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All Eyes on the European Union's Banks Stress Tests

(July 18, 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 47.10 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

As mentioned before, the widely anticipated EU bank stress tests would be published this Friday, with 91 banks to be in the spotlight.  Since last week, more details of the stress test have been published.  According to the popular press, the stress tests would assume a 3% decline in GDP relative to existing forecast and over a two-year period, with a 10% to 15% haircut on the sovereign debt of peripheral Euro Zone countries such as Greece, Portugal, Ireland, and Spain.  According to Goldman Sachs, the sovereign debts of the PIGS (i.e. excluding Italy's) countries make up just 1% or so of the EU banks' aggregate balance sheets, but that hasn't deterred investors from selling the stocks of EU banks and for their funding costs to rise since the beginning of this year.  This is all the more perplexing (according to Goldman and the European Central Bank) since bank's capital ratios in the Euro Zone are still close to 13-year highs (as shown in the following chart):

One reason may be that investors are not too concerned with the aggregate funding levels of EU banks – but rather, any dislocations (Lehman-Style) stemming from the failure of a few larger banks or a dozen medium sized banks.  Another reason could be investors' fear stemming from the possibility of a “double-dip recession” in the Euro Zone or even in the wider “developed” region encompassing the United States and Japan.  Still another reason could simply be a general distrust of banks' management and their official balance sheets.  The publication of the stress tests on the individual 91 banks should go a long way to resolving these issues, especially if a credible “bailout package” (e.g. ECB monetizing Greek or Spanish sovereign debt) is announced in conjunction on July 23rd.  Should the stock market continue to sell off into the publication of the stress tests this Friday, then we will seriously think about shifting our 50% long position to a 100% long position in our DJIA Timing System later this week or early next week. 

While technical conditions still look horrible, many of our overbought/oversold indicators suggest that a sustainable bottom is now close by, although this needs to be confirmed with renewed investors' interest in stocks (through a Lowry 90% upside day or a general, sustainable increase in upside breadth/volume over the next couple of weeks).  For example, the NYSE ARMS Index – an indicator that has aided me immensely in calling for oversold bottoms since we began writing our commentaries, just hit a reading of 5.77 at the close on Friday, 5.97 on June 29th, and 13.22 on June 4th, the most oversold daily readings since the 15.77 reading on February 27, 2007 (and prior to that, March 24, 2003, when the it hit a reading of 5.01).  Following is a daily chart showing the 10-day MA of the ARMS Index from January 1949 to the present:

As of Friday at the close, the 10-day MA of the NYSE ARMS Index was at 1.36., but had spiked to 2.15 as recent as July 2nd, and 2.63 on June 7th.  These readings surpassed the oversold readings that we got on numerous times during the October 2008 to March 2009 sell-off.  Make no mistake: We are now seeing very oversold readings on the NYSE ARMS Index – readings that we haven't witnessed since early March 2007, and prior to that, August 2004.  Unfortunately, this oversold condition isn't (yet) being confirmed by the NYSE Common Stock Only McClellan Summation Index, the VIX, or the percentage deviation of the either the Dow Industrials or the S&P 500 from their 200-day moving averages just yet.  As a result, I would not be surprised if the Dow Industrials sells off further going into this Friday's stress tests (or even immediately afterwards), but as other technical and sentiment indicators get more oversold, we would definitely think about shifting our 50% long position to a 100% long 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 16, 2010, the Dow Industrials declined 100.13 points, while the Dow Transports declined 41.90 points.  Unfortunately, the stock market could not sustain the bounce from the week prior, and it remains to be seen whether there is a more serious decline ahead, especially in light of the Lowry's 90% downside day last Friday and the ongoing scrutiny of the PIGS countries and the balance sheets of the European banking system.  As a result, this summer will continue to be tough.  For now, we will remain 50% long in our DJIA Timing System, and may shift either to a 100% long position depending on how the market action and fundamentals pan out in the next couple of weeks.

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 -5.3% to -7.3% for the week ending July 16, 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 again declined to a new 2010 low last week and is now at its most oversold level since the week ending July 17, 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 this week, 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:

The 20 DMA increased from 98.6 to 98.9 last week.  Since late May, the 20 DMA has been vacillated in an oversold range of 90 to 98, and in fact declined to as low as 90.0 on June 16th – its most oversold reading since April 1, 2008.  Last week, however, the reading finally pierced through the 98 level convincingly.  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 corrects further going into (or immediately after) the publication of the EU's bank stress tests this Friday, as I believe that the cyclical bull market that began in March 2009 remains intact.

Conclusion: Similar to our conclusion last weekend, the majority of investors are awaiting the publication of the EU-wide bank stress tests results this Friday.  In light of the still-horrible/tough technical and liquidity backdrop, I would not be surprised if the market corrects further this week or even into early next week.  Again, we are taking a wait-and-see approach and will await the results of the EU's banks “stress tests.”  Until that happens (or until the European Central Bank starts printing money in a meaningful way), we will remain cautious.  However, in light of the severely oversold readings in the NYSE ARMS Index, we not hesitate to shift to a 100% long position in our DJIA Timing System, from our current 50% long position if the market or if other technical and sentiment indicators become more oversold.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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