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DJIA Timing System Now Completely Neutral

(December 19, 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;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

As discussed in a real-time “Special Alert” email to our subscribers last Wednesday, we shifted from a 50% long position to a completely neutral position in our DJIA Timing System at a DJIA print of 11,487.  As discussed in our previous commentaries, the market is due for a correction given the overbought conditions and the overly bullish sentiment as exhibited by our sentiment indicators and others such as the equity put/call ratio, the VIX, etc.  As of last Friday, the equity put/call ratio stood at 0.48—its lowest level since late April 2010 (right before the last major correction).  Similarly, the VIX closed at 16.11 last Friday—also its lowest level since late April 2010.  Another indicator suggesting an imminent correction could be witnessed in the below chart (courtesy of Decisionpoint.com), 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 (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 74.74%, and with our technical and sentiment indicators at highly overbought levels, the U.S. stock market is definitely highly vulnerable to a correction.  This is why we shifted to a completely neutral position in our DJIA Timing System, even though the cyclical bull market that began in early March 2009 remains intact.

Aside from technical and sentiment indicators, another indicator that directly affects stock prices is the amount of U.S. and global liquidity.  I will now provide an update on one of our main U.S. liquidity indicators for the stock market.  This indicator, the amount of “investable cash on the sidelines” versus the S&P 500's market cap also suggests a near-term correction, 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 more subsequent strength in the market, this ratio has declined to just 30.91% 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 also confirms the high probability of a stock market correction.

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 December 17, 2010, the Dow Industrials rose 81.59 points, while the Dow Transports declined 48.06 points.  Interestingly, the new cyclical bull market high in the Dow Industrials was not confirmed by the Dow Transports, as the latter actually experienced a decline last week.  Given this non-confirmation (per the Dow Theory), and with the global liquidity environment still challenged (how it transpires will depend on what unfolds in Europe), I expect the market to an imminent correction in the stock market. For now, we will remain completely neutral in our DJIA Timing System, although the cyclical bull market that began in early March 2009 remains intact.

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 four-week moving average of these sentiment indicators increased from a reading of 21.1% to 23.5% for the week ending December 17, 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 again from a reading of 21.1% to 23.5% 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, the ten-week MA (not shown) rose to 21.0%, and is also at its highest level since early November 2007.  With our liquidity indicators remaining bearish—and with the potential for a “black swan” event in Europe—I expect the U.S. stock market to correction starting very soon..  We will retain our neutral position in our DJIA Timing System.

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 again spiked higher last week from 134.0 to 141.4, as the ISE Sentiment Index registered continued to register higher-than-usual readings.  The 20 DMA is now at its most overbought level since early November 2997.  Meanwhile the 50 DMA increased from 127.8 to 130.9.  With both the 20 DMA and 50 DMA at highly overbought levels (relative to their readings over the last three years), and combined with the bullishness in our other sentiment indicators as well as the challenging global liquidity conditions, the probability of a market correction is now very high.  We will remain neutral in our DJIA Timing System.

Conclusion: Based on our technical, sentiment (including the NAAIM net equity exposure indicator), and liquidity indicators, the probability of a market correction has risen again in the latest week.  Just as important, the European sovereign debt crisis remains “in play,” and should continue to do so unless some dramatic action is taken by Germany or the European Central Bank  It is difficult to see how the PIIGS countries could “grow out of their problems” given their low structural growth and given their horrible demographic situations (and generous pension systems).  I also believe that both the Euro and the Yen are still in confirmed downtrends.  We remain neutral in our DJIA Timing System and will take a wait-and-see approach until the markets get oversold again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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