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Is the Behavior of the Market Changing?

(May 14, 2010)

Dear Subscribers and Readers,

Interestingly, waiting one day to pen our commentary was the right thing to do, as the U.S. equity market sold off near the close yesterday (and the S&P 500 futures are flat as I am writing this).  According to Lowry, selling was intense on both the NYSE and the NASDAQ, with down volume representing 78% of total up/down volume on the former, and 77% on the latter.  In addition, decliners outnumbered advancers by approximately a 2-to-1 margin on both Exchanges.  Moreover, the most recent decline did the most technical damage in any correction since the bull market began in March 2009 – and correspondingly, any bounce – if it was sustainable, should be strong, accompanied by strong upside breadth and upside volume.

Unfortunately, this has not been the case so far, especially in light of yesterday's afternoon decline.  From a fundamental standpoint, this also makes sense, as the so-called Euro bailout fund still isn't in place and as Spain and Portugal have already implemented austerity measures (through raising taxes, which is the worst of all strategies) – thus constraining economic growth in the short-run.  In addition, from a sentiment standpoint, investors still remain relatively complacent, as exemplified by the following chart (courtesy of showing the 10-day moving average of the equity put/call ratio vs. the S&P 100 index:

Amazingly, the 10-day MA of the equity put/call ratio still stands at a relatively neutral reading of 0.64, despite last Thursday's decline. This reading is still nowhere close to where it was during prior market corrections in 2009.

As mentioned in the above chart, the 10-day moving average of the equity put/call ratio is actually still at a relatively neutral level of 0.60, despite the extreme intraday sell-off last Thursday.  Note that this reading is still nowhere close to where it was during prior market corrections in 2009. Until we see a more oversold condition in the equity put/call ratio (and confirmed by our other sentiment and technical indicators), we will stay with our neutral position in our DJIA Timing System.

Finally, an update of our liquidity indicators also does not support the “new bull market highs” thesis just yet.  First, a Fed balance sheet update.  In total, the Fed, under its “credit easing” policy, has made a commitment of purchasing $1.25 trillion in agency MBS and $175 billion of agency debt by March 31, 2010.  This credit easing facility should've expired over six weeks ago, but as the below chart shows, the Fed has actually made more purchases since March 31, 2010.  For example, the Fed purchased $9.5 billion of agency MBS for the week ending April 14, 2010, and another $21.6 billion for the week ending April 21, 2010.  As of Wednesday afternoon, the Fed still has $152 billion left under this commitment, although it is not obligated to purchase the full amount:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - Since the Fed's credit easing program technically ended (March 31, 2010), the Fed has actually continued purchasing agency MBS. For example, for the two weeks ending April 21, 2010, the Fed actually purchased $31 billion agency MBS. Since then, however, Fed's purchasing of agency MBS has flatlined - and thus is no longer conducive for liquidity creation purposes. That said, the Fed still has the capacity to purchase another $152 billion of agency MBS under its current $1.25 trillion limit, but I do not foresee the Fed doing this at this time unless the financial markets dive again.

More important, and as mentioned on the above chart, there is no reason to believe the Fed will resume its purchases anytime soon, especially since it actually SOLD a net $3.1 billion of agency MBS over the last three weeks.  Unless the financial markets take a dive again, I expect the Fed to be very cautious in buying more agency MBS at this point.

At the same time – part of the “Shadow Banking System” – the asset-backed security market is still struggling.  For example, the total amount of asset-backed commercial paper outstanding is still making new lows (probably because many companies are now getting long-term funding instead, but that does not change the fact that liquidity in the ABS market remains challenged):

Asset-backed Commercial Paper Outstanding

Until our technical and sentiment indicators get more oversold – and unless the European Central Bank adopts a more aggressive strategy of monetizing Euro Zone's sovereign debt – we will likely remain neutral in our DJIA Timing System.  We continue to foresee a difficult summer for global asset prices.  More to come this weekend!

Signing off,

Henry To, CFA


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