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Sentiment Indicators at Historically Oversold Levels

(October 9, 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.

Before we provide an update of our sentiment indicators (from last weekend's commentary), I want to divert our attention to liquidity in the Japanese market.  As discussed in previous commentaries in Japan, the Bank of Japan's monetary policy is still relatively tight after opening the liquidity spigots in the wake of the March 11th earthquake.  This is disappointing given the much-needed rebuilding in Japan (not to mention the lack of leadership in the rebuilding efforts) and the appreciation in the Japanese Yen.  From month-end August to month-end September 2011, the year-over-year change in the Japanese monetary base increased from 15.9% to 16.7%--but down significantly from 23.9% at the end of April.  The pullback in liquidity creation is evident in the following chart:

When April numbers were published, we reminded our subscribers that while the easing was encouraging, the Bank of Japan has tended to pull back its liquidity creation quickly after any exogenous shock.  This has again come true, given the declining growth in the Bank of Japan's monetary base.  Given all-around global tightening (we're still watching the European Sovereign Debt Crisis with interest—as no solid plans have been presented despite the promise of bank recapitalizations in the region), Japanese investors should continue to be cautious.  That said, Japanese shares are now severely oversold and undervalued.  As crazy as it sounds, overweighting Japanese equities (and U.S. large cap equities) once the market finds a sustainable bottom may be a good way to go!

Let's now discuss our sentiment indicators.  As mentioned in last weekend's commentary, since the beginning of the market correction three months ago, most of our sentiment indicators have remained stubbornly bullish.  From a contrarian standpoint, it was not the time to buy stocks. This stubbornly bullish sentiment was reaffirmed 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 survey 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).  The NAAIM readings over the last two weeks, however, finally put the 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 sank to 4.18% the week before last, and -3.56% last week!  This represents its lowest level since October 2008!  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.  In addition, short selling in all stock markets around the globe experienced its biggest increase since 2006; while short selling in the U.S. is at its highest level since 2009.  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 November 7, 2011, the Dow Industrials rose 189.74 points, while the Dow Transports rose 170.18 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.

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 -9.6% to -11.3% for the week ending November 7, 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 low last week, and is now more oversold than it was last summer.  Moreover, the ten-week MA (not shown) also declined to a new low, hitting its most oversold level since September last year.  As such, 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 decreased slightly from 91.5 to 90.9 last week, hovering near its most oversold level since mid-June 2010.  Meanwhile, the 50 DMA declined to a new low of 91.7—hitting its most oversold level since late March 2008!  Both the 20 DMA and 50 DMA remain at historically oversold levels.  More important, the oversold condition in this indicator is 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 continued to hit new oversold levels.  While there is still no solid plan to bail out Greece and the European banking system, the extremely high cash levels, cash flows, and short positions in the S&P 500 components are suggesting a buying opportunity is close at hand.  We remain neutral in our DJIA Timing System; but will likely initiate a 50% long position should the Dow Industrials fall below its recent lows.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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