Downside Acceleration?

By: Henry To | Tue, Mar 22, 2005
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It has certainly been an interesting week for the markets - both in terms of the news, the action, and in terms of what my technical indicators are telling me. Early last week, there was a flight to safety as GM forecasted a weaker-than-expected first quarter earnings. AIG and Fannie Mae (FNM) also continued the barrage of bad news. When three of the most financially-leveraged and supposedly trustworthy companies in the world are behaving badly, investor confidence in the financial system will definitely be undermined. This is very significant and important, as the modern financial system is very much dependent on investor and consumer confidence. Frankly, I was surprised that the market didn't drop much further, although individual issues like DRL took a huge tumble last week (concurrent with downgrades on the stock).

So what does that mean? I believe that the events of last week further reinforces the theme that I have been discussing over the last few months - that at some point this year, there will be a huge flight to safety not unlike the events that unfolded during the 1997 Asian Crisis and the 1998 Russian and LTCM crises. The marginal user of credit and oil (think China) will be cut off - and any emerging market economies that depend significantly on the export of commodities will also suffer greatly. With high yield and emerging market spreads near or at historic lows (correction: the 2004 default rate for high yield bonds is actually 1.249% - the lowest since 1996 - and not the 1.5% number that I mentioned - see my commentary from last Thursday morning), a lot of investors and/or hedge funds will be greatly surprised sometime this year. In fact, I will not be surprised if a major hedge fund collapses sometime this year or in 2005. Given the fact that many retail investors (and even Chinese peasants) are shifting out of the U.S. dollar and into other currencies such as the Chinese Renminbi and the Euro, I am also expecting a renaissance of the U.S. dollar sometime this year. In order to buy U.S. Treasuries during a "flight to safety scenario," foreigners will need to purchase U.S. dollars. The situation gets more interesting as I know for a fact that a significant number of hedge funds have also bought emerging market debt in the locally denominated currency.

Okay Henry, you also mentioned that it was an interesting week for your technical indicators - what was the deal with that? I will elaborate further in the following paragraphs but this has been kind of a recurring theme for the last few weeks. The fact of the matter is that some of my indicators are virtually screaming the market is oversold (such as the put-call ratio and the AAII survey) while other indicators that I also trust are not saying "oversold" at all. In fact, some are still at moderately overbought levels such as the ARMS Index and the Market Vane's Bullish Consensus survey.

So much for words and opinions. Let's now discuss the action of the Dow Jones Industrial Average vs. the Dow Jones Transportation Average by looking at the daily chart of those two indices updated to last Friday:

Given the steepness of the rise of both the DJIA and the DJTA since late October 2004, it "looks like" that both the two major Dow Indices still have more room to go on the downside assuming that this is only a "normal correction" within an ongoing cyclical bull market. Furthermore, assuming that the market is only undergoing a normal correction (which may be a correct assumption in the short-term but probably not so in the intermediate term, such as the next nine months), a logical support level would be a DJIA print of 10,250 and a DJTA print of 3,500 - which represents the support level on the trend line (for the DJTA - the one for the DJIA is not shown) drawn from the bottom in March 2003 to the bottoms in May and August of 2004.

Now, readers may recall my quick discussion of the Federal Reserve Flow of Funds report in last week's commentary. In that commentary, I outlined the fact that equities (which includes mutual funds) as a percentage of total household financial assets increased 0.73% during the fourth quarter of 2004 - and which represents an increase of 3.66% from the trough of 23.79% that was reached in the third quarter of 2002. I "concluded" that based on historical precedent, this percentage will need to rise to approximately the 30% level before I will even think about calling the end of this cyclical bull market. The Flow of Funds report contains many little "gems" and I would now like to discuss another statistic which I have been keeping track for the last few months.

Frequent readers of my commentary should know that I have always contended that we have a housing bubble in various parts of the country. The first time I discussed the following chart was in my December 12, 2004 commentary - when I compared the value of real estate assets held by households as a percentage of total assets with the quarterly increases in the OFHEO HPI - a "measure designed to capture changes in the value of single-family homes in the U.S. as a whole, in various regions of the country, and in the individual states and the District of Columbia." During the third quarter of 2004, both of these statistics set an all-time high (!) - something worth noting especially in light of the continued break down of Fannie Mae (FNM) and the technical underperformance of Countrywide Financial (CFC). The discussion of real estate and housing is especially timely this week given the continued collapse in mortgage financing stocks last week (check out DRL which provides mortgage financing in Puerto Rico). A poster on our discussion forum, pcoulter, has also asked whether this is now a good time to short the homebuilding stocks. His personal "favorite" is Toll Brothers (TOLL). Readers who are knowledgeable in the homebuilding industry and certain homebuilding stocks may want to help him out with some ideas and opinions!

The following chart shows the value of real estate assets held by households as a percentage of total household assets vs. the quarterly percentage changes in the Office of Federal Housing Enterprise Oversight (OFHEO) House Price Index from the second quarter of 1975 to the fourth quarter of 2004:

As a percentage of total household assets, the value real estate assets declined slightly in the fourth quarter - after rising substantially in the third quarter of 2004. In terms of relative value, the value of real estate assets in the United States is still at its second highest level ever - after reaching a record high in the third quarter of 2004. Please also keep in mind that we are also talking about an environment in which every other asset class is overvalued - including all types of bonds (from short-dated to long-dated U.S. Treasuries to domestic high yield debt to emerging market debt) all types of equities (from the Dow Industrials to the S&P 500 to the S&P 600 to Utilities to international stocks) and virtually all kinds of commodities. Is there a housing bubble in at least parts of the United States today? Dear readers, you make the choice.

