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Market Technical Updates

(May 19, 2011)

Dear Subscribers and Readers,

As we have covered numerous times, the market's technical conditions are at their weakest levels since the cyclical bull market began in March 2009.  One such indicator is the number of new 52-week highs vs. 52-week lows on the NYSE (common stock only), as shown in the following chart, courtesy of Decisionpoint.com:

As shown in the above chart, the 10-day moving average of the NYSE CSO 52-week high-low differential hasn't come close to hitting a new high since October of last year, despite new highs in the major market indices.  Another technical indicator that has been weakening is the NYSE CSO McClellan Summation Index, as shown in the following chart (again, courtesy of Decisionpoint.com):

Similar to the 10-day moving average of the NYSE CSO High-Low Differential ratio, the NYSE CSO McClellan Summation index hasn't come close to a new high since last year.  In fact, this indicator shows even more weakness—as it hasn't come close to a new high since April of last year (instead of October).

Fortunately for the bulls, there's no evidence suggesting an imminent decline, despite weakening liquidity and technical indicators.  In fact, the broader market can continue to rise even as technical conditions deteriorate further.  Moreover, other technical indicators, such as the NYSE CSO Advance/Decline Line, are still showing relative strength.  Furthermore, as we discussed in last weekend's commentary, our sentiment indicators are still at semi-oversold to neutral level.  For example, the 10-day moving average of the equity put/call ratio just hit 0.67, its highest level since mid-March this year.  Until these sentiment indicators get more overbought, I would stay away from shorting the stock market.

Finally—our valuation indicators still don't suggest an imminent correction.  This is exemplified by Morningstar's aggregate valuation, a 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 close to fair value, as suggested by its current ratio of 1.01 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”).  Note that 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.  Moreover, as shown in the following chart, courtesy of Morningstar, this ratio is still about 6% below where it was right before the market had its last major correction starting late April 2010:

Morningstar's proprietary valuation indicator suggests that the stock market is close to fair value.  More important, subscribers should note that – given the trend of corporate earnings over the last two years – 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 stretched, especially given the recent rise in inflationary expectations and the still-unresolved European sovereign debt crisis.  In other words, Morningstar's proprietary valuation indicator suggests that while a correction isn't imminent, there may be more-than-expected downside once the market does correct.  However, there is still some upside in the short-run—I would not be surprised if the market rallies another 5% to 7% before experiencing a major correction.  Should the Dow Industrials rally to the 13,250 to 13,500 level, we will likely go 50% short in our DJIA Timing System.

Signing off,

Henry To, CFA, CAIA

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