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May 23, 2006

A Lowry's 90% Downside Day Revisited
by Henry To

Dear Subscribers,

This week, we are going to discuss the Lowry's 90% downside day (which occurred on Wednesday) and the possible implications. The last time we had such a discussion was way back in our July 6, 2004 commentary - the day that the NASDAQ had a 90% downside day as defined by Lowry's. In that commentary, I concluded: "A single 90% downside day like today may create an oversold situation in the short-term - one which would signal a temporary bottom - but with a number of intermediate term indicators (see below charts) still neutral or in an overbought situation, the chances of a bottom here is very low. In fact, today's 90% downside day could be a signal for further panic declines down the road."

In retrospect, "further panic declines" in the NASDAQ Composite is what we exactly got, as the index continued its decline over the next five weeks - declining from 1,963.43 on July 6, 2004 to 1,752.49 on August 12, 2006. The second part of my conclusion was as follows:

"The lack of an oversold situation is also reflected in the VIX (no spike so far despite today's decline) and the fact that the unweighted S&P 500 Index and the S&P 600 actually made a new all-time high as recently as last week. While there has been some decent selling on the NASDAQ, the amount of volume on the NYSE has been below average - which may be an indicator of potential further losses. In the intermediate term, however, the author remains bullish - as both my liquidity and psychological indicators remain favorable and still show no signs of deteriorating."

Except for another brief decline later in October 2004, the market eventually took off during the latter parts of the year and hardly looked back. In retrospect, the liquidity and psychological indicators helped me out dramatically - as using those indicators, it was "obvious" (well, as obvious as can be anyway) to me that the cyclical bull market that began in October 2002 wasn't over yet at that time. Today, the situation is different, as most of the world's central banks continue to tighten and as investors have slowly erased the memories of the 2000 to 2002 tech crash from their collective memories. Bottom line: The market is oversold in the very short-run, but probability suggests that the cyclical bull market which began in October 2002 is now over.

We switched from a 25% short position to a neutral position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,144.06), this position is 244.06 points in the red. We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 - giving us a gain of 89 points. We subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275.

We then further added a final 25% short position at a DJIA print of 11,610 on the early afternoon of May 9th. A special alert email was sent to our subscribers in real time - and a message was posted in our discussion forum alerting our subscribers of this change. Subscribers please note that a real-time "special alert" email was sent out on Wednesday morning informing you of a change in our DJIA Timing System from 100% short back to a 75% short position at a DJIA print of 11,255 - giving us a gain of 355 points of the final 25% short position that we at 10,610. As we have mentioned before, we were looking to bring our total short position in our DJIA Timing System back to a more "manageable" of 75% - and we got such an opportunity last Wednesday. Going forward, however, this author would have to say that the internal condition of the market hasn't look this bad since early 2003 - and probability suggests that the market will continue to be mired in a downtrend, even though a short-term bounce is now very much overdue.

Let's now review the implications of a Lowry's 90% downside day on the NYSE. As I have mentioned before, a 90% downside day occurs when both the declining volume and the number of downside points equal or exceed 90% of the total volume and the total number of points, respectively. A 90% downside day sometimes signals the beginning of a panic decline, or if the market is already oversold, further evidence of a very oversold market. Generally, a significant market bottom is preceded by two or more number of 90% downside days. A single 90% downside day like today may create an oversold situation in the short-term - one which would signal a temporary bottom - but with a number of intermediate term indicators (see below charts) still in a semi-oversold or neutral condition, the chances of a bottom here is very low. In fact - as Lowry's points out - in four of the last six bull markets since 1980 - a Lowry's 90% downside day has occurred anywhere from 5 to 15 days subsequent to a bull market top.

The occurrence of a 90% downside day on the NYSE has significantly increased the odds that the cyclical bull market which began in October 2002 has now topped out. Combined with the other negatives that I have discussed over the last couple of months (such as a classic Dow Theory non-confirmation of the Dow Transports by the Dow Industrials on the upside, the non-confirmation of the NYSE A/D line when the Dow Industrials made a new bull market high, continued tightening by the world's central banks, record money inflows into the most speculative sectors of the world, record leverage, and the many divergences such as in the U.S. brand name stocks, etc.) in this commentary, the odds that this cyclical bull market has already topped is almost a given. As a side note, subscribers can purchase Lowry's historical study (which won the 2002 coveted Charles H. Dow Award for excellence in technical analysis) of 90% upside and downside days at the following Lowry's page. This author highly recommends it.

Probability now favors a bounce in the short-term - given that the market is oversold, but there is no question that the market is now mired in an intermediate-term downtrend. The following three-year chart (courtesy of Decisionpoint.com) showing the NYSE McClellan Oscillator and the McClellan Summation Index tells the story:

As mentioned on the above chart, the daily NYSE McClellan Oscillator touched a very oversold level of negative 230 last Thursday - an oversold level which hasn't been since October of last year. This suggests at least a bounce in the very short-run. At the same time, however, the NYSE McClellan Summation Index (which is more of an intermediate technical indicator) is still only at 633.04 - which is nowhere close to the oversold levels we saw in either April or October of last year. To top it all off, the fact that the NYSE McClellan Summation Index has been making lower highs since the end of 2003 further suggests that this cyclical bull market is now in the midst of ending.

This "prediction" of the market can also be argued by the recent action in the NYSE ARMS Index. Following is a daily chart showing the 10-day and 21-day moving average of the NYSE ARMS Index vs. the Dow Industrials:

As outlined in the above chart, the 10-day moving average of the NYSE ARMS Index is now flashing an oversold reading of 1.240 - which is approximately where short-term bounces have occurred in the past. At the same time, the 10-day moving average is still not "fully oversold" yet (this would require a reading of 1.50 or higher). Given that the 21-day moving average is only at 1.074, chances are that there is further downside to go in the major market indices.

On a slightly different topic, this author would like nothing more than for the NYSE to release their margin debt data earlier. Now Henry, why do you say that? Well, the latest April margin debt data was released last Wednesday - a full 15 days after the end of the month. While this may not have posed a problem in "normal times," I bet readers will agree with me that the action of the last two weeks is definitely something that is "not normal." My guess is that the earlier release of the April margin debt data would definitely have induced more folks to get out before the latest decline. This becomes obvious when one takes a look at the following monthly chart showing the Wilshire 5000 vs. total margin debt vs. the margin debt to Wilshire 5000 ratio from January 1997 to April 2006:

As shown on the above chart, total margin debt of NYSE and NASD members (the latter is an estimated amount since NASD data isn't released until a month later - my point exactly) increased another $4.8 billion in April - after already having climbed a whopping $9.8 billion during March. More importantly, the margin debt to Wilshire 5000 ratio rose from 1.97 to 1.99 - a level not seen since November 2000 and which is actually higher than the ratio in January 2000 (the record high is 2.14 for the month of February 2000) - signaling that the leverage in the U.S. stock market is once again at a very dangerous level. Since the April data wasn't released until last Wednesday (the day of the 90% downside day), it was already too late for individual stock investors to get out based on the margin debt indicator.

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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