Speaking of "extraordinary events," the latest NYSE margin debt data was just released last Friday. Total margin debt declined by approximately $5 billion during February - not much of a movement and certainly not a surprise. What is surprising, however, is the huge decline of cash in both cash accounts and margin accounts - with a combined total decline of approximately $31 billion! Following is the chart showing the Wilshire 5000 vs. cash in margin and all accounts to margin debt ratio vs. cash in all accounts to Wilshire 5000 ratio:

As one can see, cash levels are now at very ominous levels. Cash levels as a percentage of total margin debt is now at a low not seen since November 2000 and cash levels as a ratio of the Wilshire 5000 is now at a low not seen since January 2001. The combination of this and the fact that some of my technical indicators are actually at moderately overbought levels brings forward the possibility that we may actually see a more severe decline ahead - a decline that will be more severe than any of the declines that we have seen since March 2003). Readers please stay tuned.

I am now going to go ahead and discuss the technical indicators which I have said provide conflicting views. First up is the NYSE ARMS Index. Following is a chart I have shown many times before - that of the 10-day and 21-day moving average of the NYSE ARMS Index vs. the Dow Jones Industrials:

Please note that not only are the 10 DMA and the 21 DMA of the ARMS Index not oversold, they are actually at overbought levels - with the former at 0.968 and the latter at 0.997. During the most recent January correction, the former actually hit a peak of 1.339 while the latter hit a peak of 1.270. Based on this index, I would definitely like to see a much more oversold reading in the NY ARMS Index before I would be confident in initiating long positions.

One of our popular sentiment indicators, the Market Vane's Bullish Consensus Survey, is also showing a moderately overbought market, as evident from the following weekly chart of the Market Vane's Bullish Consensus readings vs. the Dow Jones Industrials:

As indicated by the Market Vane's Bullish Consensus readings, we are still nowhere near oversold territory. The readings which accompanied an oversold market have been in the 58% to 61% range in 2004. Before this correction is over, I expect lower readings. One thing's for sure. I will not be comfortable in initiating any long positions here unless we get a reading that has at least declined to the 50% to 55% range.

On the other hand, I have mentioned that the put-call ratio is now oversold. The following chart (courtesy of Decisionpoint.com) shows both the equity and the CBOE put-call ratios vs. the S&P 100 Index:

Note that the 10-day moving average of the CBOE P/C ratio is now at an extremely oversold level - a level which we have not seen since August of last year. However, the equity P/C ratio is still not as oversold as we would like it to be, as it is now at a level which is only comparable to the late January low. That being said, the P/C ratio is generally indicating a market that is oversold.

The message of the P/C ratio is confirmed by the Bulls-Bears% Differential reading in the American Association of Individual Investors survey, as the latest readings indicate an equal percentage of bulls vs. bears - thus giving us a Bulls-Bears% Differential reading of 0%:

Finally, the latest Bulls-Bears% Differential reading in the Investors Intelligence Survey is, at best, at a neutral level:

A shown on the above chart, the latest reading is a print of 30.2%, just slightly over the 29.2% that we got in early February (just subsequent to the late January lows). Like I mentioned in the above chart, neither of these readings are low enough to indicate a sustainable low going forward. For comparison purposes, the Bulls-Bears% Differential in the Investors Intelligence Survey declined to as low as 21.0%, 15.1%, and 9.4% during the March, May, and August 2004 lows. As of right now, I would not initiate any long positions here until this reading declines to at least the 15% to 20% range. A note from last week: "During October 1972, this reading got to as low as 7.1%, June 1987, 8.7%, and October 1999, 1.7%. Please note that the lowest reading that we saw in this survey in 2004 was a reading of 9.4% made during September - we will most probably need to see a comparable (or even lower) reading before we can experience a "blow off" on the upside in the major stock market indices." For most investors who have not initiated any long positions, it is probably a good idea to wait for such a reading before buying with both hands.

Conclusion: I would not take this current situation lightly. I believe the conflicting readings that I am seeing in my technical indicators is ominous. Please keep in mind that declines tend to accelerate while the market is in an oversold situation. We are seeing an oversold situation in some of my indicators, but neutral to even moderately overbought in other indicators. What does this mean? I am only guessing here, but it probably means that the market is vulnerable to a further acceleration on the downside from last week (since some of my indicators are oversold) - but that we may be seeing a more substantial decline than usual (since some of my indicators are at neutral to -overbought levels). This conjecture is all the more authoritative given the market's under-reaction (IMHO) to the potentially market-moving news from GM, AIG, and FNM last week. Coupled with a potential surprise from the Fed meeting this week, the market is definitely poised to further accelerate its decline. Obviously, this may not pan out, but when it doubt, it is usually best to stay out of the market. This is definitely one of those times.

Signing off,


 

Henry To

Author: Henry To

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.

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