Global Equity Markets in Corrective Phase
(January 24, 2010)
Note: Tyco acquired one of Rick Konrad's individual stock recommendations, Brinks Home Security (CFL), in a $2 billion cash-and-stock deal last Monday (at a 35% premium over the market price). Please read Rick's September 18, 2009 analysis for his original thesis on the company. Great job, Rick, and please keep them coming!
Dear Subscribers and Readers,
My (relatively) new laptop experienced a hard drive failure yesterday. I'm waiting for HP to call back about a possible refund in lieu of a new hard drive. In my mind, having a hard drive failure less than three months of usage (and I'm not a road warrior by any means) is unacceptable (my experience with my previous Dell laptop wasn't so great either in that case, the $200 battery died just after a year once the warranty expired). Given the integrity and amount of work I do on my laptop, I'm going to pay a few extra hundred dollars for better quality the next time I get a new one. I also highly recommend staying away from all Dell and HP laptops unless one can verify every individual part that goes into the manufacture of each laptop. We have enough problems dealing with the stock market without having to worry about not being able to turn on our computers in the morning.
It's also annoying when to my dismay, the local Best Buy representative could not even articulate the performance of an Intel Core i3-330M process (other than telling me that it is 2.13 GHz which is meaningless). Obviously, I have no scientific way of proving this (and neither does anyone else), but the Gen-Yers will surely have a hard time getting ahead and competing in today's globalized economy given the work ethic (or lack thereof) and attitudes I've witnessed. Sure, the hardest working of those are definitely superstars (many of them have full schedules since starting high school) and the hardest-working MBA students I know also understand much more than their parents (or even the Gen-Xers) who went to business school. Some high school students proficient in science are already interning at university research labs, and with so much information now at our fingertips, the Gen-Yers and kids of today are more empowered than ever. Unfortunately, not all Gen-Yers are being empowered. In fact, many of these tools have adverse effects that could not only lower worker productivity but also destroy lives and families. If that kid at Best Buy chooses to spend his time watching Youtube rather than studying up on performance numbers of the latest Intel mobile processors, then that's fine just don't expect to be able to compete in the global capitalistic world where wages of unskilled tend to converge to zero.
My rant aside (and subscribers know that I don't usually rant), I would just like our subscribers to know that this commentary will be relatively brief. I am working off another computer and will not be back to my full productivity level until the end of this week at the earliest. I apologize for this inconvenience.
Before we begin our commentary, let us first review 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 1,999.02 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 1,690.02 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.
After having consolidating in the 10,250 to 10,700 range since mid November, the Dow Industrials had a false breakout last Tuesday only to quickly fall back the next day. However, it did not stop there. Over the last few weeks, we had stated that the stock market was vulnerable to a short-term correction. With the stock market still in an overbought condition, and with sentiment indicators also getting too bullish too quickly, last week's correction wasn't a complete surprise. What was surprising was the ferociousness of the decline, as the Dow Industrials not only pulled back to its two-month trading range last Wednesday, but also broke below it by Friday afternoon.
While part of the decline could be attributed to the Obama administration's assault on the financial industry, there was no doubt that the market was due for (and very vulnerable to) a short-term correction. Unfortunately for the bulls given the lack of an oversold condition in the stock market and our popular sentiment indicators probability suggests that the correction isn't over yet (especially given the lack of a serious correction since early March of last year). For example, the NYSE ARMS Index an indicator that has aided me immensely in calling for oversold bottoms since we began writing our commentaries, only hit a daily high of 1.8 last week, despite the stock market's most severe decline since March of last year. Following is a daily chart showing the 10-day and 21-day MA of the ARMS Index vs. the daily closes of the Dow Industrials from January 2003 to the present:
As of Friday at the close, the 10-day and the 21-day moving averages of the NYSE ARMS Index closed at 1.37 and 1.23, respectively. At the bottom of the last correction in early December, the 10-day and 21-day closed at 1.62 and 1.28, respectively. Make no mistake: According to the NYSE ARMS Index, the U.S. stock market is still not in oversold territory. More importantly, other technical and sentiment indicators, including the NYSE Common Stock Only McClellan Summation Index, the VIX, and the equity put/call ratio, also confirm this lack of an oversold condition. At the very least, I want to see another 4% to 6% decline in both the Dow Industrials and the S&P 500 over the next six to eight weeks, as well as a VIX reading approaching the 30 level, before potentially declaring this correction to be over.
