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Dear Subscribers,

In today's world of instantaneous and constant communications and virtual 24-hour trading around the world, it never ceases to amaze me how things can change or unravel so quickly. For the week, the Dow Industrials is down 4.2%, the Dow Transports 7.3, the NASDAQ Composite 5.8%, and the S&P 500 4.4%. Moreover, the U.S. subprime industry continues to unravel - with New Century (NEW) reported that it is under federal investigation and Fremont announcing that it is exiting the subprime business at the close last Friday. In after-hours trading on Friday, Novastar (Herb Greenberg's favorite bashing stock) declined below $7 a share, after closing at $8.48 the week before and $17.19 two Fridays ago. The carnage continues...

Since I know our subscribers are pressed for time (especially in this kind of trading/investing environment), I want to cut to the chase and show you my favorite charts - but before I do that, let us first do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 729.10 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 609.10 points

While our two long signals from September of last year are still showing us gains - suffice it to say, I am definitely not happy with the recent losses suffered by our DJIA Timing System last week. While most of the classic topping signs were not there (signs such as breadth divergences, significant mutual fund inflows from retail investors, overly high equity valuations relative to treasury and corporate bonds, and so forth) - there were some signs that the market was getting a little bit "frothy" - such as a high amount of margin debt, the record lows in the VIX, and so forth. Even though the data suggests that most of the "forth" had been concentrated in the international and emerging markets, the contagion effects of a winding down of risk exposure from these markets, coupled with the meltdown in the subprime sector, was enough to send the U.S. stock markets reeling last week.

As I discussed in our mid-week commentary last Wednesday morning, I had this to say about the NYSE ARMS Index. However, a true indicator of "panic" is none other than the NYSE ARMS Index, or what they call the "TRIN." Subscribers who want a refresher of this index can do so on the education page of our website, but over the years, I have found the NYSE ARMS Index to be the most reliable as an overbought/oversold (mainly an oversold) indicator. Indeed, the NYSE ARMS Index closed at an extremely oversold reading of 15.77 yesterday.

And: On a 10-day moving average basis, the NYSE ARMS Index just hit a reading of 2.46 - the most oversold reading since October 30, 1987.

I also mentioned that - despite the relatively tame decline last Tuesday in terms of percentage (it did not come close to being in the top 20 daily declines of all time in terms of percentage) - it was a panic nonetheless, as downside volume accounted for more than 99% of the sum of both advancing and downside volume (with record high volume to boot). This has only occurred 21 times since records were kept from January 1, 1940 and onwards, with 13 of them occurring prior to 1950. The last time this occurred was October 26, 1997 - which as I have mentioned before, is a day which coincided with speculators attacking the Hong Kong Dollar (during the midst of the Asian Crisis) the night before, as well as the day of the huge margin call that Victor Niederhoffer got - the one that caused him to close down his best-performing hedge fund and to sell his house and antiques. For more clarity on why it qualified as a panic, please refer back to our mid-week commentary.

Back in 2000, a one-day NYSE ARMS Index reading of over 15 would have resulted in a crash in the Dow Industrials of more than 1,000 points (perhaps even close to 2,000 points). The fact that the Dow Industrials "only" declined 416.02 points suggests that the market is getting a bid - even though those bids are still relatively reluctant at this point. Indeed, as documented by TrimTabs, announced company buybacks and cash acquisitions hit a weekly record high of $67.7 billion, while new offerings remained below $5 billion. Moreover, net insider selling virtually disappeared last week - totaling a mere $1.4 billion. Meanwhile, U.S. equity funds is estimated to have lost $4.9 billion last week. In the "old days" of the technology and telecom bubble, any mass stampede out of the stock market would have meant a retail investor outflow of over $10 billion on a weekly basis. Combined with the fact that many technology companies were still selling shares during January to March 2000, and combined with the fact that company buybacks and cash acquisitions were virtually non-existent at the time - an intense selling day like the one we just had last Tuesday would surely have meant a decline of over 1,000 points on the Dow Industrials and most probably a similar amount (on an absolute basis) on the NASDAQ Composite as well.

