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A Bearish Shooting Star

(April 18, 2010)

Note: The origin of the term “watered stock” is generally attributed to Daniel Drew.  As legend has it, Daniel Drew (a cattle driver at the time) would feed his cattle with salt prior to each weighing.  The cattle would subsequently drink gallons of water – and its weight would be artificially inflated – hence bringing higher prices for “Uncle Dan'l.”  Selling “watered stock” has always been a morally reprehensible and illegal practice since the days of Daniel Drew – and Goldman's latest practice (if the SEC claims are true) of marketing its “Abacus” vehicle for some of its selected CDOs is no different.  Moreover, many analysts have commented that this cannot be an isolated incident.  In a previous commentary, I mentioned that an investment bank (which I did not name) had bilked its clients by not paying the full amounts due when their clients wanted to “cash in” on their credit default swap contract agreements during 2008 and early 2009.  Many of these clients were bond funds who had bought CDS contracts for hedging purposes.  Since the CDS market is an OTC market, many of its clients cannot sue for damages, as this investment bank had too much financial and legal power.  But make no mistake: This practice is illegal.  No prizes for guessing the name of this particular investment bank.

Dear Subscribers and Readers,

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 844.34 points as of Friday at the close (note that this is our only active position right now);

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.

In a cyclical or secular bull market, the bulls are typically given the benefit of the doubt.  Bearish technical patterns, such as heads & shoulders tops, shooting stars, “bearish engulfing” candlestick patterns, etc., should mostly be ignored, unless these patterns are confirmed by other indicators, such as declining liquidity, negative divergences in breadth and volume, overly bullish sentiment, and so forth.  As we chronicled over the last few weeks, many of our liquidity, technical, and sentiment indicators have turned bearish.  Coupled with an extremely overbought condition in the global equity markets (at least until last Thursday), and the still lingering crisis in the Greek financial system (which could act as a source of systemic risk as many European banks hold a substantial amount of Greek government bonds), chances were that a significant correction in global risky assets would occur sooner rather than later.

Last Friday's trading most probably signaled the beginning of such correction.  While many analysts blamed the Goldman news as the culprit for Friday's negative action, subscribers should note that downside breadth and volume were actually more intensive on the NASDAQ than the NYSE.  In other words, the market was ready to correct (notice the significant declines in GOOG and ISRG despite decent earnings reports) – the Goldman news was merely the excuse.

The decline in U.S. liquidity (such as the amount of total checkable deposits and money market funds outstanding vs. the S&P 500 market cap, loans and leases under bank credit, mutual fund cash levels, etc.) has also been well chronicled over the last few weeks.  What we haven't updated is the various liquidity indicators from other major countries/geographical areas.  For example, we know that both China and India are now actively tightening their monetary policies (subscribers should avoid commodities), but what of the Euro Zone and Japan?  Sure, both the European Central bank and the Bank of Japan have effectively adopted zero-interest policies for a long time now, but what of primary liquidity growth?

Let's first look at M3 growth in the Euro Zone.  According to the European Central bank, the annual M3 growth rate (as of the end of February) declined to -0.4% - the lowest growth rate since the inception of the Euro just over ten years ago, as shown in the following chart:

M1 vs M3 in the Euro Zone

Similarly (and not surprisingly, given the timid nature of the Bank of Japan over the last five years), the Bank of Japan further stepped on the brakes, as indicated by the following monthly chart showing the year-over-year growth in the Japanese monetary base, the change in the year-over-year rate of growth (the second derivative), and the year-over-year change in the Nikkei 225 Index from January 1991 to March 2010:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to March 2010) - The y-o-y growth in the monetary base declined from 8.2% at the end of April 2009 to just 2.1% by the end of March 2010. In addition, the change in the rate of growth has turned decidedly negative - something it hasn't done since April 2007! This suggests that liquidity in Japan has again turned bearish. Given the divergence in the Nikkei and the growth in the monetary base, I recommend subscribers to tread very carefully over the next few months.

As shown in the above chart, the year-over-year growth in the Japanese monetary base reached a five-year high of 8.2% in April of last year.  Since then, the year-over-year growth in the Japanese monetary base has consistently shrank, and is now standing at only 2.1% as of the end of March 2010 – its lowest level of growth since December 2008!  Moreover, subscribers should note that the divergence between the growth in the monetary base and the change in the Nikki Index is very wide – suggesting that the Nikkei rally has likely run out of steam.  Combined with the tightening policies by China and India – as well as the lack of further monetary stimuli from the European Central Bank, the Federal Reserve, and the Bank of England, the global liquidity situation thus remains depressed.  I thus expect global equities to correct from current levels.

The declining global liquidity situation is just one of the many underpinnings for a further correction in global equities over the next few weeks.  Others include the emerging negative divergences (declining breadth/volume indicators), hugely overbought conditions, and overly bullish sentiment (e.g. the daily equity put/call ratio hit a reading of 0.32 sometime last week, its most overbought level since August 2000!).  In addition, subscribers who follow “Candlestick” technical analysis should've noticed the “Shooting Star” reversal/bearish patterns on the weekly charts (evident on both the Dow Industrials and the S&P 500) as of the close last Friday.  According to Stockcharts.com: “The shooting star is made up of one candlestick (white or black) with a small body, long upper shadow and small or nonexistent lower shadow. The size of the upper shadow should be a least twice the length of the body and the high/low range should be relatively large.”  The Shooting Star pattern is especially authoritative after a long and significant rally, and if it is confirmed by other technical, liquidity, and sentiment indicators.  Following is a weekly chart (courtesy of Decisionpoint.com) showing the Shooting Star reversal pattern, along with two other similar patterns in the last six months.

