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Henry To

Henry To

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…

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Market Not Close to a Bottom

Dear Subscribers,

As we experience the full force of summer heat, my guess is that the bulls will also experience a tough summer this year. As I have mentioned numerous times, both in our commentaries and in our discussion forum, there are many reasons for this among them, liquidity, sentiment, and valuation reasons. I will not list them here, as subscribers can always go back and read up on our commentaries over the last few weeks for a refresher. Besides, the major purpose of this commentary is to discuss why in my opinion the correction that we experienced last week is most probably not significant enough for us to currently buy at these levels.

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 10th, we are neutral in our DJIA Timing System. As I mentioned last week, we currently do not have any plans to go short in our DJIA Timing System unless the Dow Industrials manage to rally to the 13,800 to 14,200 area. We continued to hold this position. 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 last week. 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 addition, we do not believe that the correction that we witnessed last week was significant enough for a tradable or buyable bottom. Sure, we did get a Lowry's 90% downside day on Thursday. Moreover, this was accompanied by the fact that:

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

Because of this the bulls would argue the market is now oversold enough for a sustainable bottom going forward. Looking at history, they are for the most part correct. Following is a table showing the number of days we have had such high declining volume and issues from January 1987 to the represent:

Over the last 20 years, there have only been seven previous instances (excluding last Thursday) we have witnessed such dramatic downside breadth on the NYSE. With the exception of the October 16, 1987 decline, prices effectively bottomed on that very day and would rise significantly higher over the next three to six months. Even including the October 16, 1987 decline, the 3-month and 6-month subsequent performance was 3.7% and 10.5%, respectively.

However, it is also interesting to note that the average daily decline of all those seven previous instances was 8.2%. Excluding "Black Monday," the average daily decline was still a high 5.8% - significantly overshadowing the 1.5% decline in the Dow Industrials that occurred last Thursday.

Moreover, the Dow Industrials is still sitting at 2.4% above its 50-day and 8.3% above its 200-day moving average. The 8.3% reading, in particular, tells 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 terms of relative valuations especially because of the continuing rise in long-term bond yields (not just in the U.S. but all across the globe as well, including Japan) the S&P 500 definitely did not decline very much in the latest decline. This is evident in the latest reading in the Barnes Index. As I stated in previous commentaries, we have been utilizing the Barnes Index (please see our March 30, 2006 commentary for a description) as a measure of relative valuation between the two most important asset classes with money managers and investors today that of equities and bonds. Following is the chart courtesy of Decisionpoint.com plotting the weekly values of the Barnes Index vs. the NYSE Composite from January 1970 to the present:

At the May 2006 peak, the Barnes Index rose to a level of 67.60. During the week prior when the S&P 500 closed at an all-time high, the Barnes Index rose to a similar level. As of last Friday at the close, however, the Barnes Index had only merely declined 1.2 points from the week prior to a still relatively high reading of 66.00. For comparison purposes, the Barnes Index declined a whooping 11.60 points to a reading of 52.40 on February 27, 2007. Make no mistake: The correction of last week did not get us close to oversold territory.

Moreover, there is no doubt that risk aversion among hedge funds and retail investors alike remains relatively low. One reliable indicator of these "animal spirits" is the strength of the Yen carry trade. Following is a chart showing the performance of the Yen against the Euro, Pound Sterling, the Australian Dollar, and the Canadian dollar from January 2, 2007 to last Friday:

As can be seen on the above chart, there is no doubt that risk aversion among investors today remains very low, as the Yen did not really rally in a significant way during last week's correction. In fact, the Australian Dollar actually rose to a new high against the Yen last Friday! Meanwhile, the Canadian Dollar-Yen cross rate remains at elevated levels, while the Euro and GBP-Yen cross rates are still vacillating near the highs. The lack of risk aversion is especially apparently when one compares the action of the Yen over the last week to action during late February and early March when the Yen rose anywhere from 6% to 8% against these same currencies during that period. Given the lack of aversion we are witnessing in today's market, the chances of us having a tradable bottom at current levels remain low.

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