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Sentiment Indicators Now Highly Oversold

(October 2, 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.

Since the beginning of the market correction three months ago, most of our sentiment indicators remain too stubbornly bullish.  That is, from a contrarian standpoint, it was not the time to buy stocks. This stubbornly bullish sentiment was also confirmed by another sentiment indicator (which we first covered in August 2010)—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 averaged to come up with the results (inception of the poll is 2006).  Last week's reading, however, finally put the NAAIM Sentiment survey into historically oversold territory, as shown in the following chart (courtesy of Decisionpoint.com):

As shown on the above 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.  Note that net equity exposure declined to just 4.18% last week--its lowest level since March 2009!  This is highly bullish from a contrarian standpoint.  With our other sentiment indicators (see below) and the NAAIM equity exposure now at highly or historically oversold levels, we are approaching a good buying opportunity for the U.S. stock market, despite our weak liquidity indicators and the ongoing European sovereign debt crisis.

I now want to address the recent decline in leverage within the stock market, as exemplified by the amount of margin debt outstanding.  Since the February 2009 bottom, total margin debt outstanding has increased by 55%, and has retraced about 50% of its peak-to-trough decline from July 2007 to February 2009. However, subscribers should note that margin debt outstanding has declined by 14% since its May 2011 peak.  During August, margin debt outstanding decreased by $35.7—standing at $308.9 billion:

 

No doubt margin debt outstanding plummeted again during September as the stock market stumbled again.  With both our sentiment indicators and the leverage within the U.S. stock market at or approaching highly oversold levels, we believe a buying opportunity is approaching.  As such, we will likely initiate a 50% long position in our DJIA Timing System should the market fall below its recent lows.

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 July 2008 to the present:

For the week ending September 30, 2011, the Dow Industrials rose 141.90 points, while the Dow Transports declined 29.40 points.  The daily volatility is still high, which is not surprising as investors remain skittish about the U.S. economic slowdown, the European Sovereign Debt Crisis, and other political risks.  The combination of our weak liquidity indicators, weak technical indicators, and the ongoing European sovereign debt crisis suggests the market action is likely to remain tough.  However, given our oversold sentiment indicators, we may initiate a 50% long position should the Dow Industrials fall below its recent lows—preferably to the 10,000 to 10,500 range.

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 declined from a reading of -6.4% to -9.6% for the week ending September 30, 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 2001 to the present:

The four-week MA declined made a new recent low last week—its most oversold level since July 2010.  That is, the four-week MA is now at a highly oversold level, despite the global economic slowdown, the market action, and the emereging political risks over the last several months  As such, while we will retain our neutral position in our DJIA Timing System for now, we may initiate a 50% long position in our DJIA Timing System should the Dow Industrials fall below its recent lows.

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:

The 20 DMA increased slightly from 91.3 to 91.5 last week, hovering near its most oversold level since mid-June 2010.  Meanwhile, the 50 DMA declined to a new low of 93.6—hitting its most oversold level since mid-April 2008!  Both the 20 DMA and 50 DMA remain at historically oversold levels.  More important, the oversold condition in this indicator is now confirmed by our other sentiment indicators—suggesting that market sentiment is now truly oversold.  Again, should the Dow Industrials fall below its recent lows, we may initiate a 50% long position in our DJIA Timing System.

Conclusion: As global investors and economists fear the return of a U.S. recession and a collapse in the Euro, investors' sentiment has now hit highly or historically oversold levels.  Sure, there is the potential for more “Black Swan” surprises as long as the European Sovereign Debt Crisis is allowed to run, but given the extremely high cash levels and cash flows of the S&P 500 components, we believe a buying opportunity is approaching.  We remain neutral in our DJIA Timing System; but we will likely initiate a 50% long position should the Dow Industrials fall below its recent lows—preferably to the 10,000 to 10,500 range.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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