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August 02, 2007

An Update of our Technical Indicators
by Henry To

(July 29, 2007) Note: For those would like to learn more about Modern Portfolio Theory and the latest trends in the financial markets, please read our latest book review of Peter Bernstein's latest work, entitled "Capital Markets Evolving."

One more note: My partner/webmaster, Rex, will be traveling next weekend and therefore, there will be no formal updates from us next weekend. Rather, subscribers will most likely get an "ad hoc" update directly from me through email. I apologize for any inconvenience caused and I appreciate your patience.

Dear Subscribers,

I hope all our subscribers have had a good weekend. Again, I hope the "marketing piece" that we sent on Saturday morning was not too much of a bother. In addition to being a marketing piece, the email also contained a quick update of the latest topics in our MarketThoughts discussion forum. Our forum interface is easy to use and registration is free. Please come and join us or ask a question whenever you get a chance - there are no dumb questions and chances are that other subscribers will also benefit from what you write. MarketThoughts is meant to be an interactive experience. I look forward to seeing you there.

Let us know begin our commentary by providing 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 July 29th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). While it would have worked out well if we had continue to hold our long position since May 8th, sold out and shorted last Monday, we had decided to exit our long position and remained neutral since that time, given the ample signs that were telling that this rally was getting tired. Moreover, while we had wanted to initiate a 50% short position in our DJIA Timing System, the market did not "corporate" by rallying to a level (over 14,000) that was satisfactory for us to short.

The last point (waiting for a good entry point) needs some emphasis. If this author had believed that we were entering a new bear market, then obviously I will have allowed some leeway, as a bear market will usually bail you out of a short position even if your timing was off. As I have discussed over the last couple of months, we are currently only expecting a correction within a cyclical bull market (albeit a significant correction) - and because of this, we not only are more careful when it comes to shorting, but also are reluctant in shorting in the first place. With the Dow Industrials having decline 4.2% in the latest week, it is now obviously too late to trade on the short side - and therefore, going forward, we will most likely look to get back on the long side instead. Again, at this time, we are still not looking for a new bear market, unless one of the following occurs:

The promise of significantly higher income and dividend taxes by whoever wins the next US Presidential election in 2008, along with a Congress willing to implement these higher taxation policies
A trade policy mistake by Congress in dealing with China, along with a significant response from China
If the Yen carry trade or Swiss carry trade unwinds in a violent way and ends, which we are not looking for at this time. In all likelihood, such an event will most probably collapse the Korean consumer as well as the major Eastern European economies (not including Russia)

At this point - we will continue to wait for a more oversold position before getting in on the long side, as by the middle of next week, a secondary pillar of liquidity will also be removed - as insiders are typically not allowed to sell any shares during the two weeks (before and after) surrounding the reporting of its earnings numbers. Given that the flood of earnings reports is in the midst of peaking, this means starting in early to mid August, there is a strong likelihood that insider selling will flood the market, as long as the stock market holds at current levels. That is, I believe the stock market is still trading at a valuation that is attractive enough for insiders to sell - so unless the Dow Industrials or the S&P 500 sells off more than 5% on Monday, we will continue to stay neutral in our DJIA Timing System.

So Henry, don't you think the market is now severely oversold? What kind of indicators are you looking at?

By some indicators (such as the value of the VIX relative to its levels over the last four years, the daily NYSE McClellan Oscillator reading, and the daily NYSE new lows vs. new highs), the market is now severely oversold, but in a liquidity squeeze/panic such as what we have been witnessing over the last week, this author prefers to see more of our technical indicators confirming this oversold condition before taking a position on the long side. Let us now quickly go through each of these indicators, as there are a lot to cover.

Simple 200-day Moving Average

A quick glance on our MarketThoughts charts page will reveal that - despite last week's market swoon - the Dow Industrials and the S&P 500 is still trading at 4.1% and 1.7% above their 200-day moving averages, respectively. For comparison purposes, both the Dow Industrials and the S&P 500 traded as low as 2% below their 200-day moving averages at the bottom during October 2005 and the summer correction of 2006.

The VIX, or Implied Volatility

While implied volatility (the VIX closed at 24.17 last Friday) is now at a four-year high, it is still relatively low compared to the readings we witnessed during the period from 1997 to 2002. More importantly, while we did witness a 30% surge in the VIX over the last week, we did not get a daily surge in the VIX of over 25%. The last time we had such a surge was February 27, 2007, and prior to that, May 30, 2006. True, since January 1990, there have only been 14 instances when the daily reading of the VIX surged over 30% - but given the liquidity and sentiment changes we are now witnessing in the LBO market, I would definitely expect more from the VIX before the current panic bottoms out.

Actual Volatility in the Dow Industrials

As I have shown in previous commentaries, virtually every market decline that we have witnessed has usually ended with some kind of volatility spike. Here at MarketThoughts, we usually like to calculate short-term volatility by taking a running 10-day volatility number and then annualizing that number. As of Friday, volatility hit a level of 17.94%, the highest level since March 12, when it hit 19.36%. Note that in the following chart, volatility has usually topped out (and hence, the market bottoming out) once it hits the 17.5% to 20.0% range over the last four years, with a maximum further decline of 200 points or so.

If we ignore the period from 1998 to 2002 and take a look at the 1994 to 1997 period, volatility has usually topped out in the 20% to 22.5% range, with the exception of the October 1997 period:

However, just like the October 1997, the October 1998 (not shown), and the 2001-to 2002 periods, the stock market is now in "panic mode" - as many investors are still trying to gauge the future market environment given the dramatic reversal in the buyout market and as - most likely - more hedge funds who had invested in CDOs are going to "come clean" in the coming weeks. At the end of the last LBO boom on October 13, 1989 (when Japanese banks pulled funding for the UAL buyout) - the Dow Industrials declined more than 7% that day, and volatility spiked up to over 40%. Moreover, even if volatility tops out in the 20% to 22.5% area, the Dow Industrials could still decline another 2% to 5% over the next few weeks. Bottom line: At this point, actual volatility still isn't high enough for us to initiate a long position in our DJIA Timing System just yet.

The NYSE ARMS Index

As of last Friday at the close, the 10-day moving average of the NYSE ARMS Index "only" closed at a level of 1.29 - somewhat oversold but definitely nowhere near oversold compared to the readings we got in mid June (1.52) and mid July (1.40) of last year, not to mention the 20-year high reading of 2.8 (the highest since the October 1987 crash) that we got in early March of this year. Until or unless this reading hits the 1.40 area, this author will not even think about going long just yet.

The NYSE McClellan Oscillator and Summation Index

While the daily NYSE McClellan Oscillator (ratio adjusted, so it is comparable to all time periods, going back to the 1920s) is now at a very oversold level (see following chart courtesy of Decisionpoint.com), the same still cannot be said for the NYSE Summation Index (ratio adjusted) - as it only closed at a level of -215.64 last Friday. Relative to April 2005, October 2005, and June 2006, this reading is still more than 250 points away from a similar oversold level.

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.