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A Short-Term Bottom in the Stock Market?

(February 8, 2010)

Dear Subscribers and Readers,

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 2,263.61 points as of yesterday at the close.

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 1,954.61 points as of yesterday 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.

I hope all our subscribers had a thoroughly enjoyable weekend and came out of Monday's action in reasonable shape.  While the late sell-off yesterday afternoon was disappointing, subscribers should note that the decline was week in terms of downside breadth and downside volume.  In fact, the late afternoon sell-off was most likely just a retest of Friday's intraday low, given the lack of strong downside volume/breadth and given the extremely short-term oversold condition of the stock market.

While some of the more intermediate-term indicators are still at neutral to overbought levels (such as the VIX, the McClellan Summation Index, mutual fund cash levels, etc.), many short-term technical indicators have sold off immensely.  Combined with the “retest” as suggested by yesterday's stock market action, probability suggests that the market has hit a short-term bottom and should rally over the next 5 to 10 trading days.  One such indicator is the NYSE ARMS index.  While the 10-day MA of the NYSE ARMS Index is not yet at a fully oversold level (that is, 1.50 or higher), the 4-day MA (which is inherently more short-term in nature) of the NYSE ARMS Index has spiked up to a reading of 2.00 – its most oversold reading since early December of last year (following chart courtesy of Decisionpoint.com):

NYSE ARMS Index (TRIN) 1-Yr

Unfortunately – with the 10-day MA still not at a fully oversold level, and given the ongoing problems in the Greek and Dubai financial systems, in addition to troubles in the U.S. commercial real estate market – chances are that this correction isn't over yet.  However, the very short-term picture (5 to 10 trading days) is still positive, for now.

In our weekend commentary two weeks ago, we had this to say about our target for the equity put/call ratio: “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.”  As of Monday evening, the 10-day MA of the equity put/call ratio actually hit 0.69 – its highest (most oversold) level since July 2009 (following chart courtesy of Decisionpoint.com):

10 Day Moving Average of Put/Call Ratios

While a reading of 0.69 is still nowhere near as oversold as it was during the late 2008/early 2009 “capitulation” period in the stock market, it is definitely oversold enough to signal a short-term bottom, especially in light of the “retest” that we witnessed in the stock market action yesterday.  From a fundamental standpoint, however, I still do not see how the stock market could sustain a bottom unless or until Greece comes up with a satisfactory fiscal solution, which would most likely involve some kind of “hair cut” for Greek bond investors or some kind of lifeline from the major EU countries such as Germany and France.  At this point, the most likely “solution” would be for the EU to “let Greek investors go” by forcing them to take some kind of haircut, and then afterwards, provide a “ring fence” to more systematic-important countries such as Portugal, Ireland, and Spain.  This would help solve the EU's dilemma of the moral hazard problem (i.e. letting the very marginal countries go), while preventing the EU system from disintegrating and the contagion spreading into other EU countries.

Because of this, I don't believe the correction that started a few weeks ago has really ended yet, although the market will likely rally over the next 5 to 10 trading days.  Moreover, while the stock market is now very oversold in the short run, technical and sentiment indicators suggest that it is still trading at a neutral to overbought level in the intermediate term.  For now, we will just take it one day at a time, but I believe this correction could last another four to six weeks, while the ultimate bottom will depend on when the EU takes action (it could be DJIA 9,500 or DJIA 9,000!).  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:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2007 to February 8, 2010) - For the last six trading days, the Dow Industrials declined 158.94 points, while the Dow Transports declined 102.59 points. Both the Dow Industrials and the Dow Transports have now declined four weeks in a row - and given the lack of a substantial correction since the bull market began in March last year, chances are that this correction will be deeper and longer in duration. However, the market is now very oversold in the short-term, and therefore should experience some reprieve this week (the intermediate term indicators are still at neutral to overbought). However, given the tremendous amount of liquidity being created, decent momentum, and decent valuations - the cyclical bull trend that began in early March remains intact. The troubles in Spain, Greece, and Dubai will continue to cast a deflation cloud for the rest of the world, but the major effects should be limited to commodities and certain cyclical companies. For now, we will maintain our 100% long position in our DJIA Timing System.

For the six trading days ending February 8, 2010, the Dow Industrials declined 158.94 points, while the Dow Transports declined 102.59 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.  With the U.S. stock market now at a very oversold condition in the short-run, I expect it to stage some kind of relief rally over the next 5 to 10 trading days, although it is probably not sustainable in the longer run.  Moreover, 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 Greece, Dubai, Portugal, Ireland, and Spain.  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 decreased a whopping 4.5% - from a reading of 18.1% to 13.6% for the week ending February 5, 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:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending February 5, 2010, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of 18.1% to 13.6%. The latest weekly decline of 4.5% is the largest decline since early March 2009 - suggesting that the market is now very oversold in the short-run. While the correction is probably not over yet (especially since the 13.6% reading still represents an overbought reading), the market has likely bottomed in the short-run and should rally for the next 5 to 10 trading days. For now, however, we will maintain our 100% long position in our DJIA Timing System.

After hitting a 26-month high last week, the four-week MA of the combined Bulls-Bears% Differential ratio has pulled back significantly.  In particular, the last week's decline of 4.5% was the largest such decline since early March 2009 – suggesting that the market has probably made a short-term bottom.  However, it remains relatively overbought.  Combined with its relentless rise from early March, individual investors have gotten too bullish, too quickly.  The overbought condition of this sentiment indicator suggests that the current correction isn't over, and most probably won't be over until another four to six weeks from now.  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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - After touching a fresh 6-month high of 137.6 on December 1st, the 20 DMA has traded in a range of 126 to 135; however, it penetrated below that range two weeks ago, and has continued to decline - settling at 115.6 last night. It is no longer overbought relative to its readings over the last two years, although the 50 DMA still needs to *catch up.* Given the still high bullish sentiment in our other sentiment indicators, my sense is that market is still stuck in a correction/consolidation period. For now, however, we will remain 100% long in our DJIA Timing System.

For the six trading days ending February 8, 2010, the 20 DMA declined from 123.8 to 115.6, and is now at its most oversold level since September of last year.   It is no longer overbought relative to its readings over the last two years – thus confirming the bull's case at least for the short-run.  However, the vast majority of our other technical and sentiment indicators are still not in oversold territory on an intermediate term basis – suggesting that the current correction has more room to run (although we should experience some kind of “relief rally” over the next 5 to 10 trading days).   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: While the most recent technical/sentiment action is suggestive of a “relief rally” over the next 5 to 10 trading days, subscribers should remember that the fiscal/financial crisis in Greece remains unresolved.  While I don't believe a Greek default is probable (although I do think investors will have to take some kind of haircut) and most probably won't be systemic in nature (as many banks and hedge funds have already taken a significant amount of leverage off the table over the last 18 months), the market will definitely remain jittery unless or until something is done about the dismal fiscal situation in Greece.  Given the rigidity of its financial system and the lack of its central bank to devalue and print money, it will be difficult for Greece to resolve its current situation without an EU or IMF-led bailout.

The stock market remains in a corrective phase that should likely last another 4 to 6 weeks.  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.  While I did mention that strong support for the Dow Industrials is in the 9,500 to 9,800 range, subscribers should note that the stock market could easily decline below 9,500 should the EU remain passive to the Greek fiscal crisis.  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.

Signing off,

Henry To, CFA

 

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