But I digress. One of the main points of the above argument is that the U.S. stock market is now severely oversold - at least in the short term anyway. Subscribers and other readers should expect a significant bounce later this week. A more important point, however, is this: Immediately prior to the end of a cyclical or secular bull market, two important things usually happen:

  1. IPOs and secondary offerings typically spike up, and speculation on the part of retail investors tends to be rampant. Moreover, corporate buybacks and cash acquisitions usually disappear outright - as companies choose to invest in their own businesses and use their overvalued shares to acquire other companies instead. As we have mentioned many times in our commentaries over the past 12 months or so, retail investors continue to shun domestic equities. Given that corporate cash levels are still near all-time highs and given the decent valuations of many of the U.S. large cap brand names (such as PFE, CAT, IBM, MSFT, INTC, KO, etc.), there is every reason to believe that company buybacks will remain robust for the foreseeable future;

  2. Valuations - especially equity valuations in relation to U.S. Treasury and corporate bonds - tend to be very stretched towards the end of a bull market in stocks. As of last Friday at the close, the Barnes Index (for an explanation of what this is, please refer back to our March 30, 2006 commentary) hit a level of 51.20 - down 12.80 for the week (on lower equity prices and lower bond yields). The Barnes Index is now at its lowest level since late September of 2006.

In prior commentaries and in prior posts in our MarketThoughts.com discussion forum, we discussed that unlike the May to July 2006 decline (when bond yields rose), this current decline (with bond yields declining) may be discounting a deflationary bust. In a deflationary bust scenario, all bets are off. Oversold indicators will get much more oversold, and many more companies and hedge funds will go bust before this is all over. However, the deflationary bust scenario is very suspect - as 1) the ECRI Weekly Leading Index is still rising at a healthy rate, 2) Corporate cash levels remain historically high and 3) Foreign reserves held by the world's central banks are at very high levels - unlike the situation prior to the 1997 Asia Crisis and the 1998 Russia and Brazilian Crises. Moreover, if we were really moving towards a deflationary bust or a "hard landing scenario," corporate Baa spreads would now be blowing out. So far, however, this hasn't been the case - as evident by the following monthly chart showing Baa spreads relative to ten-year U.S. Treasuries from January 1996 to March 2007 (with the latest March data taking into account the spread on last Thursday's close):

Yield Spreads of Moody's Baa Bonds over the Ten-Year U.S. Treasuries (January 1996 to March 2007) - 1) Spreads got to as high as 3.79% in October 2002 - right at the bottom of the last cyclical bear market! 2) The yield spread of the Moody's Baa bonds over the 10-year Treasuries is still at a relatively benign reading of 1.62% as of the close last Friday - which, interestingly, is actually lower than the 1.66% reading at the end of 2006. More importantly, Baa bond yields have actually declined four basis points since the end of 2006 (and a whopping 60 basis points since the end of June 2006) - evidence which supports the continuation of this cyclical bull market.

As mentioned on the above chart, the fact that Baa bond yields have actually declined four basis points since the end of 2006 (along with a whopping 60 basis points since the end of June 2006) suggests that equity prices remain relatively undervalued and that a deflationary bust/hard landing scenario is not in the offing.

Moreover, despite what many analysts or Federal Reserve officials are claiming, the odds of a deflationary bust/hard landing scenario remains relatively low - as being predicted by the intrade.com futures market. Given that a huge portion of the intrade.com futures market is dominated by financial professionals, and given that they are putting their money where their mouths are, predictions made by intrade.com futures contracts have historically been relatively reliable (for a background on the intrade.com futures market and the predictive ability of its futures contracts, please refer to the following NY Times article) - at least much more reliable than predictions made by so-called experts. Despite what the Fed says about a "50% chance of a recession" as predicted by the inverted yield curve, the traders trading on intrade.com is currently only slapping a 22.9% chance of a recession in the U.S. in 2007, as shown by the following chart (courtesy of www.intrade.com):

Traders trading on intrade.com is currently only slapping a 22.9% chance of a recession in the U.S. in 2007

Sure, the probability (as indicated by this particular intrade.com futures contract) has gone up over the last few days - but a 22.9% chance of a recession remains comparatively low, especially given that this contract traded at a high of 35% during mid January earlier this year.

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