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Still in No-Man’s Land

(June 28, 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 6.48 points as of yesterday at the close; the DJIA Timing system is currently in a 50% long position.

The G-20 meeting concluded with no solid agreements over the weekend.  This is not a surprise, as it is difficult to obtain consensus among the G-20 nations while the global economy isn't in a state of crisis.  Specifically, there was no consensus on bank reform or on deficit reduction, even though there were many formal and intense discussions about these two issues.  With respect to deficit reduction, there does not need to be a consensus, as 1) it is not “efficient” for all the world's major economies to tackle this issue (not to mention to actually reduce their deficits) at one time, and 2) to a large extent, the bond market is the final arbiter (and to a lesser extent, the rating agencies) of whether a country should reduce its fiscal deficit.  The topic of bank reform is trickier, but it is not systematically important – at least not in the short-term.

As mentioned, this will be a condensed commentary.  I first want to address the recent decline in leverage within the stock market, as exemplified by the amount of margin debt outstanding.  Since the February 2009 bottom, total margin debt outstanding has increased by 35%, and in fact has retraced over 30% of its peak-to-trough decline from July 2007 to February 2009.  Despite this retracement, total margin debt outstanding actually declined by $27.0 billion during the month of May – its largest decline since that of November 2008.  As of the end of May 2010, total margin debt outstanding stood at $268.6 billion – its lowest level since month-end February 2010:

Despite a $27.0 billion decline in margin debt outstanding during May, total margin debt remains relatively elevated at $268.6 billion.  Given the ongoing European sovereign debt crisis and the deleveraging process in the G-7 countries, it is highly likely that margin debt outstanding will stay at current levels or even decline as we head further into the summer.  We will provide an update on the amount of cash outstanding at equity mutual funds in this Wednesday's commentary in order to give you a better perspective on the stock market's direction, but for now, we are still in “no-man's land.”  We will thus remain 50% long in our DJIA Timing System – although we will think about going 100% long should the market becomes more oversold on low volume.

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 312.12 points, while the Dow Transports declined 222.59 points.  With last week's decline, both Dow indices are again below their 200-day moving averages.  The lack of a rally despite two Lowy's 90% downside days last week (Tuesday and Thursday) suggests a technically weak market.  In addition, I don't believe the European sovereign debt crisis is over unless the European Central Bank starts seriously hitting the printing presses.  As a result, this summer will continue to be tough.  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 (although we will likely go 100% long should the U.S. stock market becomes more oversold on relatively low volume).

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 increased from a reading of -3.0% to -0.2% for the week ending June 25, 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:

This reading finally had an uptick last week after declining 7 weeks in a row (when it reached its most oversold level since the week ending July 31, 2009).   While this sentiment reading remains oversold, technical and fundamental indicators suggests that the market action will likely remain tough for the next several weeks, unless or until the European Central Bank starts the printing presses.  However, should the market sell off further on relatively low volume, we will likely shift to a 100% long position in our DJIA Timing System, from our current 50% long position.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  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 93.1 to 97.3.  Since late May, the 20 DMA has been vacillated in an oversold range of 90 to 97, and in fact declined to as low as 90.0 on June 16th – its most oversold reading since April 1, 2008.  In addition, the 50 DMA has finally declined to a very oversold level.  While the oversold condition in the ISE Sentiment indicator, as well as our other popular sentiment indicators, presents a good backdrop for a rally, the weak technical and fundamental conditions suggest otherwise.  We are definitely in no-man's land, but should the market become more oversold on low volume in the coming days, we will likely shift to a 100% long position, as the cyclical bull market that began in March 2009 remains intact.

Conclusion: We await the results of the Spanish banks' “stress tests,” but until that happens (or until the European Central Bank starts printing money in a meaningful way), we will remain cautious.  Despite a $27.0 billion decline in total margin debt outstanding, the total amount of margin debt outstanding (at $268.6 billion) is still relatively high – suggesting that the market will remain tough over the summer.  However, should the market becomes more oversold – and should this decline be accompanied by relatively low volume – then we will likely shift to a 100% long position in our DJIA Timing System, from our current 50% long position.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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