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Early Second Half Liquidity Indicators

(July 11, 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 gain of 53.03 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

As mentioned previously, the EU-wide bank stress tests are scheduled to be published on July 23rd.  91 banks will be in the spotlight, although interestingly, the assumptions underlying the tests are still unknown at this point (we don't even know whether sovereign debt would be included).  We still envision a tough summer based on questionable fundamentals, horrible technicals, and lack of liquidity growth.  As we approach the publication date of the EU-wide bank stress tests, we advocate keeping our 50% long position in our DJIA Timing System.  Should there be a promise to inject more liquidity into the banking system via the European Central Bank (e.g. ECB purchasing Greek or Spanish sovereign debt) or government injections, we would likely go 100% long in our DJIA Timing System again.

Turning now to our liquidity indicators, they are for the most part neutral to moderately bearish for global equity markets.  For example, one of these indicators, the amount of "investable cash on the sidelines" versus the S&P 500 market cap –has come down dramatically since the February 2009 peak, as shown in the following chart:

As referenced 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.  This somewhat changed with the stock market correction in since the beginning of May – with the ratio rising by 3.69% since then.  However, this ratio has come down too far, too fast, and remains low relative to its readings over the last two years despite the recent uptick.  Probability suggests that the market hasn't made a sustainable bottom yet, unless: 1) A major central bank announces a new liquidity facility (e.g. the Federal Reserve announces an extension of its “credit easing” program or if the European Central Bank monetizes Greek sovereign debt), 2) the EU-wide bank stress tests are relatively benign, or 3) a major technology (one that could speed up global productivity growth) is commercialized over the next several months (which is not likely).

Another domestic liquidity indicator is the size of the Fed's balance sheet.  Total Reserve Bank credit now sits at $2.31 trillion, up $337.1 billion from a year ago.  Since the Fed ended its “credit easing” policies on March 31, 2010, the size of the Fed's balance sheet increased by only $24 billion.  Over the past 18 months, the mix of the Fed's balance sheet has shifted substantially as the Fed has shifted its focus from providing direct liquidity to the banking system and other central banks (such as the Bank of Korea) to providing direct liquidity to the broader system/economy through the purchase of U.S. Treasuries, agency debt and agency MBS under its credit easing program.  In total, the Fed has made a commitment of purchasing $1.25 trillion in agency MBS and $175 billion of agency debt by the end of March 31, 2010.  As of Wednesday afternoon, the Fed still has $142 billion left under this commitment, although it is not obligated to purchase the full amount. Not surprisingly, the Fed has dramatically slow down its purchases since the end of March, but it nonetheless purchased $45 billion in agency MBS since then, as shown in the following chart:

Interestingly, the Fed actually withdrew $4.5 billion in liquidity over the last three weeks by selling agency MBS on the market.  With the Chinese still in a semi-tightening mode, and with Western Europe and Japan still mired in a deflationary cycle, it is difficult to see global inflation popping up anytime soon (this is also confirmed by the recent weak readings in the ECRI Future Inflation Gauge).  Given that commercial banks are still not lending, and given that the EU-wide bank stress tests won't be published until July 23rd, the global liquidity situation remains precarious.  Combined with the still-horrible technical conditions and the lack of visibility on corporate earnings growth, we continue to take a wait-and-see approach with respect to the stock market and our position in our DJIA Timing System.

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:

For the week ending July 9, 2010, the Dow Industrials rose 511.55 points, while the Dow Transports rose 228.50 points.  The bounce in the market last week was impressive, but whether the rally could sustain itself is still questionable, as last week's rally may have just been an oversold bounce.  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 (the next thing to watch for would be the publication of the EU's bank stress tests scheduled for July 23rd).

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 -2.1% to -5.3% for the week ending July 9, 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 last week's decline, this reading declined to a new 2010 low and is now at its most oversold level since the week ending July 24, 2009.   While this reading is now getting oversold, it is still not too oversold when compared to its readings over the last two years.  Moreover, fundamental, technical and liquidity indicators suggests that the market action will likely remain tough for the next couple of weeks, unless or until the European Central Bank starts the printing presses or the publication of the EU's bank stress tests is benign.  Right now, we are in a wait-and-see approach, but would not hesitate shifting to a 100% long position should the market continue to correct going into the publication of the EU's bank stress tests on July 23rd.

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 last Friday, the 20 DMA increased from 97.5 to 98.6.  Since late May, the 20 DMA has been vacillated in an oversold range of 90 to 98 (although it did marginally pierce the 98 level on Friday), 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 historically oversold level.  The good thing is that our other sentiment indicators are starting to confirm the historically oversold condition in the ISE Sentiment indicator.  But we will see take a wait-and-see approach, and will likely shift to a 100% long position should the market continue its correction going into the publication of the EU's bank stress tests on July 23rd, as I believe that the cyclical bull market that began in March 2009 remains intact.

Conclusion: The next two weeks of action will mostly depend on anticipation of the EU-wide bank stress tests results, as well as the still-horrible/tough technical and liquidity backdrop.  Again, we are taking a wait-and-see approach and will await the results of the EU's banks “stress tests” that are to be published at or near July 23rd.  Until that happens (or until the European Central Bank starts printing money in a meaningful way), we will remain cautious.  However, should the market becomes more oversold going into July 23rd, we may 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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