Market Round-Up and the NYSE Specialist Short Ratio

By: Henry To | Mon, May 16, 2005
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Dear Subscribers and Readers,

I am glad to say that I'm finally back. Before we go on, I would first like to thank both David Korn and Richard Faw for writing their excellent commentaries for us during the time that I was absent. Thanks guys - I could not have done it without you.

I have received a lot of great advice over the last few weeks on how to provide a better service for our subscribers. One of them was the fact that our subscribers would like to see a shorter and more "straight to the point" commentary rather than a longer one. I understand most of our subscribers have very hectic schedules and so I wasn't too surprised - and now that I think about it, they are most probably expressing the majority's point of view. From now on, I will try to "keep it short" with (most probably) more direct (and short) emails from me throughout the week if there is something going on in the market that I think our subscribers should know straightaway. I will also try to keep the stuff that isn't directly related to the markets to the end of my commentary - that is, after the conclusion but before my signature. Hopefully, you will find the new organization of our commentaries much more "user-friendly."

Let's begin with a discussion of the Dow Jones Industrials and the Dow Jones Transports. From there, we will proceed with a short discussion on the U.S. dollar (which I am bullish on as exemplified by my May 1st commentary and in my discussion of the dollar over the last several weeks preceding that commentary) and on the recent action in commodities (which I am still bearish on). I will then provide an update on the chart showing the annual change of the U.S. dollar index and the second derivative of the level of foreign reserves (dollar reserves held by foreigners at the Federal Banks) - which I initially showed you two weeks ago. Finally, I will update our popular sentiment indicators and write a brief commentary on each of those and the NYSE Specialist Short Ratio and what they are currently saying about the stock market.

The action of the two popular Dow indices, the Dow Jones Industrials and the Dow Jones Transports, is still saying "beware." They are also currently sitting near their short-term support levels - which have acted as very good support during both the April 18th and the April 28th closing lows. Following is the daily chart of the Dow Jones Industrials vs. the Dow Jones Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to May 13, 2005) - During the past week, both the Dow Industrials and the Dow Transports gave back their gains from the prior week, with the former declining 205 points and the later declining 131 points for the week.  The short-term support levels for these two major indices are now obvious - please commit this to memory, dear readers: 10,070.37 for the DJIA and 3,388.58 for the DJTA.   These lows were made at the close on April 28th - which were also very close to the April 18th closing lows.  For now, I think buying the major large caps and brand names is still a very good strategy, but if both the DJIA and the DJTA violate these levels in a significant away (on huge negative breadth and volume) next week, then it is time to start being more careful.

As I mentioned on the above chart, both the Dow Industrials and the Dow Transports are sitting at critical support levels. The levels to watch, again, are 10,070.37 on the DJIA and 3,388.58 on the DJTA. From the early March highs, the former has already declined 7.32% while the latter has declined an astounding 12.23%. Despite the underperformance of the two major Dow indices, my initial recommendation of buying the large cap and brand name stocks (and avoiding commodities, homebuilding, and financial stocks) a little bit less than two weeks ago is still working well. For now, we will stick with that strategy until the market tells us otherwise.

Okay, I admit - I may be clueless sometimes but I am not exactly blind - especially when it comes to gauging over-excessive speculation or under-speculation in a commodity or a certain sector of the stock market. For the last two to three months, I have been pounding the table that this year will be a bearish year for commodities, and that there is a high possibility that we will see a "Renaissance" of the U.S. dollar this year as well. Perhaps the most defining commentary on this topic was the May 1st commentary entitled: "The U.S. Dollar is Going Up."

Also from our March 31st commentary: "... a good time frame for a significant top in commodities is between now and the next six months - which will fit perfectly with what I have "conjectured" in my commentaries over the last several weeks... I don't like to be repetitive but we are now definitely very late in the credit, profit, and commodities cycles. The easy money has already been made - the rallies will just keep on getting shorter and weaker until we have a great capitulation washout. The best candidates to go short over the next couple of weeks will be financials and other cyclical stocks such as companies that produce commodities or even the homebuilding stocks."

