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Technical Conditions Vastly Improving

(July 25, 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 279.62 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

Despite what the detractors say about the assumptions and conclusions of the results of the EU bank stress tests (published last Friday), there are two important (and good) things we could say about the stress tests: 1) there is now greater transparency for the 91 European banks that were covered in the tests; 2) All the banks that failed the tests have agreed (and have the ability to) raise capital to meet the 6% Tier 1 capital requirements from now until the end of the year.  More importantly, even the banks that failed the tests are not in any danger of actually being insolvent anytime soon – especially since the latest European PMI and German IFO reports are indicating that the Euro Zone's economic growth is accelerating.  Interestingly, there is now a good chance that the Euro Zone's GDP growth numbers would be revised for the rest of 2010 and the first half of 2011 (based on decent German growth and bank lending in France) – thus totally blowing out the economic assumptions built into the stress tests.  My sense is that investors should forget about the European sovereign debt crisis – at least until the end of this year.  Depending on the technical action and our liquidity indicators going forward, we may even shift to a 100% long position in our DJIA Timing System in the coming days or weeks.

Speaking of which, the technical conditions of the U.S. stock market have vastly improved over the last few weeks.  For example (as shown in the following chart, courtesy of Decisionpoint.com), the advance/decline line of the NYSE Common Stock Only index recently made a higher low at the early July lows (relative to the February lows), even though the NYSE Common Stock Only Index pierced through his February lows.  That is, the NYSE CSO A/D line never confirmed the lower low made by the index – signaling a positive divergence:

Similarly (as shown in the below chart, courtesy of Decisionpoint.com) – unless the U.S. stock market plunges tomorrow – the NYSE CSO McClellan Summation Index is on the verge of making a higher high, thus confirming the latest rally in U.S. stocks:

While our technical indicators are looking much better, our liquidity indicators remain in neutral to moderately bearish territory.  We covered the size of the Fed's balance sheet on Thursday's commentary.  Another liquidity indicator, 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 declined to new rally lows consistently since the beginning of this bull market.  This somewhat changed with the stock market correction since the beginning of May – with the ratio rising by 2.16%.  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.  From a pure liquidity, probability suggests that the market is still going to struggle this summer, 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), or 2) a major technology (one that could speed up global productivity growth) is commercialized over the next several months (which is not likely).  Because of the significant improvement of our technical indicators, however, don't be surprised if we shift from a 50% long to a 100% long position in our DJIA Timing System in the coming days.

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 23, 2010, the Dow Industrials rose 326.72 points, while the Dow Transports rose 250.71 points.  The ability of the Dow indices to make new five-week highs in the midst of the uncertainty going into the European Union's bank stress tests was impressive – all the more so given last Thursday's Lowry's 90% upside day.  Despite the ongoing threat of a Greek default, both the price and technical action suggests the future looks bright, despite the weakening liquidity indicators.  For now, we will remain 50% long in our DJIA Timing System, and may shift to a 100% long position depending on how the market action and fundamentals pan out in the coming days.

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 -7.3% to -9.9% for the week ending July 23, 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 April 10, 2009 (when the DJIA traded at just slightly over 8,000).   More importantly, this reading is now getting oversold, even relative to its readings over the last two years.  While our liquidity indicators do not suggest much upside in the market, our fundamental and technical indicators are no doubt improving, especially in light of the recent publication of the EU's bank stress tests.  Again, we would not hesitate shifting to a 100% long position should the technical conditions of the market improve further over the coming days.

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 98.9 to 101.0 last week.  From late May to early July, the 20 DMA had 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.  Two weeks ago, the 20 DMA finally pierced through the 98 level convincingly.  In addition, the 50 DMA has finally declined to a historically oversold level.  With all our sentiment indicators now at an oversold level, and with the improving technical conditions, there is a good chance the market could rally further.  Again, we will likely shift to a 100% long position should the technical conditions of the market improve further in the coming days.

Conclusion: With the publication of the EU bank stress tests, a significant amount of uncertainty has been lifted off investors' minds, despite the relative ease with which the vast majority of the 91 banks in passing the stress tests.  In addition, the technical conditions of the market have improved dramatically.  Even though the liquidity backdrop remains tough, this is not a big obstacle to a further rally in the market.  Finally, in light of the severely oversold readings in the NYSE ARMS Index (as discussed last week), and the oversold conditions in our sentiment indicators, we not hesitate to shift to a 100% long position in our DJIA Timing System, from our current 50% long position if our technical indicators improve further.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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