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When Will We Buy?

(May 16, 2010)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 11 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;

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.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points; the DJIA Timing system is now in a completely neutral position.

As I am penning this commentary, the S&P 500 futures are down over 5 points and the NASDAQ 100 nearly 10 points.  Over the weekend, the European Central Bank President, Jean-Claude Trichet, was quoted as saying that “there was no doubt the [European] economy is in its most difficult situation since World War II or perhaps ever since World War I.

It's one thing to comment that this is the worst crisis since World War II, but to go on record and state that perhaps this is the worst crisis since World War I is pretty drastic, especially as the period between World War I and World War II encompassed the German hyperinflation and the Great Depression of the 1930s (partly triggered by the widespread banking panic in Austria and the Bank of England going off the Gold Standard in late 1931).  Combined with the fact that the nearly US$1 trillion bailout package isn't approved yet, chances are that the Euro and European equities will correct again this week.  I believe that there is a good chance of a retest of the recent lows on Thursday before last (approximately DJIA 9,800).

In the long-term, the re-pricing of risk in the Euro Zone will be bullish for asset prices, as capital allocation in the region will be much more efficient.  In the short-term, we will rely on our sentiment, technical, and liquidity indicators in terms of when to go 50% or 100% long in our DJIA Timing System.  For now, virtually none of our indicators is signaling a tradable bottom.  For example, as shown in the following chart (courtesy of, the percentage of NYSE stocks above their 20-day and 50-day EMAs are still trading at mildly oversold to neutral levels (at 26.36% and 41.68%, respectively):

With the internal condition of the U.S. equity market at its weakest since the bull market began in early March 2009, and given the extended duration of the bull market, I believe the current correction will be the most serious since March 2009.  During the previous two bottoms, the percentage of NYSE stocks trading at above their 200-day EMAs bottomed at around 60%.  As of last Friday, this statistic sat at 70.38%.  I expect this to decline by at least 10% before the stock market could present us with a tradable bottom.

From a valuation standpoint, I would say the stock market is likely trading at around “fair value” right now.  One valuation factor that I regularly track – Morningstar's aggregate valuation of its entire coverage universe of over 2,000 stocks (covered by the competent analysts at Morningstar) – is now right at fair value, as suggested by its current ratio of 1.00 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”).  As shown in the following chart, courtesy of Morningstar, this ratio sank to as low as 0.55 on November 20, 2008 (this represented its all-time low since the inception of this indicator in mid-2001), and as high as 1.14 on December 31, 2004:

As mentioned, Morningstar's proprietary valuation indicator suggests that the stock market is more or less, trading at “fair value.”  Subscribers should note that – given the trend of corporate earnings over the last 12 months – Morningstar's underlying growth assumptions in their discounted cash flow analyses have gotten more aggressive since the March 2009 bottom.  In addition, the weighted cost of capital has already declined dramatically – suggesting that valuations may be a little bit stretched, especially if the Euro Zone enters into a double-dip recession.  In other words, Morningstar's proprietary valuation indicator suggests that we are probably not at a tradable bottom yet.  However, given the strong upside breadth and volume in the global equity markets since early March 2009, and given that many retail investors are still cautious, probability suggests that the U.S. cyclical bull market remains 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 May 14, 2010, the Dow Industrials rose 239.73 points, while the Dow Transports rose 189.61 points.  The market has now worked off a substantial portion of its severely oversold condition from the week prior – but more importantly, the latest bounce hasn't been too convincing – suggesting that the correction likely hasn't ended.  In addition, despite the decline during the week prior, the Dow Industrials is still up 7.2% while the Dow Transports is up 18.3% since the February 8th bottom.  Subscribers should note that the technical, sentiment, and liquidity indicators are still flashing bearish signals.  I also don't believe the European sovereign debt crisis is over unless the European Central Bank starts seriously hitting the printing presses.  I expect the market correction to quickly reassert itself and to last throughout the summer if not into early Fall.  However, given the strong momentum from the early March 2009 lows – and combined with decent valuations and strong upside breadth – probability suggests that the cyclical bull market is intact.  For now, we will remain neutral in our DJIA Timing System, and will likely shift to a 50% long position again once our technical and sentiment indicators decline to oversold levels.

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 from a reading of 19.5% to 15.6% for the week ending May 14, 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:

After rising for 9 weeks in a row, this reading has now declined two weeks in a row to 15.6%.  Despite this two-week decline, this reading remains relatively overbought, and thus I expect the correction to reassert itself over the next couple of weeks, especially given challenging liquidity situation in the financial markets.  With so much complacency still in the market, I am no longer confident that we will end 2010 with a new cyclical bull market high.  For now, we will remain neutral in our DJIA Timing System.

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 May 14, 2010, the 20 DMA declined from 120.4 to 110.8.  The 20 DMA has now plunged nearly 23 points over the last two weeks and is now at a highly oversold level.  However, the 50 DMA is still at a neutral level.  In addition, given that our other sentiment indicators (including the equity put/call ratio) are still on average at neutral levels, and given the still-challenging liquidity environment, I expect the market correction to reassert itself this week.  I also expect the correction to last until the end of the summer, if not into Fall.  We will remain neutral in our DJIA Timing System, for now.

Conclusion: With the Euro Zone sovereign debt crisis still unresolved, and combined with Trichet's comments over the weekend, chances are that the stock market will still be biased towards the downside this week.  With much of the Euro Zone's human capital in tatters (youth unemployment is reaching 40% in some areas), and with much of the capital over the last 10 years having been grossly misallocated, any further monetization of the Euro Zone's sovereign debt would result in another dramatic decline in the Euro.  Again, the Euro remains a “sell.”

I expect the stock market correction to reassert itself this week after working off a substantial portion of its oversold condition last week.  Any further correction would not be a surprise, and as even if the nearly US$1 trillion “bailout” plan passes this week, it does not change the fundamental problem of over indebtedness of the Euro Zone in general.  In particular, while the short-term refunding risk is off the table, the long-term solvency problems remain in place, especially as it pertains to the PIIGS countries.  In the meantime, U.S. liquidity conditions also remain challenging.  With our electronic trading systems now in question (after the plunge during the Thursday before last), I also expect investors to get more panicky should another correction materialize further down the road.  For now, we will stay neutral in our DJIA Timing System, although we will likely shift back to a 50% long position once our technical and sentiment indicators become oversold again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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