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A Difficult September

(September 13, 2009)

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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 2,566.59 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 2,257.59 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.

Coming into September, many large global macro hedge funds, such as Tudor and Clarium Capital, were either short or neutral on the US equities, with many of them expecting a correction to come this month.  In addition, many pension funds and endowments were still underweight global equities relative to their target allocations.  In our commentaries over the last two weeks, we expressed our concerns over the short-term outlook of the US stock market, and concluded that we were ripe for a correction.  Our reasons and outlook have not changed.  If anything, US and global equities have gotten even more overbought over the last two weeks.  The relentless appreciation of global equities over the last two weeks was most probably due to traders riding on the positive momentum and those hedge funds who were caught on the wrong side or pension funds/endowments making a conscious effort to increase their global equity allocations.

We believe some of last week's positive momentum could “spill over” into the early part of this week, especially given the surprising, ongoing strength in the Dow Jones Transportation Index (it is up 85% since the early March lows).  However, from an overbought/oversold, liquidity, and a sentiment perspective, we continue to believe that the US stock market is now vulnerable to a 5% to 10% correction over the next several weeks.  In our commentary two weekends ago, we cited the overbought condition of the NYSE ARMS Index as one reason.  Specifically, the 21-day moving average of the NYSE ARMS Index hits its most overbought reading since early October 2007 just two weeks ago.  Since then, other technical indicators have confirmed this overbought condition.  For example, the percentage of NYSE stocks above their 200-exponential moving average (EMA) rose above 80% just last week, as shown in the following chart courtesy of Decisionpoint.com:

Percent of NYSE Stocks Above Their 200/50/20-EMA (Long-Term)

The percentage of NYSE stocks above their 200-exponential moving average (EMA) rose above 80% for the first time since early October 2007, and prior to that late 2004.  While this “upward thrust” in breadth on the NYSE suggests that the intermediate uptrend remains intact, it also a good sign of a short-term overbought condition.

From a liquidity standpoint as well, we had mentioned about the deterioration in equity mutual fund cash levels to 4.2% at the end of July – its lowest level since the end of April last year.  We also expected the Federal Reserve to slow down its asset purchases starting two weeks ago, given its $106.7 billion purchase of Treasuries and agency securities for the two-week period ending August 26th.  As we mentioned in last weekend's commentary, our suspicions in the Fed's reluctance to expand its balance sheet was confirmed when the Federal Reserve announced that it only purchased $11.7 billion of Treasuries and agency securities for the week ending September 3rd.  For the week ending September 10th, the Federal Reserve purchased even less – only $10.7 billion of Treasuries and agency securities, as shown in the following chart:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After purchasing a whopping $106 billion in Treasuries and Agency securities for the two weeks ending August 26th (its most aggressive two-week purchase since the week ending April 22nd), the Fed has dramatically slow down its *credit easing* program. For the two weeks ending September 9th, the Fed has only purchased an aggregate $22 billion in Treasuries and Agency securities. Part of this may have been a reaction to the weakness in the U.S. Dollar Index last week. As a result, I expect the Fed to remain cautious, and thus for the stock market to correct over the next few weeks.

For the two-week period ending September 10th, the Federal Reserve only “monetized” (i.e. print money) approximately $22 billion of federal and mortgage debt.  With the US Dollar experiencing broad weakness late last week, I expect the Federal Reserve to remain cautious in creating “excess liquidity.”  As a result, I do not expect the Federal Reserve to ramp up its credit easing policy anytime soon – suggesting that the liquidity headwind will remain for the foreseeable future.  In the meantime, the Chinese government has committed to a relatively tight monetary policy for the rest of the year.  Combined with the psychological reluctance to invest during the historically bad month of September (this held true in spades last year), we reiterate our belief that the US stock market will correct over the next several weeks.

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 2007 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 2007 to September 11, 2009) -For the week ending September 11, the Dow Industrials rose 164.14 points, while the Dow Transports rose 211.66 points. Both the Dow Industrials and the Dow Transports made new rally highs this week - with the Dow Transports rising a whopping 5.6% on the heels of an analyst upgrade of the airlines and Friday's drop in crude oil prices.  This latest confirmation suggests that the intermediate-term trend of the market remains up, although we are still leaning towards a short-term correction over the next several weeks.  This *correction* scenario is further supported by the still-overbought condition in the market and the shakiness of the European banking system, especially in *marginal countries* such as Austria and Sweden. 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 (although we will shift to a more defensive position if the market gets more overbought from current levels).

For the week ending September 11, 2009, the Dow Industrials rose 164.14 points while the Dow Transports rose a whopping 211.66 points. Last week's action took the two popular Dow indices to a new rally high.  The latest concurrent highs in both the Dow Industrials and the Dow Transports suggest that the intermediate-term uptrend remains intact.  However, with the stock market still at very overbought levels on both a short and intermediate term basis (the Dow Industrials is up 47% while the Dow Transports is up 85% since the early March lows), and with the continued shakiness of the European banking system, we expect a 5% to 10% correction in the stock market over the next several weeks.  However, should the rally continue 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 7.4% to 5.4% for the week ending September 11, 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 September 11, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of 7.4% to 5.4%. While this latest decrease corrects for some of the overbought condition in bullish sentiment, it does not mean the stock market cannot correct from here. 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.

While this reading is not at an overbought level, its “spike” from early March to late August suggests that we should be mindful of 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, there is a good chance the market will first correct.  Moreover, while the “Bernanke Put” is still alive and well, I do not believe the Fed will expand its balance sheet in a meaningful way over the next several weeks given its record purchases during the last two weeks of August, as well as the broad weakness in the US Dollar late last week.  For now, we will remain 100% long in our DJIA Timing System, although we will likely shift to a more defensive position should the stock market rally further on relatively weak breadth and volume.

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) - For the latest week, the 20 DMA declined slightly from 119.4 to 119.3, while the 50 DMA remained near a seven-month low. While this sentiment indicator is now somewhat oversold, subscribers should keep in mind that (with the 20 DMA below the 50 DMA) this is now in a confirmed downtrend. Combined with the significant obstacles that the market needs to deal with - including the systemic risks emanating from the European banking system - we believe the correction in the stock market will continue for the next few weeks. For now, however, we will remain our 100% long position in our DJIA Timing System.

For the week ending September 11th, the 20 DMA declined marginally from 119.4 to 119.3, while the 50 DMA remained near a seven-month low.  While this sentiment indicator is now somewhat oversold, subscribers should keep in mind that – with the 20 DMA below the 50 DMA – this sentiment indicator is now in a confirmed downtrend.  Combined with the overbought conditions, the short-term liquidity headwinds and the troubles in the European banking system, we thus believe the stock market will correct over the next several weeks.  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 has already traced a short-term top and will correct over the next several weeks.  We believe this correction will be short and relatively shallow – presumably in the 5% to 10% range.  However, should the market experience broad weakness on increasing downside volume, we would not be surprised if the correction runs further.  Furthermore – and as we mentioned last week – we now believe that the correction in the stock market will be accompanied by a correction in commodity prices – as commodities face a stronger headwind in the form of a tighter Chinese monetary policy and the substantial increase in warehouse inventories over the last few months.

Despite our aversion to the stock market in the short-term, subscribers should keep in mind that 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 and the liquidity headwinds will be much stronger.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

 

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