A Tradable Bottom in Place

By: Henry To | Fri, May 6, 2005
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Special Alert: Our DJIA Timing System is now 100% long at a DJIA print of 10,395. More details below.

Dear Subscribers and Readers,

Here's an interesting thought. The latest issue of Business Week has this huge title plastered on its cover: "Why GM's Plan Won't Work." The latest issue came out just a few days ago. Today, the stock price of GM rocketed 18.11% higher in the wake of an announcement that billionaire investor Kirk Kerkorian is bidding for an additional 28 million shares of GM on top of the 22 million shares that he just bought over the last few weeks (he will now own 9% of GM). Readers may also remember the relatively optimistic article from Business Week on IBM a few weeks ago - just right before IBM's missed earnings and lower guidance going forward. The legend of the ultimate contrarian indicator lives on.

Here's another thought: Business Week also came out with a cover story on the issue of outsourcing a couple of weeks ago. As I mentioned before, I am structurally bullish on outsourcing in the long-run but in the short-run (over the next couple of years) I think outsourcing has been overdone. Witness the recent performance of IBM, ACS, INFY, and ACN. There is also a growing backlash against outsourcing and I believe this will gain momentum as the growth of the U.S. and the world economy slows down during the next six to nine months. Being the ultimate contrarian indicator, the Business Week article on outsourcing is definitely confirming my view here.

Anyway, enough. As one of our subscribers emailed me - while he likes reading interesting and educational stuff on the financial markets and on business in general, the only thing that he really cared about in the long-run when it comes to a newsletter subscription is the ability to make money from recommendations or ideas over the long-run. Is it a guarantee that we will be able to do that over the long-run? Definitely not. Any newsletter writer that claims (or implies) that he will be able to do that over the long-run is a liar - and a bad one at that. However, I believe that I am a good enough analyst so as to be able to shift the odds in our favor over the long run. Like I have mentioned many times before, trading or investing successfully in the stock market requires the careful (and sometimes tedious) analysis of history and potential events - and with it, the (relatively) successful assignment of probabilities to each event occurring. Every successful investor does it a different way, but I have never met a successful lazy investor. In fact, I have met many hard-working but unsuccessful investors. Such is the nature of the game.

So what are the probabilities saying now? Well, we can start off by taking a look at a short message that I posted in our discussion forum this morning. That is why for serious investors, I always like to advocate you to check out our discussion forum periodically throughout the day. You never know what you are going to find. I also know that most of our subscribers are very smart and knowledgeable investors - so please go ahead and start sharing your ideas and comments by posting on our discussion forum!

So what else, Henry? Well, I believe the bears have definitely run out of time to take the market lower here. It has been exactly two months since both the Dow Industrials and the Dow Transports made their recent highs. A lot of good quality stocks have tanked since then and have been treading on their respective support levels for the last several weeks. The market had every opportunity to take the major indices one step down further, but it failed to - despite the bearish sentiment and despite the hugely negative news that have been coming out of GM, FNM, AIG, FRE. In the conclusion of last Thursday's commentary, I stated: "Like I said, I am not blind to the bearish side - for readers who are currently short, I encourage you to read the latest article from Mark Hulbert - which discusses the extremely oversold readings that he is now getting in his HSNSI sentiment indicator. A ST bottom should be here quite soon, but whether we will get there when the DJIA is 10,000 or 9,500 I do not know. For now, all my indicators are still signaling "beware" including for traders who are currently sitting very comfortably on their short positions." And from the conclusion of Sunday's commentary: "Finally, the market has been oversold for weeks but the bounces have so far still been dismal. Let's see what the market can do in the coming weeks but I think the best scenario we can look for here is a rally to work off its current oversold conditions before it goes down again." I wanted to wait until after the Fed meeting to make any moves - on the notion that the market may react badly to whatever the Fed said in their statement. Given the reaction on Tuesday and yesterday, I think the "all clear" sign has been given - at least for now.

Even though the major indices are now necessarily reflecting this, the market was and still is severely oversold. You could've seen it in the sentiment indicators, the Rydex assets, the put/call ratios, the continuous mutual fund outflows from domestic equity funds, and so forth. But first, I want to take a look at the NYSE McClellan Oscillator and the NYSE McClellan Summation Index - courtesy of Decisionpoint.com:

1) The NYSE McClellan Oscillator hasn't been this strong since early February - right after the huge decline during the first three weeks of January. 2) The NYSE Summation Index hasn't been this oversold since late May of 2004.  When the Summation Index is so oversold, it can be very dangerous for both the bulls and the bears.

