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Quick Sentiment and Liquidity Comments

(February 6, 2011)

Dear Subscribers and Readers,

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.

We shifted from a 50% long position to a completely neutral position in our DJIA Timing System on December 15, 2010 at a DJIA print of 11,487.  Since then, we have been looking for a correction given the overbought conditions, the negative divergences, and the overly bullish sentiment as exhibited by our sentiment indicators and others such as the equity put/call ratio, the VIX, etc.  Another sentiment indicator (which we first covered last August) suggesting an imminent correction 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 (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 82.13%, and with our technical and sentiment indicators still at highly overbought levels, the U.S. stock market is definitely highly vulnerable to a correction.  This is another reason why we shifted to a neutral position in our DJIA Timing System, even though the cyclical bull market that began in early March 2009 remains intact.

With the ongoing deflationary trend in Japan and with global liquidity still challenged, it seems like it's a matter of time before the Bank of Japan engages in significant monetary easing.  But the “tug of war” between the Bank of Japan and the government (in where the former has constantly accused the latter on spending on wasteful infrastructure) has resulted in a “non-activist” Japanese monetary policy.  In fact, the year-over-year increase in the Japanese monetary base was relatively low at 5.5% at the end of January 2011, as shown in the following chart:

For the Bank of Japan to lift the Japanese economy out of deflation mode and to “contribute” to global liquidity, it must engage in a more aggressive easing strategy, similar to its quantitative easing strategy it adopted in late 2001.  With year-over-year growth of just 5.5%, the Japanese monetary base must rise much further before we could be bullish on global equities (or bearish on the Yen), especially given the still-challenging liquidity conditions around the world (in addition to tightening by emerging markets' central banks).

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 in the following chart from January 2008 to the present:

For the week ending February 4, 2011, the Dow Industrials rose 268.45 points, while the Dow Transports rose 60.80 points.  In retrospect, the market wasn't ready to decline yet, but with the ongoing negative divergences in the Dow Transports (it's still lagging significantly the Dow Industrials), and the loss in momentum in small and mid-caps, etc., I expect the stock market to experience an imminent correction. 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 (finally) decreased from a reading of 28.7% to 27.3% for the week ending February 4, 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:

While this sentiment indicator has now declined two weeks in a row, subscribers should note that prior to this, it has risen for a consecutive eight weeks!  More important, the four-week MA remains very overbought, while the ten-week MA (not shown) rose for the 22nd consecutive week to 27.2%, and is at its highest level since early March 2007.  By any measure, both the stock market and investors' sentiment is remains highly overbought.  Combined with our bearish liquidity indicators, I expect the U.S. stock market to experience an imminent correction.  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 from 130.1 to 128.2 last week, while the 50 DMA increased from 133.3 to 135.1.  Note that the 20 DMA declined below the 50 DMA two weeks ago—suggesting that sentiment (and the stock market) is 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 overbought conditions in our other sentiment indicators, the challenging global liquidity conditions, and a slightly overvalued U.S. stock market, we believe the market will experience an imminent correction.

Conclusion: Since we shifted to a completely neutral position in our DJIA Timing System on December 15, 2010, the market has simply gotten more overbought, while breadth/volume and sentiment suggests that the rally was built on “shaky ground.”  The tepid rise in the Japanese monetary base is simply a reflection of the challenging global liquidity conditions.  With the exception of the Federal Reserve (which we believe should stop monetizing the U.S. budget deficit now that the U.S. economy is on a sustained recovery), all the world's central banks are either standing pat or tightening.  Moreover, both CMBS and ABS origination remains low—suggesting no imminent recovery in global liquidity just yet.   Combined with extremely bullish sentiment and a slightly overvalued market, we are short-term bearish on the U.S. stock market.  We remain neutral in our DJIA Timing System and will remain so until the market becomes oversold.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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