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Quick Comments on Valuation and Liquidity

(January 18, 2011)

Dear Subscribers and Readers,

With the exception of an ongoing rise in municipal bond yields (which we will discuss in next weekend's commentary) and Steve Jobs' second medical leave, there is little significant news to report.  As such, we will simply provide a quick update of our valuation and liquidity indicators—then follow up with fundamental analyses in next weekend's commentary.

Let us begin our commentary with a review of our 13 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.

Despite the ongoing rise in the major market indices, we still believe the market is ripe for a correction.  For example, the daily equity put-call ratio hit 0.37 last Friday—a low not seen since mid-April 2010 (right before the last major correction).  At the same time, the 10-day moving average of the equity put-call ratio hit 0.47—also a low not seen since mid-April 2010.  There also continues to be many negative divergences, such as lower highs in the percentage of NYSE stocks above their 50-day moving averages, and the number of new 52-week highs vs. 52-week lows on both the NYSE and the NASDAQ Composite.  Furthermore, the market is highly overbought—with the Dow Industrials now up seven weeks in a row.

Turning first to our liquidity indicator—while the amount of cash sitting on the sidelines (as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background) is still at a relatively decent level, it has declined very quickly since its peak at the end of February this year, as shown in the following chart:

Note that we have updated the numbers as of last 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 ongoing rally in stock prices, this ratio has declined to a new cyclical bull market low of 29.97% as of Friday evening.  More important, this ratio has come down too far, too fast, and is very low compared to its readings over the last two years.  This liquidity is now calling for a correction.

While valuations of the U.S. stock market are not overly high, I would say the stock market has gotten slightly ahead of itself in terms of valuations.  One valuation factor that I regularly track – Morningstar's aggregate valuation of its entire coverage universe of over 2,000 stocks (covered by the competent analysts at Morningstar) – is slightly overvalued, as suggested by its current ratio of 1.06 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”).  As shown in the following chart, courtesy of Morningstar, this ratio sank to as low as 0.55 on November 20, 2008 (this represented its all-time low since the inception of this indicator in mid-2001), and as high as 1.14 on December 31, 2004:

As mentioned, Morningstar's proprietary valuation indicator suggests that the stock market is slightly overvalued.  More important, subscribers should note that – given the trend of corporate earnings over the last 18 months – Morningstar's underlying growth assumptions in their discounted cash flow analyses have gotten more aggressive since the March 2009 bottom.  In addition, the weighted cost of capital has declined dramatically – suggesting that valuations may be a little bit stretched, especially given the recent rise in U.S. municipal bond yields and the still-unresolved European sovereign debt crisis.  In other words, Morningstar's proprietary valuation indicator provides further evidence that the market is now highly vulnerable to a (5% to 10%) 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 January 2008 to the present:

For the week ending January 14, 2011, the Dow Industrials rose 112.62 points, while the Dow Transports rose 49.85 points.  While both Dow indices made a cyclical bull market high (thus extending the life of the bull market), note that the Dow Industrials has risen seven weeks in a row and is thus highly overbought.  Combined with the challenging global liquidity environment, the ongoing troubles in the European Monetary Union and the stubborn increase in U.S. municipal bond yields, I expect an imminent correction in the stock market. We 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 28.8% to 30.2% for the week ending January 14, 2011.  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:

Note that the four-week MA increased for the seventh consecutive week from a reading of 28.8% to 30.2%—and has pierced above its October 2007 highs to its most overbought level since late February 2007 (right before a >500-point weekly decline in the Dow Industrials).  In addition, the ten-week MA (not shown) rose for the 19th consecutive week to 25.4%, and is at its highest level since early March 2007.  Combined with our bearish liquidity indicators—and with the potential for a “black swan” event in Europe—I expect the U.S. stock market to experience a correction 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 declined slightly 140.4 to 135.9, while the 50 DMA increased from 133.8 to 136.3.  Interestingly, the 20 DMA is now below the 50 DMA.  All else equal, this sentiment indicator (and the market) is now in a downtrend. Meanwhile, the ISE Sentiment Index remains at a heavily overbought level—in fact, at the peak in late December, the 20 DMA rose to its highest level since mid-July 2007.  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, the challenging global liquidity conditions, and a slightly overvalued U.S. stock market, we believe a market correction is imminent.

Conclusion: While we remain very optimistic on global economic growth in 2011, there is still cause for concern, namely, the European sovereign debt crisis, potential troubles in the Japanese bond market, an unforeseen spike in commodity prices, and a possible dislocation in the U.S. municipal bond market. It is difficult to see how the PIIGS countries could “grow out of their problems” given their low structural growth, horrible demographics, and overly generous pension systems.  We remain neutral in our DJIA Timing System and will remain so until the market becomes oversold again.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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