And from our March 24th commentary: "I believe the commodities market will also take a hit [in 2005] - and that the U.S. dollar will experience some kind of Renaissance during 2005 as the market experiences a "flight to quality" event not unlike what we saw during the 1997 to 1998 period of the Asian Crisis and the Russian and LTCM crises."

Okay - enough. Below you can see a daily chart of the U.S. Dollar Index vs. the Commodities Research Bureau (CRB) Index over the last eight months. Please note that the CRB Index (blue line) has finally broken below the 300 level - with the U.S. Dollar Index (green line) confirming by rising above the 85.50 resistance level - a level which put a cap on the U.S. Dollar Index in early February and mid April. While the former is now oversold and the latter is overbought, the intermediate term trend for the CRB Index remains down and for the U.S. Dollar Index remains up:

Reuters CRB Index vs. US Dollar

Even though our recent buy signal of the DJIA on the morning of May 5th were early, I believe that strategy remains sound. Specifically, on our May 5th commentary (and in my May 4th post on our discussion forum), I mentioned that "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, and INTC." (Note that there was a typo in the original commentary - YHOO was erroneously mentioned twice). I still maintain this position. Interestingly, a portfolio of these seven stocks purchased on the morning of May 5th would not have performed too poorly since then. But of course, we are always constantly on the watch especially since we are now so late in the credit, profit, and commodity cycle.

The March data on foreign reserves (the amount of foreign assets held in the custody of the Federal Reserve) has just been released - remember the following chart from two weeks ago? Quote from our commentary two weeks ago: "Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied." Following is the revised chart (up to March) showing the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks:

Annual Change in U.S. Dollar Index vs. Annual Rate of Growth in Foreign Reserves - Should be converging!

Please note that at the end of March, the U.S. Dollar Index was at 81. By the close on Friday, the Dollar Index has already rallied to 86.1. However, judging from the above chart, I believe a rise of the Dollar Index to the 90 to 95 level is now inevitable.

Now, let me go ahead and update all of you on something that has been bothering me during the time I was bearish on the stock market. Remember the NYSE Specialist Short Ratio? Readers who want a refresh should go ahead and read our November 7, 2004 commentary, but here's an excerpt just to make things simpler: "The specialist short-sale ratio is published each week and represents the percentage of all shares sold short during that week by the NYSE specialist firms - who are the brokers appointed by the NYSE to maintain orderly markets in individual stocks traded on the NYSE. The NYSE specialist short-sale ratio may not represent the bullishness or bearishness of professional traders, but it is definitely representative of the bullishness or bearishness of the public - as these specialists are generally forced to short-sell when the public is bullish (and thus buy stocks) and to buy when the public is bearish. The historically low readings we are currently experiencing in the specialist short-sale ratio represent huge bearish sentiment of the public - as this indicates that the specialists are not forced to do much short-selling in order to maintain the integrity of the stock market." Over the last six weeks, the 8-week moving average of the NYSE Specialist Short Ratio has been declining precipitously. In fact, the 8-week moving average of the NYSE Specialist Short Ratio hit an all-time low last week - surpassing the all-time low reading that was only made in late August of last year. As outlined in our November 7, 2004 commentary, such a reading in the NYSE Specialist Short Ratio has historically had very bullish implications for the stock market:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to May 13, 2005) - The 8-week moving average of the NYSE Specialist Short Ratio decreased significantly over the last six weeks - from 26.41% on April 1st to a NEW RECORD LOW READING of 20.91% last Friday.  This reading is now officially the lowest reading in the history of the NYSE - surpassing the previous record low reading of 21.80% made on August 27, 2004.

There have been many arguments stating that this ratio may not be as useful as it once was, given the proliferation of hedge funds and complex hedging strategies, for example. Maybe, I believe this has a huge potential of be a very significant development. If we are to follow historical precedence, then a great many number of bears could get killed on the short side in the coming months.

