Printer Friendly

eMail Article

June 21, 2007

Market Internals Weakening
by Henry To

Dear Subscribers,

I hope all the fathers in this world had a great Father's Day Weekend. Before we go on with our commentary, I want to welcome subscribers of Mr. David Korn's BeingInvesting.com weekly e-newsletter. Mr. Korn provides a newsletter that includes his summary and interpretation of Bob Brinker's Moneytalk, as well as his own model newsletter portfolio and discussion of all things related to personal finance. Mr. Korn has graciously asked me to be a guest columnist on his newsletter this weekend (and which I am honored to be). As a result, this weekly commentary will be slightly longer than usual since I want to summarize many things that I have written in the past on why the current rally in weakening. Not only will this be a useful service for David's subscribers, I also believe that this will be a useful exercise for my subscribers as well. To justify why the stock market is now vulnerable to a correction (although I have to stress that we don't believe the cyclical bull market will or has ended yet), I will discuss things such as the Dow Theory, our most popular breadth indicators, as well as the concept deteriorating liquidity all around the world today.

As an aside, David and I (along with Kirk Lindstrom of Investment.suite101.com) are co-editors of a relatively new newsletter called "The Retirement Advisor." The Retirement Advisor was created to help individuals who are approaching or in retirement. Our philosophy is based on leading a comfortable and hassle-free retirement through prudent asset allocation and capital preservation. In this day and age, there are not many subscriptions that can fulfill that role - not the permabulls, permabears, or the majority of anyone in between. For those who are interested, you can read the inaugural issue of The Retirement Advisor right here. So far, six issues, including our latest June 2007 issue, has been published.

Now, let us continue our commentary. First of all, following is an update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on June 17th, we are neutral in our DJIA Timing System (subscribers who want to go back and review our historical signals can do so at the following link). While it would have worked out well if we had continued to hold our long position since May 8th, we decided to exit our position at that time since there were many signs - including most of our valuation, sentiment, and liquidity indicators - that the rally was getting tired. We continue to stand by this position. However, we currently do not plan to go short in our DJIA Timing System - at least not until/unless the Dow Industrials manage to rally to the 13,800 to 14,200 area. At that time, we will reconsider. Again, while equities still remain relatively cheap (as measured via valuations since 1994), readers should keep in mind that on a relative basis (especially in relation to U.S. bonds), U.S. equities are now at its most expensive level since May 2006, despite the correction we witnessed the week before last. Combined with the liquidity headwinds that we have previously discussed, stocks are definitely not too attractive at this point, especially as the Yen carry trade is now very stretched by any measure and as the world's major central banks are still in a tightening phase. Because of these reasons, we have chosen to get out of our 100% long position in our DJIA Timing System on May 8th.

In last weekend's commentary, I stated that the correction during the week before last wasn't significant enough for a tradable or buyable bottom, despite the Lowry's 90% downside day on June 7th, and despite the fact the same day was accompanied by these two conditions:

1. Declining volume on the New York Stock Exchange made up 92.5% of the sum of NYSE Advancing + Declining Volume

2. Declining issues on the NYSE made up 90% of the sum of NYSE Advancing + Declining Volume

Even though the market has typically bottomed on the same day during the seven times this has occurred since January 1987 (with the exception of October 16, 1987, when the market followed up with a crash on Black Monday, October 19th), there were other signs that the market did not become oversold enough to warrant a buyable or tradable rally going forward. These include the fact that the average daily decline during those seven instances was 8.2%, while the decline on June 7th was a mere 1.5%. Even if one removed Black Monday from our sample, the average decline was 5.8%, still nearly four times the magnitude of the decline on June 7th. Moreover, the Dow Industrials was still sitting at 2.4% above its 50-day and 8.3% above its 200-day moving average. The 8.3% reading, in particular, told us that the market is actually closer to an overbought rather than an oversold level. Moreover, this compares unfavorably with the late February to mid March decline earlier this year, when the Dow Industrials corrected to a level that was approximately 4% below its 50-day and 2% above its 200-day moving averages before continuing its rally.

In order to further compound our argument, I want to show you an additional table. For our subscribers who have been keeping track, you may realize that the bull market we have experienced since October 2002 has been one of the biggest bull markets for small and mid caps alike. Moreover, this bull market in small and mid caps has been accompanied by an unprecedented rally in many sectors that were previously very cyclical, such as materials, mining, and the utilities sector. Put another way, the bull market we had experienced since October 2002 had been unprecedented in nature - in that many stocks which don't usually have a positive correlation with the S&P 500 (such as mining and energy) all rallied at the same time. This was obvious in the impressive breadth numbers we have seen since October 2002 - and is also obvious in the fact that many mutual fund managers who have previously been able to outperform the market (such as Longleaf and Wasatch) no longer could, as the strategy of buying the best growth stocks no longer worked, since everything was going up at the same time.

However, nothing is new under the sun when it comes to the stock market. While this bull market is somewhat unique, it is not unprecedented. The last time the U.S. stock market had experienced such positive breadth numbers (accompanied by a bull market in small and mid caps) was during the June 1949 to January 1953 bull market, and prior to that, the April 1942 to May 1946 bull market. During the subsequent bear markets of those periods, they were accompanied by many days that fit the above criteria, as similar to the action of the previous bull market when all stocks rose at the same time, all stocks declined at the same time in the subsequent bear markets - thus causing extreme downside breadth numbers which did not result in very oversold conditions. Following is a table showing similar downside days (to the June 7th downside day) during those two subsequent bear markets:

Interestingly, there were eight such downside days (compared to only eight over the last 20 years) during the May 1946 to October 1946 bear market. After the first such downside day, the Dow Industrials proceeded to decline another 16% before bottoming four months later. Similarly, there was five such downside days during the January 1953 to September 1953 bear market, with the Dow Industrials declining another 7% or so after the first such downside day before bottoming five months later.

In other words, while the June 7th decline was definitely a significant downside day in terms of both volume and breadth, this does not mean the market has become extremely oversold just because of that one-day decline. In fact, based on the 1946 and 1953 bear market experience, the stock market can experience many such downside days before bottoming, and this is especially so given the extreme upside breadth we have witnessed since the October 2002 bottom - upside breadth which was only rivaled by the April 1942 to May 1946 and the June 1949 to January 1953 bull market.

As an aside, it is also interesting to see that the ultimate bottom in these two bear markets were immediately preceded by back-to-back 92.5% declining volume and 90% declining issues days (September 12, 1953 was a Saturday). Should we ever get such back-to-back declines in any upcoming bear market, then it may actually be a great time to buy and leveraged yourself on the long side.

Speaking of breadth indicators, I now want to give our subscribers an update on the McClellan Oscillator and the McClellan Summation Index. As explained in our "Education page," both the McClellan Oscillator and the Summation Index can be used either as a breadth or as an overbought/oversold indicator. More specifically, when the McClellan Oscillator is positive, then it means there is new money coming into the market - with the magnitude of the McClellan Oscillator determining the amount of money coming into or leaving the market. Meanwhile, the level of the McClellan Summation Index is obtained by summing up the daily values of the McClellan Oscillator. By eyeballing the Summation Index, we easily see the cumulative effects of the McClellan Oscillator - and is therefore a great indicator of stock market breadth. For our purposes, we will review the McClellan Oscillator and Summation Index for only the common stocks (this removes the fixed income funds, the close-end funds, and the ADRs) that are traded on the New York Stock Exchange. Following is a three-year chart showing the NYSE Composite Index vs. the NYSE Common Stock Only McClellan Oscillator and Summation Index, courtesy of Decisionpoint.com:

As mentioned on the above chart, a weakening McClellan Oscillator and Summation Index is a sign of deteriorating breadth and is typically a precursor for a correction in the stock market. The McClellan Summation Index was instrumental in "calling" for a significant correction during May of last year - as well as the most recent corrections of April 2005 and October 2005. More ominously, the NYSE Common Stock Only McClellan Summation Index made a lower high coming off of the late February to mid March correction (even as the major indices continued to make all-time highs) - and has since continued its deterioration even though the NYSE Composite, the Dow Industrials, and the S&P 500 are testing their all-time highs. Make no mistake: The internals of the market has greatly deteriorated, and it will take a very strong rally going forward in order to get it fixed. Odds are against this, however, given the fact that (as I have mentioned before) the market never really got that oversold in the first place.

Moreover, it is unlikely that the internals of the stock market can greatly improve in the coming weeks, as stock market liquidity has historically tended to deteriorate during the summer. In addition, given the recent rise in long-term yields, private equity investors (whom collectively have been a huge liquidity supplier for the stock market over the last couple of years) are now - for the first time - encountering more scrutiny in both borrowing terms and in many deals in general. Make no mistake: The current borrowing environment for private equity investors, mortgage borrowers, and even credit card holders will continue to get tighter in the months ahead, as the major Central Banks around the world continue with their current hiking cycles - including the European Central Bank, the Bank of England, the People's Bank of China, the Bank of Japan, and the Swiss National Bank. Moreover, as I mentioned in our commentary from two weeks ago, one of our primary indicators of U.S. liquidity, the MEM indicator, has continued to deteriorate and is now at its weakest level since January 2002. Since that time, our MEM indicator has continued to make new lows, as the Federal Reserve has continued to take liquidity out of the financial markets (via the St. Louis Adjusted Monetary Base) while commercial banks and hedge funds continued their Herculean efforts in multiplying the money supply.

Of course, this huge dichotomy isn't possible without some kind of external aid. Given that we are now in a globalized world, it makes logical sense that the power of the Fed will continue to weaken going forward, and we are witnessing such a case now - as the continued surge in liquidity over the last couple of years has, for the most part, been aided by both the Yen carry trade and the Swiss carry trade. Folks who want to get a refresher of how big the Yen carry trade can go back and read our June 3, 2007 commentary ("Liquidity and the Yen Carry Trade Redux") - but over the last week, the Yen carry trade has continued to get more overstretched, as can be witnessed by the following chart showing the Euro-Yen cross rate and its percentage deviation from its 200-day moving average:

Note that the Euro-Yen cross rate rose to another all-time high last Friday. Moreover, the Euro-Yen cross rate's deviation from its 200-day moving average - after briefly declining to the zero line in early March, has recovered strong and has been vacillating between 4% to 6.5% since early April (it is currently at 5.96% above its 200 DMA). No doubt, the Euro-Yen cross rate is now overbought and can correct at any time - especially given that the Yen carry trade is now overwhelmingly dominated by Japanese retail investors (who have historically had very bad timing).

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.

Copyright © 2005-2008 MarketThoughts.com

Image rendition and html coding Copyright © 2000-2008 SafeHaven.com

« BullionVault.com -- Buy gold online - quickly, safely and at low prices »
« Honest Money: A History of U.S. Gold & Silver Currency -- by Douglas V. Gnazzo »

« Opinions expressed at SafeHaven are those of the individual authors and do not necessarily represent the opinion of SafeHaven or its management. Articles are available via RSS/XML. Please visit RSSHelp for instructions. »