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Correction in Store for the Market

Dear Subscribers and Readers,

We switched from a 50% long position to a completely neutral position in our DJIA Timing System last Monday morning at DJIA 10,485. Over the next three to five months, I still don't believe the probability favors the bull's side - there's just too much bullish sentiment given the overbought condition in the markets, the slowing global economy, and high oil and copper prices. For now, we will remain neutral, but don't be surprised if we switch to a 50% short position within the next couple of weeks.

The results of our latest poll are in! More than 80% of our subscribers actually reside in North America - with most of the rest coming from Western Europe. We also have some from Central and Eastern Europe, Oceania, and Asia, including China and India. So far, none of our Japanese readers have voted, but I sincerely wish they could participate in our forum as well as other forms of feedback since Japan is definitely a country that we should continue to watch going forward. I also apologize to our Middle Eastern readers for the omission of the Middle East. It is also a region that should bear watching going forward and I hope our readers in Saudi Arabia and Qatar, etc., will be kind enough to give us some feedback as to how we can improve our website and our analysis on the Middle Eastern economies as well as the oil and energy markets!

Post of the week goes to Bill R. for his post on Friday afternoon regarding KB Homes' latest earnings report. Keep up the great work, Bill! FYI, Bill will be writing a guest commentary for us this Thursday morning on the art of screening for value stocks. Bill is a very active poster on our discussion forum. I asked him for a quick profile of himself and this is how he responded: "Bill R. drank his way out of a scholarship to Tulane in 1985, and went back to college for his math degree years later, graduating in 1995. Since then, Bill R. has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife are amateur investors with a variety of holdings, but they prefer to buy and hold value investments." Bill is a math nerd like myself and eats, breathes, and thinks about numbers all day.

Let's now get on with your commentary. On the bullish side, we know that the differential between Lowry's Buying Power and Selling has been making three-month highs day after day since Wednesday. We also know that the Primary Trend Indicator (PTI) as developed and used by Richard Russell of Dow Theory Letters has been making all-time highs as well - with Friday's close a whopping 57 points above its 89-day moving average - near an all-time high. Both the S&P 400 mid caps and the S&P 600 small caps made all-time highs. Therefore, it can be said that the cyclical bull market remains intact (which is consistent with my views over the last few months), but at the same time, this renders the stock market and the major indices in an overbought condition. Look, I have never liked to buy stocks on breakouts, and I certainly do not like our readers to buy stocks in a market that has just broken out on the upside - UNLESS we are just coming out of a hugely oversold condition similar to the March 2003 lows. Buying stocks on breakouts today and buying stocks on breakouts back in the 1960s and 1980s to 1990s are totally different stories, for two reasons:

  1. Back in the 1960s and even in the 1990s, buying on breakouts was not a popular thing to do among retail investors. With the proliferation and popularity of such methods (and of Investors Business Daily, for example), everyone and his neighbors are buying on breakouts nowadays. As a rule, doing the popular thing has never been profitable in the stock market. Remember Richard Russell's "recommendation" to buy some DIA and SPY right at the top in early March of this year because of such a breakout?

  2. In general, buying on breakouts in a secular bull market and cyclical market should ultimately be a profitable strategy. As my regular readers should know, however, I believe we are currently in a secular bear market. Moreover, while there *should* still be a "blowoff phase" that will eventually take the major market indices up in a significant way before the demise of this cyclical bull market, it can be argued that this cyclical bull market is now very, very mature - and that the risks are now to the downside in the majority of stocks.

Since their recent lows, both the S&P 400 and the S&P 600 have appreciated more than 10%. Initiating long positions in this market is most probably not a good bet at this point - unless you're a very good stock picker (which I am not). By the way, buying the hottest stocks on the IBD 100 list just doesn't qualify you as being a good stock picker.

