The MarketThoughts Global Diffusion Index

By: Henry To | Wed, Jun 1, 2005
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Dear Subscribers and Readers,

Please note that we switched from a neutral position to a 100% long position in our DJIA Timing System on the morning of May 5th at DJIA 10,395. For now, we will continue to hold.

Announcement: We have revamped our charts section to include an interactive chart of the Dow Jones Transportation Average vs. its deviation from its 50-day moving average and its 200-day moving average. You can customize this chart and look at any timeframe you want - going back to October 1, 1928.

Before I begin our commentary, I want to admit to an error that I made in last weekend's commentary. The monthly chart showing the NYSE short interest vs. the Dow Jones Industrials should be labeled "May 2005" instead of "April 2005." All the other numbers on that chart are still correct, with the exception being that the 10.8% increase in short interest was actually a four-month number; not a three-month number.

Now, let's begin our commentary: Globalization, globalization, and globalization. I bet all our subscribers are tired of hearing this "buzz word" now, but ever since the fall of the Berlin Wall in 1989, this has been one of the most important themes for both the stock market and for doing business. Of course, the term globalization had always been relevant throughout modern history - even the huge Chinese Empire was not able to shelter herself from it by the time the British Envoy George McCartney arrived on her shores in the late 1700s. With the help of falling transportation costs and subsequently the international gold standard, economic integration started to accelerate in the late 1800s. Total world foreign direct investment as a percentage of the global economy reached 9% by 1913 - the year before the beginning of World War I. World War I and World War II, however, stopped globalization in its tracks. Then, there was the ascension of the Iron Curtain - which effectively shut out half of the world's population from doing productive and innovative work. As late as 1991, total world foreign direct investment as a percentage of the global economy was actually lower than that of 1913 - a full 78 years ago.

So why am I saying this? I am saying this because critics who claim the concept of globalization is overstated (because we have always had globalization since the proliferation of the modern printing press since the 16th century) don't know what they are talking about. East Germany was integrated into West Germany as recently as 1989. Deng Xiaoping accelerated reforms in China in 1978 - sure, there was the "Tiananmen Square incident" in 1989 but ever since 1978, financial and economic reforms have successfully integrated a significant (but still small) part of China's population into the global economy. After its brush with financial Armageddon in 1991, India's economy has also surged on the drastic implementation of reforms made 14 years ago. The Baltic States of Estonia, Latvia, and Lithuania are now collectively one of the most dynamic economic regions, not just in Eastern Europe, but in the entire European region. The integration of so many countries and so many hard-working people in our global economy in such a short timeframe (and it is only the tip of the iceberg as many areas in China and India are still yet to be integrated) will no doubt have profound changes going forward. The way of life which Americans and Western Europeans have been used to since the end of World War II will not apply in the coming decades. In short, there will be no free ride anymore.

That being said, an analysis of the U.S. stock market should logically involve looking at other stock markets and economies around the world. Using the "Leading Indicators" data for the 23 countries in the Organization for Economic Co-operation and Development (OECD), we have constructed a "Global Diffusion Index" which have historically led or tracked the U.S. stock market and the CRB Index pretty well ever since the fall of the Berlin Wall. This "Global Diffusion Index" is basically an advance/decline line of the OECD leading indicators - smoothed using their three-month moving averages. Following is a monthly chart showing the YoY% change in the Global Diffusion Index (GDI) and the rate of change in the GDI vs. the YoY% change in the Dow Jones Industrial Average and the YoY% change in the CRB Index from March 1990 to March 2005. Please note that the data for the Dow Jones Industrials and the CRB Index are updated as of May 27, 2005 (the April OECD leading indicators won't be released until June 11th). In addition, all four of these indicators have been smoothed using their three-month moving averages:

Global Diffusion Index (GDI) vs. Changes in the Dow Industrials & the CRB Index (March 1990 to March 2005) - Historically, the rate of change in the GDI has led or tracked the YoY% change in the CRB Index very closely. However, note that recently the rate of change in the GDI and the YoY% change in the CRB Index has diverged from each other!

As noted on the above chart, the rate of change (second derivative) in the GDI has historically led or tracked the YoY% change in the CRB Index very closely. Recently, however, a divergence has appeared between them - most probably due to the fact that the increase/blowoff in commodity prices got way out of hand earlier this year. Commodity bull market or not, I don't believe the current scenario will ultimately be any different. It is also to be said here that blowoffs don't usually end with a whimper, and so I fully expect the CRB Index to be more than 10% lower from its current levels in the weeks ahead.

