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A New Sentiment Indicator

(August 15, 2010)

Dear Subscribers and Readers,

I am still tackling my recent move of apartments so this will again be a relatively quick update.  I apologize for any inconvenience caused.  I promise that I will write a more substantive commentary in next weekend's regular commentary.  Until then, all our eyes are on the Fed's upcoming FOMC meeting later today.

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 158.15 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

We mentioned in last weekend's commentary that there's a good chance the Fed would announce the resumption of its “quantitative easing” policy in last Tuesday's FOMC meeting, and that the stock market may have already priced in the minor step where the Fed would reinvest its matured agency MBS holdings in U.S. Treasuries.  In fact, the market was probably looking for more, as the U.S. stock market endured a delayed Lowry's 90% downside day the next day (although the Chinese economic slowdown and  the surprisingly high U.S. trade deficit no doubt played a role).  In light of the cloudy economic outlook of the Euro Zone, the U.S., and Japan for the next several quarters, earnings (and earnings guidances) of U.S. companies would thus likely remain downbeat for the next couple of quarters. 

Again, given the political and populist resistance further fiscal stimuli, any further easing will have to come from the Federal Reserve.  Should global equity markets remain downbeat (i.e. below DJIA 10,000) going into the next FOMC meeting on September 21st, we believe that the Fed would announce another quantitative easing (most probably in U.S. Treasuries only) package at that time.  This package is likely to start small – possibly $250 billion to $500 billion, and should expand over time should the stock market remain downbeat and should the U.S. dollar index hold up.  Because of the minimal impact of last week's “easing,” global liquidity conditions would remain tough going into September.  Therefore, we are still taking a wait-and-see approach with respect to our DJIA Timing System.

Another reason why we are taking a wait-and-see approach could be witnessed in the below chart (courtesy of, which shows the percentage of overall equity exposure for 40 NAAIM (National Association of Active Investment Managers) member firms who are active money managers.  Since this contains leveraged and long-short strategies, responses can vary widely – the results are then averaged to come up with the results on the below chart (inception of the poll is 2006):

As can be seen on the chart, the U.S. stock market has either corrected significantly or endured a tough time whenever NAAIM net equity exposure pierced the 80% level over the last three years.  Conversely, the best time to buy U.S. equities is when NAAIM net equity exposure declined to 20% or below.  With NAAIM equity exposure at 54.68%, the U.S. stock market can be classified as in “no-man's land.”  While our other sentiment indicators are now flashing bullish signals, those are not being confirmed by the NAAIM sentiment poll, and nor our global liquidity and technical indicators.  This is why we are taking a wait-and-see approach (going forward, we would provide periodic updates of the NAAIM sentiment poll).

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 August 13, 2010, the Dow Industrials declined 350.41 points, while the Dow Transports declined 255.45 points.  After last week's significant decline (including a Lowry's 90% downside day on Wednesday – arguably a one-day decline reaction to the implication of the FOMC meetings), both the Dow Industrials and the Dow Transports are back down below their 200-day moving averages.  Thus – after having steadily improved for the previous two weeks – the technicals of both Dow indices have deteriorated.  Combined with our declining global liquidity indicators (which we have discussed for the last several weeks), the lingering default risks for Greek sovereign debt, and a further slowdown in the U.S. economy (although we do not believe there will be a double-dip recession), probability suggests that the market will remain a tough place to be for the rest of the summer, if not into October.  For now, we will remain 50% long in our DJIA Timing System, and should eventually shift to a 100% long position depending on how the market action and fundamentals pan out in the coming 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 increased from a reading of -2.5% to 0.3% for the week ending August 13, 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 declining to its most oversold level since the week ending April 10, 2009 just three weeks ago, this reading has bounced back with a vengeance – rising from -9.9% to 0.3% over the last three weeks.  Typically, the most bullish time is when sentiment levels reverse from a very oversold level (which obviously this sentiment indicator has done in the last few weeks) – but in this case, the action of this sentiment indicator may be slightly misleading given the relatively high readings of the National Association of Active Investment Managers sentiment indicator, as well as our deteriorating global liquidity and technical indicators.  Make no mistake, we are still looking to shift to a 100% long position in our DJIA Timing System, but would likely do so only once our liquidity indicators improve.  In the meantime, the U.S. stock market will likely remain tough over the summer, if not into October.

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 yet again from 107.5 to 112.9 last week.  From late May to early July, the 20 DMA 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.  Five weeks ago, the 20 DMA finally pierced through the 98 level.  At the same time, the 50 DMA declined to a historically oversold level of 94.1 on July 14th, and has been on an uptrend since that time.  With all our popular sentiment indicators having reversed from extremely oversold conditions, probability suggests that the cyclical bull trend remains intact.  However, we are still looking for a further consolidation period for the rest of the summer (possibly into October), and will only shift to a 100% long position should the liquidity conditions improve.

Conclusion: We are still waiting for the Federal Reserve to act decisively to “solve” the global liquidity situation once and for all, as global banks are still not lending and global corporations are still not spending.  The soonest time for the Fed to act decisively is the date of the next FOMC meeting on September 21st – this is the time when we expect the Fed to announce a decisive resumption of its quantitative easing policy – starting with a $250 to $500 billion commitment to purchase more U.S. Treasuries.  However, with bank lending still subdued, the biggest “bang for the buck” would be for the Fed to purchase private sector assets, such as AAA-rated asset-backed securities (which would allow the “shadow banking system” to supply more credit to the private sector) or even AAA-rated corporate bonds (although we are not looking for the Fed to exercise this option). 

In addition – given the deteriorating liquidity and technical conditions, as well as the relatively neutral reading of the NAAIM equity exposure poll, we are thus still taking a wait-and-see approach in terms of our DJIA Timing System.  Until our global liquidity indicators improve in a meaningful way, we will refrain from shifting to a 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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