When I advised our readers to buy the stocks that they felt comfortable with buying on May 5th - it wasn't a popular decision at that time but it has worked out quite well. Like our decision to buy at that time, our current position of shifting to a completely neutral position on our DJIA Timing System isn't exactly a popular decision, but that is the way I like it. I love to be a contrarian. If all Warren Buffett or George Soros did were to make popular decisions, they would be sitting in the poor house right now. Of course, I could be wrong - but we will let history be the judge, shall we? We will only adopt a strategy of buying on breakouts once it becomes the unpopular thing to do.

So what indicators am I watching now, you may ask? Besides the usual sentiment indicators that we discuss every weekend, I am also watching indicators such as the ARMS Index, the McClellan Oscillator and the Summation Index, the put-call ratio, the percentage of stocks above their 20 EMAs, and so forth. Recently, however, a number of commentators have suggested that the recent "explosion" in M-3 growth carries bullish implications for the stock market just right up ahead. I do not agree - I have seen the most recent M-3 data and I can find three other instances since January 2004 where M-3 has grown at a similar rate over the same timeframe, and yet the market failed to explode on the upside. Moreover, in the grand scheme of things, M-3 growth since January 2004 has and continues to be dismal, as evident in the following chart:

52-Week % Change in M-3 (20-Week and 40-Week Moving Averages) vs. DJIA (January 1, 1982 to June 6, 2005) - M-3 growth peaked in late 2001 and early 2002 and has continued to decline (with the exception of a slight 'bump up' in late 2003) since that time.  Please note that the recent uptick in M-3 does not even register on this chart.

The above chart shows the year-over-year appreciation in the 20-week and 40-week moving averages of the level of M-3 in the United States. Please note that M-3 growth peaked and has been trending down since late 2001 and early 2002. More importantly, the most recent growth in M-3 does not even register on the above chart. In fact, the Y-O-Y appreciation of the 20-week moving average just crossed below the Y-O-Y appreciation of the 40-week moving average three weeks ago - suggesting that the trend in M-3 growth is leaning towards a further decline, as opposed to the current popular bullish views on many financial websites.

You may now wonder: Well, what if we just chart the recent levels of M-3 against their 20-week and their 40-week moving averages? Surely they should show up as spikes in our data? That is a good assertion, but the following chart says otherwise:

Deviation (%) of Weekly M-3 With its 20-Week and 40-Week Moving Averages (January 1, 1982 to June 6, 2005) - Recent weekly growth in M-3 has also not been too inspiring - the % deviations from its 20 WMA (1.032%) and its 40 WMA (1.939%) are still hovering below their 23-year averages (1.124% and 2.3%, respectively).

As you can see from the above chart, the latest level of M-3 is only 1.03% and 1.94% above its 20-week and 40-week moving averages, respectively - which does not bode too well for further M-3 growth going forward. In fact, the percentage deviation from the current level of M-3 relative to its 20 and 40 WMAs is actually below its 23-year averages. Not too inspiring and certainly cannot be counted as a bullish factor for the stock market in the weeks and months ahead. Coupled with high oil prices and the continued slowdown in the global economy, I would say that the chances of a significant correction in the stock market over the next few months are relatively high, indeed.

Speaking of the global economy, the declining liquidity around the world has also been showing up in the Japanese monetary numbers. Below is a monthly chart showing the year-over-year growth (along with the second derivative, or the rate of growth) in the Japanese monetary base vs. the Nikkei from January 1990 to May 2005:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1990 to May 2005) - 1) Note that Japanese money growth has been plunging since the end of 2003 and has thus far shown no signs of letting down. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) is still in negative territory and has turned down again in May.

As shown on the above chart, the growth in the Japanese monetary base has been declining significantly since late 2003, and is now growing at only about 2% or so year-over-year. Moreover, the rate of growth is still in negative territory and has turned down again in the latest month - suggesting this growth rate will continue to decline in the weeks and months ahead. The last time that monetary base growth dipped into negative territory was January 2001 - can this happen yet again? Recent trends suggest that this is a very good possibility. Interestingly, the recent growth in the Japanese monetary base from early 2002 to late 2003 has been unprecedented since the stock market and real estate bubble burst in late 1989, but yet this has failed to revive the Nikkei or the Japanese economy in any significant way. Now that the growth in the Japanese monetary base is hugging the flat line, what are the implications for the Japanese stock market and for the world economy? My guess: At least another significant correction in the weeks and months ahead.

Until we can maintain the M-3 growth of the last few weeks, M-3 growth (and liquidity growth around the world) should be treated as a bearish phenomenon; not a bullish one. The continued rise in oil prices over the last few weeks is also very bearish - as it further represents a drain in global liquidity. At some point, either the economy or oil will have to give (and if the economy slows down first, oil will follow later anyway). For readers who are interested in reading about crude oil, please see our latest post on the subject in our discussion forum. Bottom line: My personal opinion is that anyone investing in oil or oil stocks at this point has most probably come too late to the party.

Let's now go ahead and catch up with the Dow Theory. Following is our usual chart showing the most recent daily action of the Dow Jones Industrial Average and the Dow Jones Transportation Average:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to June 17, 2005) - 1) While the Dow Industrials has already surpassed its June 2nd high of 10,553.49, the Dow Transports has still yet to do the same (its June 2nd high is 3,649.96) - even as the latter rose 68 points for the week to close at 3,591.95.  Again, such a divergence has not been witnessed in these two Dow Indices since early October 2004.  At that time, the Dow Transports actually experienced a positive divergence - ultimately leading the Dow Industrials on the upside.  Since the major cyclical bottom in October 2002, the Dow Transports has always been the leading index - signaling that the Dow Industrials is still in danger unless the Dow Transports can confirm on the upside in due time. 2) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials!

This is probably just a minor oversight - but so far, I have not heard of any Dow Theorist discussing the latest negative divergence of the Dow Transports from the Dow Industrials. Even as the Dow Transports rose 68 points last week, it is still 58 points away from its June 2nd high of 3,649.96. Until the Dow Transports surpasses its June 2nd high, we still have a negative divergence - which means that investors should exercise caution as the Dow Transports has been leading the Dow Industrials ever since the cyclical bear market bottom in October 2002.

As for our popular sentiment indicators, they are generally getting increasingly overbought - but nothing extreme except for the Market Vane's Bullish Consensus Survey. Following is a weekly chart showing the Bulls-Bears% Differential in the AAII survey vs. the Dow Industrials.

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey increased from 26% to 29% this week - consolidating at the 25% to 30% range over the last three weeks.  On a ST basis, it is a little overbought, but on a ten-week moving average basis (still only at 6.6%), this reading is still not overbought, although it is definitely time to start trimming positions here.  The 'sell at any price signal' does not come unless this reading increases to over 40% - which may or may not come - but I hope our readers will not wait until such a reading before trimming long positions.

The latest reading of 29% is slightly overbought but not extremely so. Moreover, the 10-week moving average of this reading is still oversold at a mere 6.6%. Given my views on the current market and given the slowing global economy and liquidity growth, however, I would not advocate initiating long positions here. In fact, don't be surprised if we switch to a 50% short position in our DJIA Timing System at some point within the next couple of weeks.

The Bulls-Bears% Differential in the Investors Intelligence Survey also continues its ascent - rising slightly from 29.7% to 32.3% in the latest week. In the short-term, this indicator is overbought, but similar to the AAII survey, the 10-week moving average is only at 20.73% - which still qualifies it as one of the most oversold readings over the last 18 months.

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - 1) The Bulls-Bears% Differential in the Investors Intelligence Survey increased slightly from 29.7% to 32.3% in the latest week - rendering us in a slightly overbought situation.  However, the 10-week moving average is still at 20.73% - still one of the most oversold readings over the last 18 months.  Again, I will not wait for a more overbought situation in the Investors Intelligence Survey before our trimming long positions. 2) Readings consistently over 30%!

