Negative Divergences Abound
(April 4, 2010)
Dear Subscribers and Readers,
Before we begin our first commentary for the month of April, I want to update our DJIA Timing System's performance to March 31, 2010. Note that subscribers who want to independently calculate our historical performance could do so by tallying up all our signals going back to the inception (August 18, 2004) of our system (we have sent our subscribers real-time emails whenever there is a new signal). Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to March 31, 2010:
Our DJIA Timing System was created as a tool to communicate our position (and thoughts) on the stock market in a concise and effective way. We had chosen the Dow Industrials as the benchmark (even though all institutional investors today use the S&P 500 or the Russell 1000), since most of the American public and citizens around the world have historically recognized the DJIA as “the benchmark” for the American stock market. In addition, the Dow Industrials has a rich history going back to 1896, while the S&P 500 was created in 1957 (although it has been retroactively constructed back to 1926).
Looking at our performance since inception, it is clear that most of our outperformance was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and when we decided to shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we subsequently closed out on January 9, 2008). While we have stayed on the long side for the most part since mid-January 2008, we also made a couple of timely tactical moves during the May to June 2008 period – which gave our DJIA Timing System nearly 5% in outperformance during that timeframe. Looking at the last 12 months, our 25% additional long position that we bought on February 24, 2009 (and which we exited on June 8th) provided about 4% in outperformance, although that resulted in slightly higher volatility (since we were 125% long).
Subscribers should keep in mind that our goal is to beat the Dow Industrials by a significant margin over a market cycle with lower volatility. While we are not totally happy with our performance over the last two to three years, subscribers should note that we are still ahead of the Dow Industrials by nearly 8% on an annualized basis over the last three years, or since the beginning of the credit crisis. In addition, on a cumulative basis, we are ahead of the Dow Industrials by more than 17% since the inception of our DJIA Timing System on August 18, 2004, returning 24.76% vs. 7.67% for the Dow Industrials (on a price-only basis). Our goal is to beat the stock market with less risk over the long run, and so far, we have done that.
In last weekend's commentary, we stated that we expect a short-term correction in the U.S. stock market. Based on the highly overbought conditions, increasingly bullish sentiment, declining liquidity, and emerging negative divergences (which I will mention later in this commentary), we argued that we will shift from a 100% long position in our DJIA Timing System to a less risky 50% long position should the stock market rise early in the week. Last Monday morning, we decided to do just that – alerting our subscribers in a real-time email that we were shifting to a 50% long position at a DJIA print of 10,888. As of today, we remain 50% long in our DJIA Timing System. Make no mistake, however: We still believe that the U.S. stock market is in a cyclical bull market that shows no signs of a major peak. Our latest shift to a 50% long position was done solely to reduce risk. As soon as the U.S. stock market sells off to an oversold condition, we will shift to a 100% long position, once again.
Subscribers should remember that:
- It is the major movements that count. Active trading – for the most part – only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries (note that our two stock picks, Best Buy and Carnival Cruises have beaten the S&P 500 by a very wide margin since they were recommended);
- Capital preservation during times of excesses is the key to outperforming the stock market over the long run. That being said, selling all your equity holdings or shorting the stock market is not something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back in the next innovation cycle. I am not going to change my mind on this unless: 1) the Fed or the ECB makes a major policy mistake, 2) an inflationary spiral emerges, 3) the Obama administration makes a major policy mistake, such as protectionist policies or higher taxes (interestingly, letting Pfizer go with a “slap on the hand” is just one of a series of market-friendly policies that have been in place since the Lehman bankruptcy), 4) extreme overvaluations in the U.S. stock market, or 5) a major regional war becomes a possibility, especially in the Middle East. At this point, I do not see much threat to the stock market on any of these five counts (versus late 2007, when valuations were overly high and when the Fed was reluctant to cut rates), although Iran remains on our watch list.
Also note that our long-term volatility levels continue to be lower than the market's, given our tendency to sit in cash during sustained periods of time of market excesses, resulting in relatively good Sharpe Ratio readings across all time periods. For now, we believe that the stock market made a solid bottom in early March 2009, and thus we will likely shift to a 100% long in our DJIA Timing System again should the market corrects. We will again update the performance of our DJIA Timing System at June 30, 2010.
Let us begin our commentary with a review of our 10 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;
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 935.93 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;
10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.
Since mid-March, the technical condition of the U.S. stock market has stalled – as relatively weak upside breadth and upside volume started kicking in after a rip-roaring recovery from the mid-January to early-February correction. At the same time, the U.S. stock market (as we covered in our March 25, 2010 and April 1, 2010 commentaries) has moved to highly overbought levels, while liquidity has continued to decline. There also exist strong fundamental forces that could trigger a larger-than-expected correction in global equities, including the weakness in the European banking system (which could be systemic in nature), the ongoing troubles in the U.S. commercial real estate market, and the dysfunctional state of the residential housing market and in bank lending in general. As an example of the still-dysfunctional state of bank lending, following is a monthly chart showing the year-over-year change in loans and leases by held by U.S. commercial banks for the period January 1948 to March 2010:
Note that the plunge in U.S. commercial bank lending is unprecedented. To see similar stats, one would need to go back to the Great Depression – a period when more than one-third of all banks failed in the U.S. Note that the dramatic decline in bank lending came after the disintegration of the “shadow banking system” – if the Federal Reserve and the U.S. Treasury had not provided support under its various liquidity facilities and its latest credit easing policy (which expired on March 31st), there is no doubt that the U.S. and much of the developed world would have been in a second Great Depression as bank lending surely would have declined much faster as it followed the destruction of the “shadow banking system.” The intervention of the Federal Reserve and the U.S. Treasury not only provided “cushion” to the shadow banking system, but also the global sovereign bond market, the U.S. mortgage market, and the U.S. corporate bond market. This strategy has allowed corporations and REITs to continue to tap into the financial markets for capital. As U.S. commercial banks rebuild their balance sheets (earnings of U.S. banks are projected to be positive for the rest of this year), I expect bank lending to stage a revitalization. In the meantime, the lack of bank lending will continue to be a headwind for both economic growth and the U.S. stock market.