Following is a chart (courtesy of Decisionpoint.com) showing the 10-day moving average of the equity put/call ratio (blue line), versus the S&P 100 index:
At 0.60, last Friday's reading of the 10-day MA of the equity put/call ratio is still relatively overbought. My initial target for a sustainable bottom is 0.65 but even that may not be high enough given the overbought condition in the stock market prior to the current correction. For now, we will just take it one day at a time, but I believe this correction could potentially last six to eight weeks, and with a bottom in the 9,500 to 9,800 range for the Dow Industrials. For now, however, we will remain 100% long in our DJIA Timing System, as we believe that the cyclical bull trend that began in early March 2009 is still intact.
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:
For the week ending January 22, 2010, the Dow Industrials declined a whopping 436.67 points, while the Dow Transports declined 175.71 points. While we did not expect such a deep correction so quickly, we had maintained that the U.S. stock market was vulnerable to a short-term correction given the overbought conditions coming into this correction. While the U.S. stock market is no longer overbought, it is also not sufficiently oversold for a sustainable bottom just yet (both in terms of the percentage of the decline and duration). I expect the stock market to bounce a little bit early this week, but it will not likely be sustainable. Given the lack of a serious correction since early March of last year, I expect this current correction to be deeper and longer than all the corrections since that time, especially given the heightening policy risk and the ongoing concerns over the economies of Spain, Greece, and Dubai. However, given the strong momentum from the early March 2009 lows and combined with decent valuations, strong liquidity, and strong upside breadth there is no question that the cyclical bull market is intact. In the meantime, we 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 increased from a reading of 19.4% to 20.0% for the week ending January 22, 2010. 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:
The four-week MA of the combined Bulls-Bears% Differential ratio just hit another 26-month high and remains very overbought (not just relative to its readings over the last two years, but over the last decade as well). In addition, its relentless rise from early March suggests that individual investors have gotten too bullish, too quickly. The overbought condition of this sentiment indicators suggests that the current correction isn't over yet, and most probably won't be over until late March to early April. However, given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a decent rally starting in late spring and summer of 2010, and probability suggests that we will end 2010 with a new cyclical bull market high. For now, we will remain 100% long in our DJIA Timing System, as we believe the cyclical bull trend that began in early March 2009 remains intact.
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:
For the week ending January 22, 2010, the 20 DMA plunged from 135.0 to 126.7, after hitting a fresh 6-month high of 137.6 on December 1st. While the latest decline suggests this reading is becoming more oversold, subscribers should keep mind that it is still overbought relative to its readings over the last two years. More importantly, the vast majority of our other technical and sentiment indicators are still not in oversold territory suggesting that the current correction has more room to run. In addition, the macroeconomic backdrop - specifically the heightened policy risk, the ongoing troubles of Spain, Greece, and Dubai the European banking system, as well as the US commercial real estate market - is suggestive of a further correction in the stock market.
Conclusion: The stock market is now in a corrective phase. Given the overbought conditions coming into the correction and the lack of a serious correction since early March of last year, probability suggests that the correction will be deeper and last longer than all prior corrections since March of last year. Moreover, the lack of an oversold condition in both our technical and sentiment indicators coming off the severe decline in the stock market last week is also suggestive of a further correction. I expect this correction to last six to eight weeks, with strong support for the Dow Industrials in the 9,500 to 9,800 range. However, we maintain that the U.S. stock market is still in the midst of a cyclical bull market and thus we remain 100% long in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA