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U.S. Stock Market Still Overbought and No Longer Bullish

Dear Subscribers,

First of all, I hope all our subscribers and readers have had a good week and weekend - and that none of you was caught shorting the stock market over the last few weeks. While we did close out our 100% long position in our DJIA Timing System at a DJIA print of 13,299 on May 8th (the ones that we went long of in early to late September of last year) - we hesitated to go short for many reasons - and for us, the major reasons were:

  1. Our belief that the market was still going to make a higher high sometime during the Fall, as valuations were not expensive enough to signal a top on May 8th, even though a significant number of divergences (such as the non-confirmation of the Dow Industrials by the Dow Transports on the upside, the weakening NYSE McClellan Summation Index, and so forth) was already occurring at the time;

  2. We did not believe that any upcoming correction would be deep enough - and that our move out of our long position in our DJIA Timing System was more of a "tactical allocation" rather than a strategic allocation. Given the historical fact that the U.S. stock market has been biased towards the upside (with the exception of the September 1929 to June 1932 period) - we usually do not go short in our DJIA Timing System unless we believe any upcoming correction has a good chance of turning into more significant - i.e. a correction of anywhere over 10% or a new cyclical/secular bear market.

Since May 8th, however, the Dow Industrials (and many of the world's major market indices) has continued to power higher without so much as a pause. Many formerly bearish commentators and analysts have instead "capitulated" and turned bullish on the stock market - citing, among other things, the record buyout activity by global private equity funds, huge amounts of low-cost capital flowing from Japan, China, and Switzerland, and of course, the record levels of cash sitting on the balance sheets of the world's major corporations.

Of course, these reasons are all legitimate reasons - and actually, we have been articulating these reasons on MarketThoughts over the last 12 months or so (although we have always believed that the Yen carry trade was not sustainable) as justification for our overall bullish stance. Taking a difference stance to many of the popular commentators out there, we have also tried to make a case that the world economy and the U.S. stock market are now much better places for the buy-and-hold investor to invest - as the fundamental shift away from agriculture/manufacturing to the service industries have made the world economy significant less volatile and cyclical. Compound that with the explosion of new risk management tools due to the concept of securitization and much better access to information and faster computers, we were of the belief that the earnings of U.S. companies would be significantly less volatile going forward - and thus the higher P/Es that we are "enjoying" in today's market relative to earlier periods would be justifiable.

Like I said, all these reasons are still legitimate today - but with one MAJOR difference. Over the last month or so, these relatively optimistic views have all been adopted by commentators that have been previously bearish or by retail investors whose major sources of financial information come from the Wall Street Journal, BusinessWeek, or USA Today. With regards to the latter, there is nothing wrong with these publications. In fact, I believe these publications are very informative and are usually very accurate, and the reporters who work for these publications also have very high integrity. For the professional investor or trader, however, obtaining original information from these publications to use as a basis for a trade, however, is next to useless - since many original and profitable trading or investing ideas don't make it to these publications until they have become mainstream. More often than not, the cover stories on these publications (and on others such as Fortune or Forbes) have acted as great contrarian indicators instead.

Because of this one main reason, and because of the overbought condition in the world's stock markets, we have chose to get out of our 100% long position in our DJIA Timing System. And should the U.S. stock market continue to rally further in the coming days or weeks, then we may actually initiate a 50% short position in our DJIA Timing System. In the following commentary, I will give you a timeframe as to when we may "pull the trigger" so to speak.

Now, let us continue the rest of 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.

So when can our readers expect us to initiate a short position in our DJIA Timing System? In terms of being in an overbought condition, the Dow Industrials has been overbought for the last couple of weeks now, as illustrated by the following daily chart showing the closing values of the DJIA along with its percentage deviation from its 50-day and 200-day moving averages from January 2003 to May 18, 2007:

Daily DJIA Closing Values vs. its % Deviation from its 50 and 200 DMAs (January 2003 to May 18, 2007) - 1) Deviation from the 50 DMA: 6.07% Deviation from the 200 DMA: 10.76% 2) Note that the Dow Industrials is now more than 6% and 10% higher than its 50 DMA and 200 DMA, respectively. On this basis, the Dow Industrials has not been this overbought since January 2004 - when the U.S. stock market was rally from its hugely oversold conditions made during October 2002 to March 2003.

As mentioned in the above chart, the Dow Industrials - as measured by its deviation from its 50 and 200 DMAs - has never been this overbought since January 2004. In many ways, the overbought conditions immediately after the bottom of the last bear market in March 2003 were to be expected, given its hugely oversold condition during March 2003. Like they say, for every action in the stock market, there is usually an opposite reaction of similar magnitude. On the other hand, the latest overbought conditions came as somewhat of a surprise - as the Dow Industrials never really was in danger of crossing below its 200 DMA during the late February to mid March decline. Sure, the NYSE ARMS index and the ISE Sentiment Index did get severely oversold, but the stock market recovered quite quickly and has never looked back since.

Given the above alone, the reader would conclude that we should start shorting now - but just like many overbought indicators, this above indicator can also last for longer-than-expected, most probably longer than the leveraged short position. In our commentary over the last 9 months or so, we have maintained that the ultimate top (or at least a top that is ripe for shorting) will most probably not come until the Barnes Index has hit a level of 70 or higher. As I have mentioned before, this author uses the Barnes Index (see our March 30, 2006 commentary for a discussion on the Barnes Index) to measure the relative valuation of equity prices to bond prices. Note that the Barnes Index was instrumental in getting us into our final 25% short position in our DJIA Timing System in early May last year (see our May 7, 2006 commentary "Playing the Probabilities" for a refresher). As of last Friday at the close, the Barnes Index jumped a whooping 4 points for the week to end at a reading of 64 - a mere 6 points below our 70-point target. Following is a chart showing the Barnes Index vs. the NYSE Composite from 1970 to the present, courtesy of Decisionpoint.com:

Barnes Index

Of course, a huge decline isn't imminent even if the Barnes Index hit a level of 70 - especially given the fact that the market has previously gone on to make higher highs until the Barnes Index touch the 90 level (or even higher such as August 1987, April 1998, and January 2000) in 1981, 1983 and 1990. But a reading of 70 or higher would be consistent with the level made in the 1973 top, as well as the January 1980 top (which occurred in conjunction with the top in gold and silver prices). One should at least expect a significant correction if the Barnes Index continues to rise higher in the coming days, especially given the lack of desire of the Federal Reserve to cut rates. On the contrary, many of the world's central banks are still either in a hiking cycle or looking to raise rates - thus creating a further headwind for equities in the coming days, especially given today's valuation levels in equities.

But Henry, isn't a Barnes Index reading of 70 still a relatively low reading - especially compared to the 1997 to 2000 period?

Yes, like I mentioned before, a Barnes Index reading of 70 or even does not mean an imminent decline, but given the overbought condition of the Dow Industrials and the global equity markets, and given the many divergences we are currently witnessing, such a reading is definitely an ominous red flag. Moreover, a Barnes Index reading of 70 or over would represent the highest reading we have seen since early 2002 - just immediately prior to the May to July 2002 capitulation period in the U.S. stock market.

At the same time, subscribers and readers should keep in mind that a major reason why the P/E of the S&P 500 is still at a decent level is the fact that two of the sectors of the S&P 500 - financials and energy - are trading at a forward P/E of 12.1 and 11.5, respectively. Given the huge run in energy and in financials since 2002, I would argue that these relatively low P/Es "do not do justice" to the valuations of these two sectors. As a matter of fact, the huge run-up in financials in recent years caused its market cap weighting within the S&P 500 to rise to nearly 22%. Such a high sector weighting has not been since 2000 - when information technology made up a whooping 32% of the S&P 500. While a forward P/E of 12.1 on financials would seem low - readers should keep in mind that we have also had outsized profit growth in this sector - further compounded by the explosion of derivative trading and mergers & acquisitions activity as well. Are we now in a financials bubble, similar to the technology bubble in 2000 and the energy bubble in 1980 (when energy rose to a 26% weighting in the S&P 500)? You be the judge.

Given that these two sectors make up nearly 1/3 of the market capitalization of the S&P 500, is it any wonder that valuation levels on the S&P 500 have continued to remain decent, at least on a basis relative to P/Es over the last 10 to 15 years? Following is a table showing the market cap weighting of each of the sub-sectors within the S&P 500, along with the 4-quarter forward P/E of these sectors:

Weighting and Forward P/Es of S&P 500 Sectors (Unadjusted and Adjusted as of April 30, 2007)

Note that the forward P/E of the S&P 500 was at 16.0 at the end of April 2007. Removing both the energy and the financials sectors from the S&P 500, however, would instead yield a forward P/E of slightly over 18 - which is probably a better reflection of a more sustainable earning stream in the S&P 500 going forward.

Finally, as I have mentioned before, one pillar of support for the bulls has been the fact that the 55-day moving average of the NYSE ARMS Index has continued to remain at a very oversold level - all because of the historically high one-day reading of 15.77 registered on February 27, 2007. Given that the stock market has never topped out while the 55-day moving average is oversold, this was a very powerful argument for the bulls. However, as of the close on May 16, 2007 (last Wednesday), this was no longer the case, as the 55-day moving average has now come back down in a dramatic fashion - declining from a level of 1.33 as of last Tuesday to 1.04 last Friday, as shown by the following daily chart of the 21-day and 55-day moving average of the NYSE ARMS Index vs. the Dow Industrials from May 2002 to the present:

21-Day & 55-Day ARMS Index vs. Daily Closes of DJIA (May 2002 to Present) - At its most recent low, the 21 DMA of the NYSE ARMS Index closed at a reading of 0.899 on May 4th and 7th - the lowest reading since the May 2, 2006 reading of 0.895. In the last instance, the DJIA would go on to rally another 200 points from May 2 to May 10, 2006 before its summer correction, and so far, we are witnessing the same scenario being played out (as the DJIA has also rallied about 250 points since May 7th). More importantly, the 55 DMA of the ARMS Index is no longer at elevated levels - meaning that a significant pillar of support for the bulls is no longer there.

As mentioned on the above chart, the 55-day moving average is no longer at elevated levels - removing a significant pillar of support for the bulls. More ominously, the 21-day moving average of the NYSE ARMS Index remains significantly overbought - closing at 12-month low of 0.899 recently on May 4th and May 7th. While the Dow Industrials could and will probably continue to rally in the days ahead, my guess is that the rally is numbered, given the deteriorating breadth and the many divergences we are now currently witnessing in many of the major indices within the U.S. stock market.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2005 to the present (note that we have just changed our starting point, as our old daily chart was getting quite congested):

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2005 to May 18, 2007) - Over the last week, the Dow Industrials continued its tremendous ascent, rising another 230.31 points - its seventh consecutive weekly rise. Meanwhile the Dow Transports rose 47.79 points to close at 5,213.71 - but again, note that the last time the Dow Transports managed to surpass its all-time high was over four weeks ago, or April 25th (and has been making lower highs since). Given the overbought conditions in these two indices, and given the deteroriating internals of the U.S. stock market over the last few weeks, chances are that both the Dow Industrials and the broader market will experience a significant correction over the next few weeks. As of May 8th, we have trimmed our 100% long position in our DJIA Timing System to a completely neutral position at a DJIA print of 13,299, and will most likely go short if the DJIA continues its rally over the next couple of weeks, especially we continue to witness the divergences that we are seeing now.

For the week ending May 18, 2007, the Dow Industrials rose 230.31 points to another all-time high while the Dow Transports rose 47.79 points. While it is encouraging (for the bulls) to see the Dow Transports "confirming" the Dow Industrials for the week, it is also disconcerting to see that the Dow Transports has still not surpassed its all-time high of 5,243.60 made on April 25th . This "divergence" is a good confirmation signal that the market is now getting weaker (this is consistent with the divergences being seen in the NYSE McClellan Oscillator and in NYSE and NASD new highs vs. new lows). Even should the Dow Transports confirm on the upside by rising to an all-time high tomorrow, we will continue to maintain our completely neutral position in our DJIA Timing System and will probably initiate a 50% short position in our DJIA Timing System should the Dow Industrials continues its ascent over the coming days.

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 latest four-week moving average of these sentiment indicators decreased from last week's 24.3% back to 23.3% for the week ending May 18, 2007. 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 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending May 18, 2007, the four-week MA of the combined Bulls-Bears% Differentials decreased from 24.3% to 23.3%. While the four-week MA is not very overbought, it is certainly not oversold either - and thus it is likely that the market will not embark on another significant rally until we see more of an oversold reading in this indicator. Should we see a 3% to 5% spike in this indicator over the next couple of weeks, then we may actually go short in our DJIA Timing System. Readers please stay tuned.

At this point, my guess is that keeping a close watch on our most popular sentiment indicators is no longer that relevant - given that significant tops do not necessarily need to be preceded by highly overbought sentiment indicators. Rather, a significant top in the stock market is usually preceded by significant divergences within many sectors of the stock market combined with moderately overbought to highly overbought readings in the popular sentiment indicators. However, should we see some kind of spike in our popular sentiment indicators over the coming weeks, then it may be a good signal to initiate a short position in our DJIA Timing System. Moreover, we will most likely not go long again unless these indicators again reach an oversold signal at least consistent with what we witnessed during the April 2005 and October 2005 corrections.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. 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 for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA of the ISE Sentiment bottomed at a reading of 98.5 on March 21st (representing the lowest reading since the 97.6 reading on October 30, 2002) and has since bounced to a reading of 134.3 as of last Friday. Meanwhile, the 50 DMA has also risen, rising from a low of 111.6 on April 16 to a reading of 122.6 as of last Friday. Even though the absolute readings in these two moving averages are still relatively low - given the latest run-up in the 20 DMA, my guess is that the market will most probably correct and continue to struggle throughout the summer.

While the 20-day moving average of the ISE Sentiment (at a current reading of 134.3) is still not close to overbought levels, its rally from a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) is getting "long in the tooth" in the short-run. Should this continue to rise higher in the coming days, then we will most likely initiate a short position in our DJIA Timing System. Moreover, unless the 20 DMA gets more oversold again, we will continue to avoid a long position our DJIA Timing System.

Conclusion: The recent renewed bullishness of the popular market commentators, along with the overbought conditions in the U.S. and global stock markets has made me wary as a bull - and thus we have decided to exit our 100% long position in our DJIA Timing System on the afternoon of May 8th (a long position which we entered during September of last year). In addition, there are now obvious divergences in place - divergences which I will update our readers in this coming mid-week commentary.

As I mentioned last week, true to human nature, investors typically don't get bullish until AFTER we have witnessed a rise in the stock market, as students of Warren Buffett can attest to. This author does not intend to make that mistake, and we will thus stay completely neutral in our DJIA Timing System - and may actually even initiate a 50% short position in our DJIA Timing System should the market continue its rally over the coming days or weeks. Subscribers please stay tuned.

Signing off,

 

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