Dow Jones Industrial Average ($INDU) - Over the last six months, there have been three bearish *Shooting Star* reversal candlestick patterns on the DJIA weekly charts. The market endured a quick one-week correction immediately after the first occurrence, and a three-week 9% correction after the second. The most recent occurred last week – and is especially authoritative given its long *upper shadow* and the bearish signals coming from our liquidity, technical, and sentiment indicators.

As mentioned in the above chart, there have been three such patterns over the last six months, including one that occurred last week.  In the first instance (during October of last year), the market immediately endured a quick one-week correction, while experiencing a three-week, 9% correction after the second Shooting Star pattern.  From a purely candlestick analysis standpoint, the most recent occurrence is especially authoritative given its long “upper shadow.”  From a fundamental standpoint, I also expect the market to endure a bigger correction than the last two occurrences, given the tougher liquidity, sentiment, and technical conditions that the market is currently experiencing.  The combination of a Shooting Star candlestick reversal pattern, emerging negative divergences, declining liquidity, and rising investor bullishness all point to a significant correction in the U.S. stock market over the next few weeks.  I do not have a price target, although subscribers should note that there is strong support in the DJIA 10,000 to 10,300 range.  Since we believe the U.S. cyclical bull market is still intact, however, we will likely go 100% long in our DJIA Timing System again once our intermediate-term indicators become oversold.

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 April 16, 2010) - For the week ending April 16, 2010, the Dow Industrials rose 21.31 points, while the Dow Transports rose 138.10 points. Both Dow indices managed to make new cyclical bull market highs last week - suggesting that the bull market is nowhere near close to peaking. However, in light of the reversal last Friday, the still highly overbought conditions and the emerging negative divergences - subscribers should note that the U.S. stock market is most probably in the midst of a correction. Moreover, there are still lingering troubles in the European banking system, the policy risks in the U.S. financial system, and the ongoing troubles in the U.S. commercial real estate market. However, given the decent momentum and valuations in the U.S. stock market - the cyclical bull trend that began in early March 2009 remains intact. For now, we will maintain our 50% long position in our DJIA Timing System.

For the week ending April 16, 2010, the Dow Industrials rose 21.31 points, while the Dow Transports rose 138.10 points.  Note that the Dow Industrials has now risen 11.2% while the Dow Transports has risen 22.5% since the February 8th bottom.  While both Dow indices managed to make cyclical bull market highs last week, subscribers should note that the technical, sentiment, and liquidity indicators are now flashing bearish signals.  In addition, the Greek fiscal crisis has flared up again, and won't be resolved until early May in the best-case scenario.  I expect any correction from here to last at least a few weeks, if not a few months.  However, given the strong momentum from the early March 2009 lows – and combined with decent valuations and strong upside breadth – there is no question that the cyclical bull market is intact.  We will remain 50% long 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 rose from a reading of 16.5% to 18.4% for the week ending April 16, 2010.  Over the last seven weeks, this reading has made a stunning advance of 14.0%.  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 April 16, 2010, the four-week MA of the combined Bulls-Bears% Differential ratios increased from a reading of 16.5% to 18.4% - its most overbought reading since the week ending January 22, 2010. The latest rise in bullish sentiment suggests that the market is still very vulnerable to a correction, especially given the overbought nature of the market and the elevated policy risk in the U.S. financial system. For now, we will maintain our 50% long position in our DJIA Timing System, and will most likely shift back to a 100% long position once our sentiment and technical indicators shift back to an oversold level..

After rising by 14.0% over the last seven weeks, this reading is again at an overbought level.  With this rise in bullish sentiment, I expect the market to stage an imminent correction, given the flagrant negative divergences and declining liquidity in the financial markets.  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 later this year, and perhaps into the end of 2010.  I still expect to end 2010 with a new cyclical bull market high, but the policy risk remains overly 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:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - After declining to its lowest level since late November 2008 just seven weeks ago, the 20 DMA has turned up dramatically, and has now reached an overbought level - at least compared to its readings over the last two years. With bullish sentiment now overbought - and combined with an overbought market, heightened policy risk in the U.S. financial sector, and negative divergences - the market remains very vulnerable to a short-term correction. For now, we will remain 50% long in our DJIA Timing System, and will most likely shift back to a 100% long position once our technical and sentiment indicators become oversold again.

For the week ending April 16, 2010, the 20 DMA rose from 130.5 to 132.2.  Over the last seven weeks, the 20 DMA has literally skyrocketed – rising from just 107.4 (its most oversold level since November 2008) to 132.2.  With this bounce, the 20 DMA is now at an overbought level, at least relative to its readings over the last two years.  Given the overbought condition in the ISE sentiment indicator (and as confirmed by our other sentiment indicators, including the equity put/call ratio), and given the Shooting Star candlestick reversal pattern on the weekly charts of the DJIA and the S&P 500, I expect the market to correct immediately from current levels.  I expect the correction to last at least a few weeks, if not a few months.  Again, we will remain 50% long in our DJIA Timing System, for now.

Conclusion: Since the beginning of the cyclical bull market that began in early March 2009, we have remained stayed at least 100% long (with a shift to a 125% long position during the early parts of the bull market).  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.  In addition, the “Shooting Star” candlestick reversal pattern finally emerged on the weekly charts last week.  The “Shooting Star” pattern – especially in light of the long rally since March 2009, declining liquidity, and overly bullish sentiment – is one of the more authoritative reversal patterns in technical analysis.  I thus expect the market to correct immediately, and as such, we will remain 50% long in our DJIA Timing System in order to control for risk. 

Subscribers should note that there is strong support for the Dow Industrials in the 10,000 to 10,300 range, but I would not be surprised if we pierce those levels given the heightened policy risk as exemplified by the SEC charges against Goldman Sachs and the ongoing troubles in the Greek financial system.  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.

Signing off,

Henry To, CFA

 

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