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Still Not Supportive for a Rally

(November 14, 2010)

Dear Subscribers and Readers,

Let us now begin our commentary with a review of the 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 1,047.58 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

It is difficult for any bull market in equities to sustain itself if the balance sheets of the financial sector are impaired or if financial sector stocks fail to participate on the upside.  A good gauge of the latter is the AMEX Broker/Dealer Index (the XBD).  As mentioned in our commentaries over the last several weeks, we had been expecting a correction.  That correction finally came last week—as the major market indices embarked on their steepest weekly declines since mid-August.  More important, the XBD is still exhibiting significant relative weakness, as exemplified by the following week chart (bottom panel is the relative strength index of the XBD vs. the S&P 500) from January 2009 to the present:

Since peaking in early October, the relative strength of the XBD vs. the S&P 500 had been on a persistent downtrend—and in fact recently hit its lowest level since late March 2009.  While the XBD does not have to continue to make new highs to confirm the bull market in the major market indices (such as the S&P 500)—the fact that the XBD is still lower than its October 2009 level is definitely cause for concern!  This is all the more concerning given the ongoing European sovereign debt crisis—especially now that it has spread to Ireland.

Note that the state of U.S. banks' balance sheets and stock prices is directly related to the amount of U.S. and global liquidity.  I now want to provide an update on one of our main U.S. liquidity indicator for the stock market.  This indicator, the amount of “investable cash on the sidelines” versus the S&P 500's market cap remains unsupportive for a year-end rally, as it continues to make new lows (as shown in the following chart):

Note that we have updated the numbers as of Friday evening.  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 temporarily bottomed at the end of April, with the ratio rising by 4.47% from the end of April to the end of August (from 32.30% to 36.77%).  However, with the best rally in a decade in September, and with the further rally in October, this ratio has declined to 32.18% as of Friday evening.  More important, this ratio has come down too far, too fast, and remains low compared to its readings over the last two years.  As such, this liquidity indicator does not support a year-end rally.

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 November 12, 2010, the Dow Industrials declined 251.50 points, while the Dow Transports declined 116.57 points.  Last week's decline was the largest weekly decline since mid-August 2010.  With the market still relatively overbought, and with the lack of bullish signals stemming from our global liquidity indicators (and the fact that the market has already discounted the Fed's QE2 policy), the market action should at least be range-bound (or correct) into the end of this year.  For now, we will remain 50% long in our DJIA Timing System.

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 19.1% to 20.4% for the week ending November 12, 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 19.1% to 20.4% last week, and is now at its most overbought level since early November 2007—just a few weeks after the peak of the last bull market.  In addition, our liquidity indicators are no longer bullish, especially since the Fed's QE2 policy had been less than expected.  As a result, the action of the U.S. stock market will likely remain range-bound (or even correct) into the end of the year.  We will retain our 50% long position in our DJIA Timing System, for now. 

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 decreased from 121.1 to 119.6 last week, while the 50 DMA increased from 118.4 to 120.7.  The 20 DMA marginally declined below the 50 DMA last week—suggesting that bullish sentiment may now be in a downtrend.  Moreover, given the still-overbought condition in the market, as well as the challenging liquidity conditions, probability suggests the market will likely be mired in a consolidation period into the end of the year.  We will remain 50% long in our DJIA Timing System.

Conclusion: The correction that began last week promises to wreck more havoc to the market going into the end of the year—especially given the relative weakness in the AMEX Broker/Dealer Index, the challenging global liquidity conditions, and the ongoing European sovereign debt crisis.  I also believe that both the Euro and the Yen are now in confirmed downtrends.  With the Fed's QE2 program being smaller-than-expected, I also believe that the market will likely consolidate of correct going into the end of the year.  We are staying with our wait-and-see approach, and remain 50% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA


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