In our "A Turn in the Tide" article that I penned on April 17th, I stated: "The latter [the NYSE McClellan Summation Index] is now at a level of negative 369.25. Is it oversold? Sure, it is oversold - just like the many times I have mentioned over the last couple of weeks. However, it is notable that the serious declines in the stock market usually just start when the McClellan Summation Index is at this level. And I am talking about looking back the stock market going back to the 1920s. This includes the 1929 crash, the various declines during the 1929 to 1932 bear market, the 1937 crash, the 1957, 1962, 1966, 1969 to 1970, 1973 to 1974 declines, the 1987 crash, the 1990 Gulf War Scare, the 1998 LTCM and Russia Crises, September 11th, and not to mention the June to July 2002 decline." Don't get me wrong - I am still not too enthusiastic on equities over the next six to nine months - given that we are now so late in the liquidity and business cycle (not just domestically but worldwide as well). However, when the McClellan Oscillator turns up in such a strong way (after acting so weak since the beginning of February) and when the market fail to sell off further given that the McClellan Summation Index is so oversold (it hasn't been so oversold since May 2004), then it is time to take notice. Like I said in the above chart, then it is dangerous for both bulls and bears alike when the Summation Index is so oversold, and now it looks fairly certain that the favor is now in the bull's court.

The NASDAQ McClellan Oscillator and Summation Index are pretty much saying the same thing:

The NASDAQ Summation Index hasn't been this oversold since August 2004, and before that, October 2002!

The only major difference is that the NASDAQ (per the NASDAQ Summation Index) hasn't been this oversold since August of last year, and prior to that, October 2002! This is significant, as any rally here (even if it is only to work off its oversold conditions before going down again) could be explosive, especially given the record short interest we have on both the NYSE and the NASDAQ Composite (which I will update for our readers in a couple of weeks for the NYSE and in three weeks for the NASDAQ Composite).

The Rydex Cash Flow Ratio is also reaffirming the current oversold conditions (I apologize but Decisionpoint.com hasn't updated this chart to reflect Wednesday's data yet as I am writing this):

The Rydex Cash Flow Ratio is also reaffirming the current oversold conditions

The Rydex Cash Flow Ratio is basically the ratio of cumulative cash flows into the Rydex bearish and money market funds over the cumulative cash flows into the Rydex bullish and sector funds). Again, it acts as a contrarian indicator. Notice the relatively high ratio (keep in mind that the y-axis on the bottom chart is inverted) during the early parts of August last year - right when the NASDAQ McClellan Summation Index was at its most oversold level since October 2002.

Like I said before, I am still relatively bearish on the U.S. equity markets (even more so when it comes to emerging markets and commodities) but I now believe that we are in the midst of a tradable bounce. Valuations in general are not compelling but probability says that the short-term bear cycle may be over for now as the market works off its oversold condition - a condition that has been in the works since late December of last year. From a relatively young age, I learn that perma-bulls can do okay - if they can stick to their guns (and have the ability to stick to their guns) during bear periods and even average down into their index funds. Perma-bears, meanwhile, are generally not a fun category to be in. This category tends to be (in general) more knowledgeable than your average investor, but they tend to agonize most of their time while their bullish (and less knowledgeable) friends make money in the stock market. It has been very difficult for U.S. stock market bears ever since that bottom in 1942 - at the height of the Nazi Germany and Imperial Japan empires in the middle of World War II. When the market fails to decline in a substantial away and all evidence points to a reversal from an extremely oversold situation, then shorts should get out of the way.

And this just in: The latest Investors Intelligence Bulls-Bears% Differential just declined from last week's 14.3% to this week's 13.1%. Okay, I didn't get my sub-10% reading here but I think this is as good as it gets for now (on a contrarian basis, of course).

Conclusion: The short-term trend is now most likely up. Furthermore, it now looks like that virtually all the bad news has been discounted in our "favorite bashing list" which consisted of GM, FNM, and AIG. Make no mistake, the GM news yesterday was huge - not only because of the favorable effect it had on stock market sentiment but also in the amount of cash that went straight into stocks because of the investment by Kirk Kerkorian ($28 x 50 million shares is $1.4 billion). We have now gone 100% long in our DJIA Timing System this morning at 10,395 (because of our belief that large caps will outperform going forward) and I also believe that while the upcoming rally will be pretty narrow in focus, certain individual stocks will do very well in this environment - even if this rally turns out to be only a two to three-month bounce (we will continue to reevaluate as this rally matures). Like I said in my message on our discussion forum, there are still some sectors that we should avoid - such as very cyclical sectors like commodities (this includes oil, basic materials, and metals stocks), homebuilding, and mortgage financing stocks. The rally going forward should be pretty selective given that we are now late in the liquidity and business cycle. I have discussed this before but I now believe that large cap growth stocks should outperform going forward - especially the major beaten-down brand names such as KO, SBUX, HDI, MRK, YHOO, EBAY, YHOO, and INTC. In this environment, we will not settle for second best. What do I mean by second best? Names such as Overstock, AMD, and PalmOne come to mind.

Best of luck to our subscribers in the coming week!

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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