 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 2,627.80 points as of Friday at the close.

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 2,318.80 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.

Japan is making political history tonight.  For the first time in more than a half-century, the Liberal Democratic Party will no longer be governing the country.  Fueled by a population desperate for reforms and still reeling from the fallout of the 1980s bubble and the 2008 financial crisis, the Democratic Party of Japan beat the incumbents decisively – taking the Lower House's 308 seats out of a total of 480 seats.  Perhaps in anticipation of broad reforms and other policies that could result in higher GDP growth, investors bid up the Nikkei by more than 200 points during the first half-hour of trading after the announcement of the election's results.  But voters' sentiment and their biases towards the DPJ were known weeks in advance – and thus the election results were not a major surprise.  As I am writing this commentary, the short-term bullish sentiment in Japanese stocks has (rightly) collapsed.  From its peak during the first half-hour of trading, the Nikkei has reversed to the downside by nearly 260 points and is now trading down more than 40 points.

Since mid July, the Nikkei has appreciated by about 15% - and no doubt, was overbought and was thus vulnerable to a short-term correction.  As mentioned over the last several weeks, the major US equity indices have also been trading in overbought territory since early August.  While the intermediate-term (over the next 6 to 9 months) uptrend of the US stock market most probably remains intact, I believe the short-term trend is now reversing to the downside.

But Henry, the stock market was already overbought during the beginning of August.  What makes you think now is the time for the market to correct?

Since the beginning of August, the stock market has gotten more overbought.  For the month of August, the S&P 500 (total return index) rose 4.45%.  Within the S&P 500, the Financials sector rose a whopping 13.30%, Industrials 5.36%, and Consumer Discretionary 5.05% (the worst-performing sector, the telecommunications sector, declined 1.83%).  In addition, the NYSE ARMS Index – an overbought/oversold indicator that has aided me immensely in calling overbought peaks and oversold troughs (although it has historically been more useful in calling short-term troughs) is also suggestive of a hugely overbought condition.  Specifically, the 21-day moving average of the ARMS Index (see following daily chart, courtesy of Decisionpoint.com) is now at its most overbought reading since early October 2007:

NYSE ARMS Index (TRIN)

As subscribers may remember, the 21-day MA of the NYSE ARMS Index hit this overbought level in early October 2007 at the same time the Dow Industrials made its all-time high – hardly a coincidence!  Of course – in a bull market (this author believes that we have been in a cyclical bull market since early March) – an overbought condition typically gets more overbought.  And even in hugely overbought conditions such as what we have now, the market typically only experiences a shallow and quick correction.  This is the reason why we remain 100% long in our DJIA Timing System, although as I have emphasized many times – we will not hesitate to shift to a more defensive position (i.e. 50% long or completely neutral) should the market gets more overbought on weak upside breadth and/or weak volume.

The extremely bought condition in the US stock market is also confirmed by the latest equity mutual fund cash levels reading from ICI.  Specifically – and as shown in the following chart – mutual fund cash levels have declined to 4.2% at the end of July, after hitting a eight-year high as recent as February:

Monthly Equity Mutual Fund Cash Levels (January 1996 to July 2009) - Aftering spiking to an 8-year high of 5.9% at the end of February, cash levels as a percentage of total assets at equity mutual funds has declined back to 4.2% - its lowest level since the end of April of last year.

Note that the S&P 500 rose an additional 4.45% since the end of July – suggesting that mutual fund cash levels may have declined even further over the last month.  The lack of a higher cash cushion suggests that equity mutual fund managers may have to liquidate some of their holdings should investors sell their mutual fund holdings.  This lack of a cash cushion will make the stock market more vulnerable to a correction going forward.

Finally – after buying a whopping $76.1 billion in Treasury and Agency securities under its “Credit Easing” policy two weeks ago – the Federal Reserve slowed down its purchases last week.  For the week ending last Wednesday, the Federal Reserve “only” purchased $30.1 billion in securities, as shown in the following chart:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After slowing down its purchase of Treasuries and agency securities earlier in August, the Fed purchased a whopping $76.1 billion in Treasuries and Agency securities two weeks ago (its most aggressive purchase since the week ending April 22nd), while maintaining a *respectable* purchase of $30.1 billion last week. Note that this two-week purchase is the largest such purchase since mid April. As a result, I expect the Fed to somewhat slow down its *Credit Easing* policy, and thus for the stock market to correct over the next few weeks.

Nonetheless, the Fed's security purchases over the last two weeks under its “Credit Easing” policy represent the largest two-week purchase since mid April – the size of which suggests that the Federal Reserve may slow down its purchases over the next several weeks.  More importantly, I expect no “positive” surprise (such as a further expansion of its balance sheet) from the Federal Reserve until the next Federal Reserve meeting on September 23rd.  This will certainly clear the way for a correction in the stock market from now till September 23rd.

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 July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 2006 to August 28, 2009) - For the week ending August 28th, the Dow Industrials rose 38.24 points, while the Dow Transports declined 44.34 points. The diveregence between the Dow Industrials and the Dow Transports is the first weekly *non-confirmation* since the week ending June 26th. From the March 9th bottom till now, the Dow Industrials and Dow Transports are up 46% and 73%, respectively. This weekly non-confirmation - combined with the overbought conditions in the Dow indices - suggests that the market is now technically weakening. Coupled with the shakiness of the European banking system, we are now anticipating a short-term correction in the stock market over the next weeks For now, however, we will maintain our 100% long position in our DJIA Timing System, as all indicators suggest that the the intermediate uptrend remains intact (we will not move to a more defensive position unless the market gets more overbought from current levels).

