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U.S. Dollar Index Getting Overbought

(June 8, 2010)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 12 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;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145; giving us a loss of 328.51 points as of Monday at the close; the DJIA Timing system is now in a 50% long position.

To the extent that the latest spike in the U.S. Dollar Index is tied to the European sovereign debt crisis – and subsequently, the decline in global equities – there's a good chance that global equities could stage a bounce this week, as the U.S. Dollar Index is now hugely overbought.  This overbought condition is evident in the following chart showing the level of the U.S. Dollar Index vs. its percentage deviation from its 200-day moving average:

As shown in the above chart, the U.S. Dollar Index is now 11.81% above its 200-day moving average – its most overbought level since December 9, 2008 (when global flows into the U.S. Dollar peaked during the height of the financial crisis).  In addition, the U.S. Dollar Index – at a level of 88.44 – is at its highest level since March 10, 2009.  With global “safe haven” flows into the U.S. Dollar index (particularly away from the Euro) spiking to such a high level in such a short period, chances are that the Euro would try to stage a bounce sometime this week.  That being said, long-run economic fundamentals in Europe are still horrible, and I would not be surprised if the Euro declines to parity (or below) against the U.S. Dollar over the next two to three years.

The stock market decline last Friday, coupled with the decline on Monday, also smelled of a short-term capitulation.  Over the last two trading days, the Dow Industrials declined 4.3% while the Dow Transports declined 8.0%.  Sure, on a percentage basis, the latest decline is not even in the top 20 of all declines, but the downside breadth last Friday (99.2% declining volume on the NYSE and 93.0% declining volume on the NASDAQ) was there.  This is confirmed by another reliable indicator of “panic,” the NYSE ARMS Index, or what they call the “TRIN.”  Subscribers who want a refresher of this index can do so on the education page of our website, but over the years, I have found the NYSE ARMS Index to be very reliable as an overbought/oversold (mainly an oversold) indicator.  Indeed, the NYSE ARMS Index closed at an extremely oversold reading of 13.22 last Friday.  For comparison purposes, there have only been 40 instances since January 1940 when the NY ARMS/TRIN closed over 5.

Also, prior to yesterday, there were only 26 instances when the NYSE ARMS Index closed over 6; 23 instances over 7; 22 instances over 8; 15 instances over 10; and 10 instances over 13.  The last time the NYSE ARMS Index closed at over 13 was February 27, 2007 (when it closed at 15.77, heralding in the beginning of the U.S. subprime crisis).  Despite the horrible fundamentals that accompanied the selling, the Dow Industrials would bottom five trading days later, and would not ultimately peak until October 12, 2007.  On a 10-day moving average basis, the NYSE ARMS Index just hit a reading of 2.63 – the most oversold reading since March 12, 2007 (and prior to that, the days immediately following Black Monday, or the October 19, 1987 crash).  Following is a history of the 10-day moving average of the NYSE ARMS Index from January 1949 to the present (notice the one-day spike at the end caused by the extremely high reading last Friday):

While the selling over the last two trading days cannot be classified as a true panic, it signals at least short-term capitulation, and so I expect the market to stage some kind of rebound in the coming week.  Whether this develops into a sustainably rally will depend on the fundamental backdrop and the technical action of the market.  With the European sovereign debt crisis not resolved (and with Spain's 8 billion Euro refunding due on June 18th), I expect this rebound to be short-lived.  For now, we will stay 50% long in our DJIA Timing System, although we may shift back to a neutral position or even a 100% long position in the days ahead depending on the future action of the market.

Let us now discuss the most recent action in the U.S. stock market using 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:

Since the Friday before last, the Dow Industrials declined 320.14 points, while the Dow Transports declined 298.08 points.  Most significantly, both the Dow Industrials and the Dow Transports made new recent lows on Monday, with the Dow Industrials actually breaking below its February 8, 2010 low!  The decline over the last two days has sunk the market to its most oversold condition since the March 2009 bottom.  In light of this severely oversold condition, probability suggests that the market will rebound this week.  Whether this rebound becomes more sustainable will depend on the subsequent fundamental backdrop and technical action.  However, at this point, I don't believe the European sovereign debt crisis is over unless the European Central Bank starts seriously hitting the printing presses.  I still expect a tough summer.  For now, we will remain 50% long in our DJIA Timing System, and will shift either to a neutral or 100% long position depending on how the market action pans out.

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 declined from a reading of 5.4% to 0.4% for the week ending June 4, 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 five weeks in a row to 0.4%, and is now at its most oversold level since the week ending July 31, 2009.   In light of this oversold reading, I expect the market to stage a rebound this week.  However, we will let the future action of the market dictate our position.  In addition, given the lack of resolution in the European sovereign debt crisis and the decline in liquidity over the last six months, I am no longer confident that we will end 2010 with a new cyclical bull market high.  For now, we will remain 50% 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:

Since the Friday before last, the 20 DMA increased from 92.5 to 94.7.  The 20 DMA is now vacillating at near a historically oversold level.  However, the 50 DMA is still at a neutral level, at least relative to its readings over the last two years.  With our other sentiment indicators now approaching oversold levels, I thus expect the market to stage a rebound this week.  Whether it turns into a sustainable rally will depend on the future fundamental and technical backdrop.  For now, I still believe that any bounce that emerges this week will be short-lived.  At this point, we will remain 50% long in our DJIA Timing System.

Conclusion: With global flows into the U.S. Dollar now reaching extreme levels, and with the NYSE ARMS index signaling short-term capitulation, the market action is certainly conducive for a rebound rally this week.  However, unless the European Union or the IMF releases a more comprehensive package that could take care of the fundamental solvency problems of the PIIGS countries, chances are that the financial markets will next focus on Spain or Portugal, given their refunding schedules and highly negative financial asset position.

At this point, I still believe the challenging liquidity environment and the inevitable debt restructuring in Europe will pose a problem for the stock market during this summer.  This should not be a surprise, as the €750 billion bailout bill 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.  For now, we will stay 50% long in our DJIA Timing System, although we may shift back to a neutral or even a 100% long position should our technical and sentiment indicators tell us to.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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