Again, similar to the AAII survey, I would not advocate initiating any long positions even though the longer-term average of the Investors Intelligence Survey is still very oversold. This is further reinforced by the Market Vane's Bullish Consensus - a survey which has remained stubbornly bullish during the last 18 months. In retrospect, it has been the most "accurate" (in terms of foretelling the magnitude of subsequent upside moves) out of the three most popular sentiment indicators that we consistently watch every week:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - 1) The 50% line 2) The Market Vane's Bullish Consensus increased yet further from 68% to 69% in the latest week.  Over the last four weeks, the Market Vane's Bullish Consensus have registered readings of 67%, 67%, 68%, and 69% respectively - rendering this survey in very overbought territory.  Again, even though this indicator actually got very overbought (with a reading of 70%) in the early and middle part of November 2004 and yet the rally still continued, I believe it is definitely time to be cautious here.  Don't be surprised if we decide to switch to a 50% short position within the next few weeks.

The latest reading of 69% is more consistent of a reading seen at stock market tops than at stock market bottoms. Please note the highest weekly readings that we have gotten since this cyclical bull market began in October 2002 have been the 70% level - suggesting that we are near "the end of the road," so to speak. In fact, the last four weeks' readings of 67%, 67%, 68%, and 69% represents the most overbought string of readings since early February of 2004. Based on this survey, all we need for an intermediate top is a reading of 70% or over during this upcoming week. Stock market bulls should definitely continue to monitor the readings of this survey going forward.

Finally, we will end this commentary with a quick "analysis" of the latest margin debt data released by the NYSE late last week. During the latest month of May, margin debt outstanding held by the customers of the NYSE member firms increased $2.1 billion - raising the total slightly to $196.3 billion. Assuming that the amount of margin debt outstanding held by customers of NASD member firms remain steady (these numbers usually come out later in the month), total margin debt is estimated to be approximately $219.6 billion. Following is a monthly chart I have updated from a previous commentary - showing the change in margin debt over the last three, six, and 12 months vs. the level of the Wilshire 5000 from January 1998 to May 2005:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to May 2005) - As shown on this chart, the rise in margin debt got slightly out of hand in late 2003 but it has certainly been dying down since then (with the exception of November and December of last  year).  However, this author would still like to see the six-month change hug the flat line (it is currently at $8.5 billion) before I would call for a sustainble uptrend here.  The solution?  A significant correction along the line of the July to August 2004 correction.

While the increase in margin debt has definitely cooled down in the last four to five months, this author would like to see a further "cool down" before I would be willing to call for a sustainable uptrend in the stock market going forward. Such a further cool down will most probably involve another significant correction in the stock market, which will fit in perfectly with my current scenario calling for a significant correction within the next three to five months.

Conclusion: Last week, I stated: "So what is the scenario I am currently envisioning for the stock, you may ask? Well, I have always been troubled by the fact that the oversold conditions that we have been experienced over the last 18 months - March 2004, May 2004, July/August 2004, October 2004, and finally, April/May 2005 - did not render all my indicators to "very oversold" status - unlike even the corrections during the late 1990s when we had the Asian Crisis, and Russian/LTCM crises, for example. Even the correction in the Fall of 1999 was even more oversold than any of the corrections we have seen since January 2004. This is also evident judging by the stubbornly high bullish readings in the Market Vane's Bullish Consensus over the last 18 months. In order to finally have a sustainable uptrend, we will need to have more of a severe correction, and my "optimal" scenario is for that to happen over the next three to five months. If all goes according to script, then we will finally see a sustainable uptrend - an uptrend that may see the Dow Industrials rise to an all-time high." I still currently stand by this scenario. The stock market action over the last week has not changed my mind one bit, and so don't be surprised if you see our DJIA Timing System switch to a 50% short position sometime within the next couple of weeks. At this point, I still believe commodity prices will continue to weaken - with the latest bounce being just that - a mere bounce. The long bonds are still a "sell" - and even though the homebuilders are still making all-time highs as late as Friday afternoon, I would not dare to initiate long positions here given the huge speculation in housing in some of the hottest areas of the United States and given and how late we are already in the current cycle in housing.

Signing off,

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