For the week ending August 28, 2009, the Dow Industrials rose 38.24 points while the Dow Transports declined 44.34 points.  The divergence between the two popular Dow indices is the first weekly “non-confirmation” (i.e. a weekly up or down move in either the Dow Industrials or the Dow Transports not confirmed by the other) since the week ending June 26th.  With the stock market at a very overbought on both a short and intermediate term basis, and with the Dow non-confirmation and the continued shakiness of the European banking system, I am now looking for a correction in the stock market over the next several weeks.  That being said, the strong upside breadth and volume since the early March bottom suggests that any upcoming correction will be quick and relatively shallow.  However, should the market continue its rally on relatively weak breadth, we will then shift to a more defensive position in our DJIA Timing System (such as a 50% long or even completely neutral position).  For now, we will maintain our 100% long position 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 decreased from a reading of 8.8% to 8.4% for the week ending August 28, 2009.   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 August 28, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of 8.8% to 8.4% -its first down week since mid July. That said, the *spike* in bullish sentiment over the last six weeks suggests that we should now be mindful of a short-term peak. While the strong upside breadth in the stock market since early March suggests the intermediate uptrend remains intact, there are many signs suggesting that the market is now tilting towards the downside in the short-run. For now, however, we will maintain our 100% long position in our DJIA Timing System but would shift to a more defensive position should the market or this sentiment indicator get much more overbought lin the short-run.

The 4-week MA of the combined Bulls-Bears% Differential ratios declined for the first time since mid July.  While this reading is still not at an overbought level, its “spike” over the last six weeks suggests that we should now be mindful for at least a short-team peak in both bullish sentiment and the stock market.  That is, while there is still enough “fuel” for a longer-term rally, I believe the market will correct before doing so.  Moreover, while the “Bernanke Put” is still alive and well, I do not believe the Fed will expand its balance sheet in any meaningful way over the next several weeks given its whopping purchases over the last two weeks.  For now, we will remain 100% long in our DJIA Timing System, although we will not hesitate shifting to a more defensive position should the stock market fail to correct (and actually rally further) over the next several weeks.

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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - The ISE Sentiment Index is the only sentiment indicator giving us contradicting signals. For the latest week, the 20 DMA declined from 127.8 to 123.8, while the 50 DMA actually made 6-month lows last week! From a contarian standpoint, this is bullish for the US stock market - and thus does not confirm the increasingly bullish readings in our other sentment or overbought/oversold indicators. However, there are still some significant obstacles that the market needs to deal with - including the systemic risks emanating from the European banking system. For now, we will remain our 100% long position in our DJIA Timing System, however.

For the latest week, the 20 DMA declined from 127.8 to 123.8, while the 50 DMA remained stagnant (but actually made new 6-month lows during the past weeks)!  From a contrarian standpoint, the ISE Sentiment readings is actually bullish (both in the short and the long run) – and thus is the only indicator that is not confirming out other technical and sentiment indicators.  Nonetheless, there are still strong obstacles against the stock market in the short-run.  This is another reason why we're staying 100% long in our DJIA Timing System, as not all of our signals are suggesting an imminent top (although the probabilities do suggest a short-term top).  But should this sentiment indicator or should the market become overbought; we would not hesitate to shift to a more defensive position.  For now, we will remain our 100% long position in our DJIA Timing System.

Conclusion: While we believe the intermediate (6 to 9 months) uptrend remains intact, there are many fundamental, technical, liquidity, and sentiment indicators suggesting that the US stock market is now tracing a short-term top.  It should come as no surprise that we're getting short-term bearish just as the worst month of the year (i.e. September) is hitting the market.  While “sell in May and go away” certainly did not work this year (and we certainly did not advocate such a stance), “sell in September” may be an attractive stance to take for short-term traders.  But short-term tops and corrections are notoriously difficult to time (and most importantly, are typically quick and shallow) during a cyclical bull market (this author believes that a new cyclical bull market began in early March of this year) – and thus we will continue to remain 100% long in our DJIA Timing System.  By the time we come close to a major peak in this cyclical bull market, my sense is that retail investors will be much more bullish again (which will show up in our sentiment as well as our technical indicators such as the NYSE Common Stock Only McClellan Summation Index). 

Again, we continue to remain interested in natural gas.  Interestingly, UNG (the natural gas ETF) reached a whopping 19% premium to its NAV last Friday at the close, suggesting that retail investors are still too bullish on the commodity (although many in the UNG Yahoo message board are starting to catch on).  In addition, the winter gas contracts could still decline (resulting in a more shallow contango) should the rest of the 2009 hurricane season in the Gulf of Mexico remain subdued or should milder winter weather predictions are published over the next several weeks.  While this author has turned longer-term bullish on natural gas, we will not go long the commodity until there are more signs of retail investor capitulation.  For now, we will continue to keep track of the commodity and inform you once we change our mind.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

 

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