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Know Thyself

(September 26, 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 715.26 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

The process of self-discovery is important, enlightening, and necessary.  It is a lifelong process, although many people don't engage in the process until some dramatic life event occurs, such as the death of a loved one, a broken relationship, or the loss of one's fortune.  For most people, self-discovery and self-reflection is painful, especially if one is on a constant start of comparison with others and can't come to terms with his/her imperfections.  Ultimately, a constant quest for “knowing thyself” is necessary.  While it could be painful initially, people in a constant state of self-discovery know what they want in life.  They know what jobs would make them happy.  They know what relationships are bad for them, and their own vulnerabilities and flaws.  Some even find their life purpose.  For the vast majority of people, this is the only way to fulfill one's happiness in life. 

In our August 19, 2010 commentary (“Determinism vs. Free Will and its Ultimate Impact on Your Investments”), we argued that one's free will is actually very limited, and that it is imperative to understand one's personality and disposition in order to achieve the right path (for you) to investment success.  Quoting our August 19, 2010 commentary:

No matter which side of the argument one believes, there is no arguing that one's free will in this world is very limited.  A classic example is our physical limitations, such as our lack of ability to fly.  We are also limited by our intelligence in making significant technological leaps, or doing mental calculations faster than a personal computer.  On an individual level, we are limited by our environment, including where we were born and whom we have as our parents, and thus how we were raised (we ignore the moral dilemma of John Rawls' “Veil of Ignorance” for now).  Our genes, upbringing, and overall environment all help to shape our personalities, and consequently where we obtain our education and what careers we aspire to or work in.  More importantly (as least for the purpose of this commentary), it also shapes who we are as investors – whether we possess the ability to become good investors (starting early helps – e.g. Barton Biggs, encouraged by his father, had to study the book Security Analysis when he was young), and which investment philosophies and processes are the most suitable.  I encourage all of you to consider this philosophical question this weekend, and more importantly, revisit one's personality and disposition in order to better understand whether one is on the right path to investment success!

As human beings, we are all subject to the same emotions that govern our lives—emotions that essentially limit our free will.  Anger, jealousy, feat, ego, etc., are important and provide a “benchmark” for how human beings react to certain situations, but many of these emotions also control our lives.  One can avoid such a fate by avoiding people or situations that bring out these emotions to the extreme—this will entail one to “know thyself.”  For example, we made a blunder in the summer of 2008 when we shifted to a 100% long position in our DJIA Timing System (very) early—right before the U.S. Treasury placed the GSEs under conservatorship, the bankruptcy of Lehman Brothers, and the failure of the TARP bill in Congress.  Through maintaining our long position, our composure, and making timely tactical shifts in 2009 and earlier this year, the performance of our DJIA Timing System ultimately turned out fine—outperforming the Dow Industrials by nearly 700 basis points on an annualized basis over the last two years ending June 30, 2010!  Nevertheless, some subscribers were not satisfied with market returns.  For example, there was some (but not many) who interpreted our signals as a green light to go long U.S. financials.  Mind you, purchasing a basket of U.S. financials in the summer of 208 should pay off eventually, but there were some who could not hold on to their long positions because of fear, leverage, or a combination of both.  The cardinal rule of investing: Before one invests, one should evaluate his/her own risk tolerance and level of wealth so one could construct an appropriate investment portfolio.

For those that are prone to extreme fear, anger, or jealousy, what can one do besides putting all his/her retirement basket into a CD or Treasury bills, and not revisit his/her portfolio until the end of each year?  The old “take a deep breath before you react” trick may work, but the “noise” of one's relatives, friends, and mainstream media can be a powerful stimulant.  In other words, it doesn't work, and alcohol and drugs don't work either—the latter because we still don't really understand how the human brain functions (as an aside, we still do not understand why certain animals can sense incoming natural disasters such as earthquakes and tsunamis).

My personal toolbox to control my negative emotions is simple: meditation.  For the metaphysically inclined, meditating allows one to be more “in tune” with one's spirit and sense of “being,” allowing one to establish a greater sense of calm, clarity, and concentration.  For the religiously inclined, one could liken praying as speaking to God; and meditating as listening to God.

Quoting/paraphrasing from an ancient text:

The majority of people is more or less the slaves of heredity, environment, etc., and manifests very little Freedom.  They are swayed by the opinions, customs and thoughts of the outside world, and also by their emotions feelings, moods, etc.  They manifest no Mastery, worthy of the name.  They indignantly repudiate this assertion, saying, "Why, I certainly am free to act and do as I please--I do just what I want to do," but they fail to explain whence arise the "want to" and "as I please."  What makes them "want to" do one thing in preference to another; what makes them "please" to do this, and not do that?  Is there no "because" to their "pleasing" and "wanting"?  The Master can change these "pleases" and "wants" into others at the opposite end of the mental pole.  He is able to "Will to will," instead of to will because some feeling, mood, emotion, or environmental suggestion arouses a tendency or desire within him so to do.

The majority of people are carried along like the falling stone, obedient to environment, outside influences and internal moods, desires, etc., not to speak of the desires and wills of others stronger than themselves, heredity, environment, and suggestion, carrying them along without resistance on their part, or the exercise of the Will.  Moved like the pawns on the checkerboard of life, they play their parts and are laid aside after the game is over.  But the Masters, knowing the rules of the game, rise above the plane of materials life, and placing themselves in touch with the higher powers of their nature, dominate their own moods, characters, qualities, and polarity, as well as the environment surrounding them and thus become Movers in the game, instead of Pawns--Causes instead of Effects.  The Masters do not escape the Causation of the higher planes, but fall in with the higher laws, and thus master circumstances on the lower plane.