I will now provide an update on our most popular sentiment indicators. Nothing new here - I will start off with the weekly chart showing the Bulls-Bears% Differential in the AAII survey vs. the Dow Jones Industrials:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey increased from negative 16% to negative 5% this week.  This indicator is still in negative territory and is immensely oversold.  Note that the 10-week moving average for this indicator is now at negative 8.3% - a reading which we have not seen since early April 2003 (and prior to that, July 2002).  However (again), readers should keep in mind that the most serious declines have occurred while the AAII bulls-bears% differential is in negative territory.  Readers please stay tuned.

The Bulls-Bears% Differential in the AAII survey has been oversold for several months. In fact, the 10-week moving average of this indicator is now at negative 8.3% - the lowest reading since April 2003. Moreover, if this ratio is again in negative territory by the end of this week, then the 10-week moving average would be under negative 10% - a very highly oversold reading. As I have said in the last eight to ten weeks, based on the historical implications of a highly oversold reading in this survey, we are going to either have a very strong rally here or the market is going to crash. Volatility, here we come!

The Bulls-Bears% Differential in the Investors Intelligence rose from 13.1% to 18.2% in the latest week. We never got our sub-10% reading, but the 10-week moving average is now at 21.67% - a reading which we haven't seen since May of 2003:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey increased from 13.1% to 18.2% in the latest week.  The reading of 13.1% was the lowest reading since the 9.4% reading in late August 2004.  Note that the 10-week moving average of 21.67% is also the lowest reading since the mid-May 2003 reading of  20.26%.

Finally, the following weekly chart shows the Market Vane's Bullish Consensus vs. the DJIA:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading remains steady at 61% in the latest week.  Nothing new here - except for the fact that there is a possiblity that the 59% reading that we saw two weeks ago may have been the low, for now.  Keep in mind that the post-election rally was preceded by 'merely' a 60% reading in the Market Vane's Bullish Consensus on October 22, 2004.

Like I said in the above chart, there is nothing new here - the latest weekly reading of 61% is not overly high relative to the readings of the last 18 months. Moreover, the 59% reading from two weeks ago is sufficient to give the bulls some "ammunition" here before the market gets overbought again.

Conclusion: The short-term trend of the major indices is still murky, although I believe the major brand name stocks will do well over the coming weeks. Investors should also pay a lot of attention to the NYSE Specialist Short Ratio going forward - in that we are to follow historical precedence, the market is due for a huge rally in the upcoming months. In the meantime, we should watch the two major support levels of the Dow Industrials and the Dow Transports - they are 10,070.37 on the DJIA and 3,388.58 on the DJTA. Like I have mentioned over the previous weeks, commodities and financials are still a sell, although the action of the Philadelphia Bank Index may be suggesting a temporary low in the financials going forward. Commodities (except for oil and natural gas) are currently very oversold on a technical basis, and so may experience a good bounce in the coming days. The U.S. Dollar Index is still a buy until it gets in the 90 to 95 range. For readers who want to participate in a discussion on the U.S. Dollar, please take a look at the following two threads in our discussion forum:

Best of luck to our subscribers in the coming week!

But wait, there's more: It has been brought to my attention that residents in Hong Kong (800,000 households out of a total of 2.2 million households) are now able to enjoy high-speed internet access of up to 1Gbps (I current have roadrunner and I only get about 1.5Mbps) for only US$215 per month. If that is too expensive for you, you can get a connection of 100Mbps at a cost of only $US34 a month, and a connection of 10Mbps for US$16 a month. Japan, meanwhile, is slightly ahead of Hong Kong. They have already rolled out their 1Gbps service at the end of last year. Plans are for a residential service of up to 10Gbps by 2010. Since the end of World War II, America has thrived partly because of our having the most efficient highway system in the world. Being able to dominate or to succeed economically in the 21st century will require a different "highway system," - and America is currently very far behind when it comes to broadband services or access. It is still not too late, but if the majority of our kids still do not have access to high-speed internet (whether it is through fiber optics or Wi-Max) within the next few years, then we will definitely start to lose our competitive edge in this globalized world. Professors and teachers please take heed!

Signing off,


Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. 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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