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Investor Sentiment Stubbornly Optimistic

(July 31, 2011)

Dear Subscribers and Readers,

Let us now 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 various overbought conditions, weak liquidity and technical indicators, the festering European Sovereign Debt Crisis, 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 the end of last week, our sentiment indicators (with the exception of the ISE Sentiment index) remain stubbornly bullish (which is bearish from a contrarian standpoint), despite the decline last week.  As I am penning this commentary, S&P futures are up nearly 20 points—suggesting an imminent rally Monday morning.  As our stubbornly bullish sentiment indicators suggest, however, such a rally could be short-lived—as the dearth of leadership in Washington and around the world (EU and Japan) is now obvious for all to see.  Let's first look at the U.S. equity put/call ratio (following chart is courtesy of

Note that while the 10-day moving average of the U.S. equity put/call ratio hit a high of 0.90 in late June (most oversold level since January 2009)—today it merely sits at 0.64, despite last week's 538-point decline in the Dow Industrials.  With positive earnings surprises outnumbering negative surprises through the first half of “earnings season,” investors have simply gotten too complacent, despite the global economic slowdown and the still-festering European Sovereign Debt Crisis.  Another sentiment indicator (which we first covered last August) suggesting overly bullish sentiment is evident 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.  While NAAIM equity exposure hasn't been at the 80% level since April, its current level of 62.70% is still stubbornly high—at least relative to the mid-20s readings during the most recent bottom in late June.  With the equity put/call ratio and the NAAIM equity exposure stubbornly high, and with our liquidity and technical indicators still weak, the U.S. stock market will likely remain tough this summer, despite the late-night rally in S&P futures.

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 July 29, 2011, the Dow Industrials declined 537.92 points, while the Dow Transports declined 244.19 points.  Since hitting an all-time high in early July, the Dow Transports has declined a whopping 7.7%.  However, both Dow indices are still near their late June lows, and are still not oversold.  Combined with our weak liquidity and technical indicators, the festering European sovereign debt crisis, and the stubbornly optimistic investors sentiment, the market action is likely to remain tough this summer. We remain neutral in our DJIA Timing System as we take a wait-and-see approach.

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 15.3% to 17.3% for the week ending July 29, 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 2000 to the present:

After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA declined to 3.5% four weeks ago—near its most oversold level since mid-September last year. Despite this oversold reading, and especially in light of the bounce to 17.3% over the last four weeks, this indicator was and is nowhere as oversold as it was during last summer's correction.  We will retain our neutral position in our DJIA Timing System, as we believe the market will remain tough this summer.

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.  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:

Since declining to a new recent low of 97.6 two weeks ago (its most oversold level since late July 2010), the 20 DMA has bounced to 109.5.  Meanwhile, the 50 DMA also declined to a new low two weeks ago, and has bounced slightly, and is still near its most oversold level since early August 2010.  Both the 20 DMA and 50 DMA remain very oversold.  However, while this indicator's oversold conditions suggest the market could stage a rally, the fact that our other sentiment indicators is not as oversold is troubling—and suggests caution is warranted, especially given the weak liquidity and technical conditions.  We will remain neutral in our DJIA Timing System and will take a wait-and-see approach.

Conclusion: The raising of the U.S. debt ceiling notwithstanding, the most recent debt crisis in both the U.S. and Europe has made the lack of leadership at the highest levels in government abundantly clear.  For Japan, the lack of leadership is manifested in the weak response to the March 11 earthquake and the still-rolling blackouts.  The contagion effects of the European Sovereign Debt Crisis remains strong.  In the meantime, the overly bullish sentiment, despite the 538-point decline in the Dow Industrials last week, suggests the U.S. stock market hasn't made a sustainable bottom, and will likely remain in a consolidation period this summer.  I also believe that both the Euro and the Yen are unattractive relative to the U.S. Dollar.  We remain neutral in our DJIA Timing System, for now.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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