For those scientific minds among us, scientific analyses of the last 60 years have been shown that meditation works, although the process of meditation and how it changes the inner workings of one's brain/mind remains unclear.  A recent Scientific American article provides the latest scientific confirmation the effectiveness of “compassionate meditation.”  Hundreds of years of tradition and subsequent word-of-mouth also confirm the benefits of meditation—which not only leads to better investment results, but a happier and healthier lifestyle.  Fortune Magazine also penned an article a few years ago describing the benefits of meditation in the business world.  Interestingly, the author of “Never Eat Alone” actually spends ten days each year at a silent meditation retreat.  As for myself, I try to meditate every morning right after I wake up.

With respect to the U.S. stock market, the technical conditions have continued to improve.  Both the Dow Industrials and the Dow Transports are sitting comfortably above their (upward trending) 200-day moving averages New highs vs. new lows on both the NYSE and NASDAQ are at their highest levels since late April.  The NYSE CSO McClellan Summation Index has been generally trending up since early July, and has matched the action on the NYSE Composite.  Lowry's proprietary Buying Power index is at a cyclical bull market high, while its Selling Pressure index is at a cyclical bull market low.  Despite this strong technical condition, our liquidity indicators are still weak—and thus isn't too supportive for a year-end rally, especially given the uncertainty surrounding the European sovereign debt crisis and Federal Reserve/Bank of Japan policy.  For example, the amount of “investable cash on the sidelines” versus the S&P 500's market cap – has continued to decline, as shown in the following chart:

Note that we have updated the numbers using the most updated numbers as of last Friday.  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 consistently hit new lows since February 2009.  The ratio bottomed at the end of April, with the ratio rising by 4.44% from the end of April to the end of August (from 32.29% to 36.73%).  However, with the best rally in a decade this month, this ratio has declined to 33.47% as last Friday.  Moreover, this ratio has come down too far, too fast, and is low compared to its readings over the last two years.  The reading of this liquidity indicator is thus not conducive to a year-end rally, but should the Dow Industrials, the Dow Transports, and the S&P 500 make new cyclical bull market highs, nearly every technical signal would turn bullish.  We would then need to reevaluate and think hard about shifting out 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 July 2007 to the present:

For the week ending September 24, 2010, the Dow Industrials rose 252.41 points, while the Dow Transports rose 81.35 points.  Both the Dow Industrials and the Dow Transports have risen above their early August highs and are decisively above their 200-day moving averages.  While the technical condition remains solid, subscribers should be concerned about “whipsaw risk,” as the market has been really volatile and “indecisive” over the last few months.  Combined with the  lack of bullish signals from our global liquidity indicators and the lingering default risks for Greek sovereign debt, the market action could remain indecisive until the end of the year.  That said, the technical condition is very bullish, and while we will remain 50% long in our DJIA Timing System, we will think hard about shifting to a 100% long position should the market make new cyclical bull market highs.

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 -6.8% to -2.8% for the week ending September 24, 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 1998 to the present week:

The four-week MA increased from a reading of -2.8% to 3.9%, and is now at its highest level since late May.  More importantly, while this sentiment indicator is relatively oversold, our liquidity indicators are not yet flashing bullish signals.  We will thus wait for a more oversold reading before shifting to a 100% long position in our DJIA Timing System, but should the market indices make new cyclical bull market highs, we would have to reevaluate and possibly go 100% long.  In the meantime, the action of the U.S. stock market will likely remain range-bound into the end of the year.

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 slightly from 110.3 to 111.6 last week, while the 50 DMA increased from 107.6 to 109.1.  The 20 DMA rose above its 50 DMA two weeks ago, suggesting that ISE Sentiment is again in an uptrend.  While this is normally a bullish signal, subscribers should keep in mind that this sentiment indicator and the markets have been prone to whipsaw over the last several months.  Moreover, since our liquidity indicators are not flashing bullish signals, the market will likely be mired in a consolidation period into the end of the year.  Nevertheless, should the major indices make cyclical bull market highs, we will likely have to respect the technical signal and shift from a 50% long position to a 100% long position in our DJIA Timing System.

Conclusion: Know Thyself.  This is the key to happiness and finding one's true purpose in life.  Too many people wander around life aimlessly—switching from relationship to relationship, job to job, and trying to compensate this void through material pursuits or the accumulation of wealth.  Wandering around life aimlessly—and trying to invest at the same time—is also detrimental to one's pocketbook.  To succeed in long-term investing, one must know thyself, or better yet, have the ability to control one's negative emotions through daily meditation.   Achieving a state of just “being” not only results in more clarity and concentration, but also allows one to engage in “higher thoughts”—such as thinking about the implications of the commercialization of quantum computing, as we discussed in last week's commentary.

As for the stock market, we remain on a wait-and-see approach in terms of our DJIA Timing System given the challenging liquidity conditions.  However, should the major indices make new cyclical bull market highs; we will likely honor the bullish technical signal and shift from a 50% long position to a 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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