As I mentioned in last weekend's commentary, many of these fundamental forces have been in place for a while, but it is only in recent times when investors have started to ignore these bearish forces – continuing to bid up equity prices. In the short-run, the stock market is now highly vulnerable to a correction, especially given the negative divergences that are now clearly emerging (negative divergences in the face of a highly overbought market, declining liquidity, and high bullish sentiment is always a recipe for disaster). For example, as shown in the following chart (courtesy of Decisionpoint.com), the percentage of stocks on the NYSE that are above their 20-day, 50-day, and 200-day exponential moving averages peaked in mid-March. In a couple of cases (i.e. the 50-day and the 200-day EMAs), it could be argued that the peak occurred as early as mid-September of last year:
Similarly (and more flagrantly), the number of 52-week highs vs. the number of 52-week lows on the NYSE (Common Stocks Only) made a clear peak in mid-March. As shown in the following chart (again, courtesy of Decisionpoint.com), the 10-day moving average of the differential between the number of 52-week highs and 52-week lows on the NYSE peaked at over 200 in mid-March, and has since declined to just 173.30 (in fact, it declined again last Thursday despite an up market):
Despite the superficial strength in the major indices last week, I expect a significant correction in the U.S. stock market. While we simply cannot know when and where any upcoming correction will halt – I believe for the most part that any correction should last from 2 to 6 weeks, or until our intermediate term technical/sentiment indicators become oversold. As for the price target, I also do not have a solid one (and anyone who tells you otherwise is lying through their teeth) – although subscribers should note that there is strong support in the DJIA 10,000 to 10,300 range.
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 April 1, 2010, the Dow Industrials rose 85.86 points, while the Dow Transports rose 57.93 points. Note that while the Dow Industrials again made a new cyclical bull market high, the Dow Transports is still lagging, as it remained 30 points below its March 18th high (the mid-March peak we have been discussing). The latest non-confirmation of the Dow Industrials by the Dow Transports on the upside (per the Dow Theory) – in light of highly overbought conditions – suggests that the U.S. stock market remains highly vulnerable to at least a short-term correction. While the Greek fiscal crisis has now died down, I still expect the global equity markets to consolidate further, given the highly overbought conditions as well as lingering concerns about Greece's (and other peripheral countries in the Euro Zone) austerity plans, the troubles in the European Banking System, as well as the ongoing troubles in the U.S. commercial real estate market. My guess is that any upcoming consolidation will last from 2 to 6 weeks. 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. We will remain our 50% long position in the DJIA Timing System for now.
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 rose from a reading of 13.8% to 14.3% for the week ending April 1, 2010. Over the last six weeks, this reading has made a stunning advance – rising 9.4 percentage points from just 4.9%. 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:
After rising from 4.9% to 1438% over the last six weeks, this reading is now again at an overbought level. Because of this rise in bullish sentiment, I expect the market to stage an imminent correction given the flagrant negative divergences. However, given the decent valuations in the stock market and strong momentum from the March 2009 bottom, 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 50% long in our DJIA Timing System, although we will likely shift to a 100% long position again should the market reach oversold levels again.
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 April 1, 2010, the 20 DMA rose from 126.1 to 129.4. Over the last five weeks, the 20 DMA has literally skyrocketed – rising from just 107.4 (its most oversold level since November 2008) to 129.4. Given the bounce over the last four weeks, the 20 DMA is no longer at an oversold level. While the latest reversals in both the 20 DMA and the 50 DMA are a bullish sign in the longer-run, I still expect the market to correct over the next few weeks, given the overbought nature of the U.S. stock market and the negative divergences that are now clearly emerging. Again, we will remain 50% long in our DJIA Timing System, for now.
Conclusion: Since the inception of MarketThoughts.com in August 2004, we have clearly communicated our thoughts on the U.S. stock market through the signals in our DJIA Timing System. While not all our moves were perfect (in fact, we made some costly decisions during the summer of 2008), I would like to think that we have made some brave and gutsy moves that were highly contrarian at the time but which in retrospect, turned out very well (such as our decision to remain 100% long during the October 2008 to March 2009 period, and our decision to shift to a 125% long position on February 24, 2009). Since the beginning of the cyclical bull market that began in early March 2009, we have remained 100% long. We have continued to stay long despite signs showing that the market were overbought as early as September, but we decided to remain 100% long as upside breadth, upside volume, momentum, and liquidity remained strong at the time (not to mention that investors were also still bearish). However, this has recently changed, as the technical condition of the market has deteriorated despite the superficial strength in the major indices. The negative divergences that were clearly emerging over the last two weeks were the final straw, and as such, we have decided to shift to a 50% long position in our DJIA Timing System in order to control for risk.
I continue to expect a short-term correction. Assuming the correction come, subscribers should note that there is strong support for the Dow Industrials in the 10,000 to 10,300 range. However, we maintain that the U.S. stock market is still in the midst of a cyclical bull market. We remain 50% long in our DJIA Timing System, but will likely shift back to a 100% long position to should the market becomes oversold again. Subscribers please stay tuned.
Henry To, CFA