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Is the Third Time a Charm?

(June 3, 2010)

Dear Subscribers and Readers,

For our readers who do not recall, a 90% downside day (as defined by Lowry) occurs when both the declining volume and the number of downside points equal or exceed 90% of the total volume and the total number of points, respectively.  A 90% downside day sometimes signals the beginning of a panic decline, or if the market is already oversold, further evidence of a very oversold market.  Generally, a significant market bottom is preceded by two or more number of 90% downside days.  A single 90% downside day may create an oversold situation in the short-term - one which would signal a temporary bottom.  If the 90% downside day is followed by a 90% upside day, then the probability of at least a temporary bottom is increased exponentially.  In addition, the closer the 90% upside day follows the 90% downside day, the greater the chances for at least a temporary bottom.

Note that Tuesday's down day qualified as a Lowry's 90% downside day on the NYSE.  More importantly, yesterday's action (based on preliminary data) on both the NYSE and the NASDAQ qualified it as a 90% upside day.  Under “normal circumstances” (and in a bull market), such action would signal a solid bottom.  However, subscribers should note that yesterday's 90% upside day was the third such day since the April 23 peak.  The two previous 90% upside days (which occurred on May 10th and May 27th) did not lead to any sustainable rally (note that the May 10th rally occurred on the heels of the ECB's announcement that it will monetize the debt of the PIIGS countries, which it has subsequently failed to do in any significant manner).  As a result, subscribers should monitor the market closely.  Unless strong demand for stocks is evident (typically signaled by strong upside breath and upside volume), subscribers should remain cautious.  If strong demand does not emerge, then the market should retest and will likely even break its most recent lows.

Technically, the stock market looks set for a rally, especially given the oversold conditions coming into yesterday's 90% upside day.  Fundamentally, however, the situation has gotten trickier, as the threat of contagion in the Euro Zone increased yet again.  Yesterday, the yield spreads between two-year Spanish government and German Bunds increased to 2.7% - near its record high (since the European Monetary Union was created).  In addition, Spain's refinancing schedule looks quite aggressive in the near term, as €8 billion of its debt needs to be refinanced by June 18th, and another €16 billion by the end of July.  Spain's refinancing needs over the next 3 to 4 months will total around €38 billion.

More important, the funds from the €750 billion bailout package are still not available, as it has not been ratified by many countries.  With the European Central Bank still out of the picture, probability suggests that the Euro Zone and the Euro will again be put to the test in the next couple of weeks leading to the first Spanish refinancing.  In addition, we are still very cautious on Portugal as discussed in our latest weekend commentary, given the country's historical indebtedness, especially with the leverage in its nonfinancial corporate sector.

Moreover, despite the correction in May, our liquidity indicators remain relatively bearish.  In particular, the amount of cash sitting on the sidelines (as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background) is still deteriorating, despite the correction in May (which should lead to a lower denominator and thus a higher ratio) – suggesting that the correction may not be over (I still think this will be a tough summer for global equities)  As shown in the following chart, “cash on the sidelines” relative to the S&P 500's market cap (as of June 2, 2010) has declined by 47.6% since its peak at month-end February 2009 (after declining as much as 51.5% at the end of April 2010):


As mentioned in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has been making new rally lows consistently since the beginning of this bull market (with only slight pauses in June 2009 and January 2010).  For the months of February to May 2010, as well as the first two days of June, this ratio declined by 4.5% (due to a combination of a rising stock market and a decline in money market funds outstanding).  In addition, this ratio is no longer high from an absolute standpoint (especially when compared to its historical experience excluding the late 1990s and mid 2000s).  While the long-term trend of the stock market is still up, probability suggests that the market will remain challenged, unless a major central bank announces a new liquidity facility (e.g. the Federal Reserve announces an extension of its “credit easing” program or the European Central Bank monetizes a significant portion of the Euro Zone's sovereign debt).

Signing off,

Henry To, CFA

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