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Eyes Still on Europe

(October 23, 2011)

Dear Subscribers and Readers,

Let's 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.

I have to admit—I did not foresee the rally over the last four weeks, despite the severely oversold conditions in our sentiment indicators (including the NAAIM survey).  One major reason (aside from our weak liquidity and technical indicators) has been the lack of resolution to the European Sovereign Debt Crisis.  This is not a trivial matter.  For example, the French 10-year OAT to German Bund spread hit a 20-year high of 114 bps early last week, partly because of Moody's threat to downgrade France's AAA rating.  Despite massive purchases of European sovereign debt by the ECB totaling €165 billion, both Spanish and Italian spreads remain high.  The time has come for a comprehensive solution to the European Sovereign Debt Crisis.  As I am penning this commentary, however, the only agreement is a forced €100 to €150 billion recapitalization of the region's banks and a larger-than-expected haircut to Greek debt—hardly sufficient to resolve a crisis that has been brewing for the last couple of years.  Failure to find a systemic solution over the next several days (see calendar below, courtesy of Goldman Sachs) could lead to a systemic crisis—at the very least a widening of spreads in France, Italy, and Spain—leading to a recession in the Euro Zone.  A recession in the Euro Zone would have global implications—most likely, it would tip the U.S. into recession as well.  Please keep in mind, however, that a systemic crisis in the Euro Zone, and/or a U.S. recession is not our base case scenario.

Note that early November contains three key dates—namely, the transition of the ECB leadership from Trichet to Mario Draghi on November 1st, the ECB rate decision on November 3rd, and the G-20 Summit from November 3rd to 4th.  While I don't expect a leadership style change, I do expect the new President of the ECB to reassure the markets by adopting a stronger stance—such as more purchases of European sovereign debt or an immediate rate cut on November 3rd.  Note that the ECB still has significant firepower to support the sovereign debt market and cap yields across the region; but ultimately, stronger leadership from Germany and/or the G-20 countries would need to emerge to resolve the crisis and to prevent a European recession.  Should we shift to a long position in our DJIA Timing System (or to purchase U.S. financial stocks for my personal portfolio), my sense is that we will do so immediately before the ECB rate decision/G-20 summit on November 3rd.

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 October 21, 2011, the Dow Industrials rose 164.30 points, while the Dow Transports rose 122.37 points.  Over the last four weeks, the Dow Industrials has risen a whopping 1,037.31 points (9.5%), and the Dow Transports 595.06 points (14.2%).  Despite stronger-than-expected earnings and the prior oversold conditions a month ago, the four-week rally has come too far, too fast.  We did not foresee such a tremendous rally, especially since no solid solutions to the European Sovereign Debt Crisis have yet arisen from the latest EU Summit.  Since our liquidity indicators and technical indicators remain weak, we anticipate a correction over the next several weeks.  We believe the Dow Industrials will at least revisit the sub-11,000 level.  Given our severely oversold sentiment indicators, we may initiate a 50% long position should the Dow Industrials fall below 11,000.

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 bounced from -10.0% to -7.9% for the week ending October 21, 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 bounced from a severely oversold level over the last two weeks, but remains near its lows during last summer's correction.  Moreover, the ten-week MA (not shown) declined to a new low, hitting its most oversold level since early September last year.  As such, we may initiate a 50% long position in our DJIA Timing System, but only should the Dow Industrials fall below the 11,000 level again.

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:

Both the 20 DMA and the 50 DMA decreased slightly last week.  Last week's decline notwithstanding, both the 20 DMA and the 50 DMA have likely reversed from historically oversold levels from two weeks ago.  In general, a reversal from a historically oversold level has significant bullish implications from a sentiment standpoint.  Coupled with bullish confirmations from our other sentiment indicators, my sense is that the U.S. stock market has already hit its lows three weeks ago.  However, given the significant volatility, we will refrain from initiating a 50% long position until the Dow Industrials decline to 11,000 or below.

Conclusion: The European Sovereign Debt Crisis is now approaching its 11th hour.  Whether this could be effectively resolved—i.e. to avert a systemic crisis or a European recession—depends ultimately on German leadership and/or the G-20 summit on November 3/4. In the meantime, the ECB will likely continue to support the European Sovereign Debt market through outright purchases of Italian and Spanish sovereign bonds and its existing repo operations.  I expect a buying opportunity in U.S. equities and U.S. financial stocks sometime over the next couple of weeks—but subscribers should note that the situation remains highly in flux.  We remain neutral in our DJIA Timing System; but may initiate a 50% long position should the Dow Industrials fall below the 11,000 level.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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