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A Final DJIA Timing System Update

(January 31, 2012)

Dear Subscribers and Readers,

I apologize for the tardy commentary. I wanted to publish this after Monday's trading—specifically to gauge the strength (or the lack thereof) Portuguese sovereign debt, as well as the latest Fed's Senior Loan Survey. The latter continues to be a pillar of strength of the US economy, showing a significant rebound in borrowing among US corporations (and among small businesses in particular). This signals that US economic strength should be resilient at least in the first half of the year. That said, the ongoing rise in Portuguese yields is a source of concern, especially if the Greek debt talks drag on. Combined with the overbought conditions in the stock market and our sentiment indicators, I would not be surprised if the market embarks on a correction soon.

Before we continue our commentary, I want to update our DJIA Timing System's performance to December 31, 2011.  Note that subscribers could independently calculate our historical performance by tallying up all our signals going back to the inception (August 18, 2004) of our system (we send our subscribers real-time emails whenever there is a new signal).  Without further ado, following is a table showing annualized returns (price only, i.e. excluding dividends), annualized volatility, and the Sharpe Ratios for our DJIA Timing System vs. the Dow Industrials from inception to December 31, 2011:

Our DJIA Timing System was created as a tool to communicate our position and thoughts on the stock market in a concise manner.  We chose the Dow Industrials as the benchmark (even though all institutional investors use the S&P 500 or the Russell 1000), since most of the investing public around the world have historically recognized the DJIA as “the benchmark” for the American stock market.  In addition, the Dow Industrials has a rich history going back to 1896, while the S&P 500 was created in 1957 (although it was reconstructed back to 1926).

Looking at our performance since inception, it is clear that a significant portion of our outperformance since inception was due to our positioning in 2007 and the first half of 2008 – when we chose to go neutral (from our 100% long position) in our DJIA Timing System on May 8, 2007, and when we decided to shift to a 50% short position on October 4, 2007 at a DJIA print of 13,956 (which we subsequently closed out on January 9, 2008).  While we stayed on the long side for the most part from mid-January 2008 to April 2010, we also made a couple of timely tactical moves during the May to June 2008 period – which gave our DJIA Timing System nearly 5% in outperformance during that period.  Looking at the last three years, our 25% additional long position that we bought on February 24, 2009 (and which we exited on June 8th) provided about 4% in absolute outperformance, although that resulted in slightly higher volatility (since we were 125% long).  In the last two years, however, we underperformed significantly, given our decision to sit in 100% cash for the entirety of 2011.  On a risk-adjusted basis (Sharpe Ratio), however, we still outperformed (assuming a 3.8% risk-free rate), with a two-year annualized Sharpe Ratio of 0.33, versus the DJIA's 0.24. Finally, our 3-year annualized performance of +11.51% is also ahead of that of the Dow Jones Credit Suisse CoreHedge Fund Index (+4.23%).

Subscribers should keep in mind that our goal is to beat the Dow Industrials by a significant margin over a market cycle with lower volatility.  Subscribers should note that on a cumulative basis, we are ahead of the Dow Industrials by about 13% since the inception of our DJIA Timing System on August 18, 2004, returning 34.16% vs. 21.17% for the Dow Industrials (on a price-only basis).  Our goal is to beat the stock market with less risk over the long run, and so far, we have done that. 

Subscribers should remember that:

  1. It is the major movements that count.  Active trading–for the most part–only enrich your brokers and is generally a waste of time – time that could otherwise be spent researching individual stocks or industries;
  2. Capital preservation during times of excesses is the key to outperforming the stock market over the long run.  That being said, selling all your equity holdings or shorting the stock market for a sustained period is not something I would advocate very often, given the tremendous amount of global economic growth that will inevitably come back in the next innovation cycle. 

Given our tendency to sit in cash during sustained times of market excesses; our Sharpe Ratio readings have been market beating across all periods.  That said, we regretted our decision to not go 50% or 100% long during the recent market correction last September. At the time, we were worried about a potential “Black Swan” event due to the evolving European Sovereign Debt Crisis. The market has proved more resilient than we thought, especially after the ECB made a further commitment to provide unlimited funds to Euro Zone banks over a three-year time period. Again, while Portugal could be a burden on the market in the short-run (especially given the market's overbought conditions), I believe the market will decisively pierce the 13,000 level over the next several months. The European Sovereign Debt Crisis hasn't been resolved, but we may not experience the effects of it until later this year.

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 January 27, 2012, the Dow Industrials declined 48.36 points, while the Dow Transports rose 103.84 points.  Last Thursday, the Dow Industrials made a fresh nine-month high, while the Dow Transports made another new six-month high. Note that the Dow Transports is on the verge of making an all-time high.  With the Greek debt talks making decent progress, and with the Fed committed to a more dovish policy (near-zero Fed Funds until 2014; and potential QE3 later this year, it is likely that the Dow Industrials will surpass the 13,000 level decisively over the next several months. We remain bullish on US and US financial stocks, but given that we are dissolving the end of February, we will not make any more moves in our DJIA Timing System.

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 19.7% to 22.7% for the week ending January 27, 2012.  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:

Since hitting a multi-year low of -11.3% in early October, the four-week MA has surged by a whopping 34.0%. The four-week MA is now at its most overbought level since March 2011. As such, we would not be surprised if the market corrects over the next couple of weeks. That said, it is still at a neutral level in the long-run  With the European Sovereign Debt Crisis on the backburner—and combined with cheap US$ swap lines, a dovish Fed, and the resilience of the US economy—we continue to look for a rally in US stocks and US financial stocks over the next several months.

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:

Ever since breaking 100 in mid-December, the 20 DMA has been on an upward tear. The 20 DMA finally corrected last week, however, declining from 123.9 to 118.0. This pullback was much-needed as this indicator was getting very overbought in the short-run. That said, the 20 DMA remains overbought on a short-term basis—hence, the market will likely correct over the next couple of weeks. Over the next several months, we remain bullish on US stocks and US financial stocks.

Conclusion: With the Fed's Senior Loan Survey showing significant credit demand among US corporations, and with bank lending showing signs of life, I believe the US will experience decent GDP growth this year (over 3%). That said, the European Sovereign Debt Crisis remains in flux, as exemplified by the ongoing spike in Portuguese sovereign debt yields. Our base line scenario suggests a market correction soon (probably triggered by fears over a Portuguese default); then a market rally from starting mid- to late February and extending into early Fall. Whether the European Sovereign Debt Crisis comes back to haunt us later this year will depend on policy makers' actions over the next several months.

Signing off,

Henry To, CFA, CAIA

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