Again, please also note that the OECD usually reports their data on a six-week lagging basis, and so the April data won't be released until about two weeks from now. In the meantime, research outfits such as the ECRI and the Conference Board have been tracking the leading indicators of the various countries in the OECD (including that of the U.S.) and it is definitely not pretty - which further exuberates the case for a lower CRB Index in the weeks ahead.

So Henry, why did you include the YoY% change in the Dow Industrials on the above chart as well? Well, it is to be noted here that the rate of change in the GDI has also led or tracked the Dow Industrials at various points over the last 15 years - although to a lesser extent to that of the CRB Index. The bears would think they are now in for a treat. However, that is not guaranteed (although I have maintained my position that I am looking for another significant correction to the stock market later this year). If one looks closely at the above chart, however, one can see that (with the exception of late 1990 and the bursting of the tech bubble during 2001 to 2002) the Dow Industrials does not have to crash when the global economy slows down. Of course, I will say differently if I see a recession ahead, but I just don't see it right now. Please note that the 3-month average of the YoY% change in the Dow Industrials is now at the zero line, and historically, that has been enough to sustain a significant bottom (note late 1994/early 1995 and late 1998). We may yet see a correction later this year to the 9,500 level on the Dow Industrials, but for now, I just don't see anything which will take us anywhere below that level. For now, we will remain overweight the large cap/brand name stocks; and underweight commodity and homebuilding stocks.

Let's now go ahead and update for our readers the performance of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to May 27, 2005) - After the very impressive rally the week before last, both the Dow Industrials and the Dow Transports were pretty much in 'consolidation mode' last week - with the former rising only 0.67% and the latter rising 0.06% for the week. Again, for now, I still think holding the major large caps and brand names is a very sound strategy.  I still do not like the major commodity or cyclical stocks - no matter how low the P/E ratio of each of those companies may be.

The rally which began two weeks ago (despite declining volume which is actually normal for this time of the year) was very impressive, and thus it is no surprise that the major market indices were, for the most part, in "consolidation mode" last week. While some of our technical indicators are getting overbought on a daily basis, one does not really see an overbought condition judging by the look of these two popular Dow Indices. On a related note, I would urge our readers to keep track of the charts in our charts section - which shows the Dow Industrials, the Dow Transports, and the NASDAQ price levels along with their respective deviations from their 50 DMAs, and their 200 DMAs (these charts are updated every Wednesday and Sunday evening). I believe these charts tell the overbought/oversold story very well. For example, as of the close on May 27th, the Dow Industrials is only 1.86% above its 200 DMA. Does this indicate an overbought condition? Most certainly not.

Speaking of the market being overbought, let's review our most popular sentiment indicators to see what they are telling us. First up is the chart showing the weekly bulls-bears% differential reading of 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 10% to 21% this week - signaling increasing bullishness among individual investors.  However, we are still not close to an overbought situation just yet.  In fact, the four-week moving average of this indicator has just turned positive - a development which has nearly always meant positive action for the stock market in the coming weeks (especially after coming off of such an oversold situation).  For now, we will keep an eye on this weekly indicator although bulls shouldn't be too worried until we start getting readings in the high 30s.

The bulls-bears% differential in the AAII survey experienced a significant jump this week - increasing from a reading of 10% to 21% (my data service shows 21% as opposed to 19% which I am seeing on some sites). Again, this reading is not indicative of an overbought condition in the stock market. On the contrary, the four-week moving average of this reading has only just turned positive - which historically has signaled more gains in the weeks ahead, especially since the AAII survey readings got really, hugely oversold during the late March to early May period.

The Investors Intelligence Survey is pretty much telling us the same story. Following is the weekly chart showing the bulls-bears% differential in the Investors Intelligence Survey vs. the Dow Industrials:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey increased slightly from 17.6% to  20.6% in the latest week - still in pretty oversold territory.  It is interesting to note that the 10-week moving average actually declined from 20.02% to 19.06% this week - the lowest such reading since the May 14, 2003 reading of 16.98%.  The bulls shouldn't be worried until we see readings in the high 30s or even the low 40s.

Even though the bulls-bears% differential in the Investors Intelligence Survey is now increasing, we are still in pretty oversold territory, especially since the 10-week moving average of this survey currently only stands at 19.06% - which is the lowest such reading since the May 14, 2003 reading of 16.98%. Like I noted in the above chart, the bulls shouldn't start worrying until we see much higher readings - possibly in the high 30s or even the low 40s.

Out of our three popular sentiment indicators, the one sentiment indicator that has baffled me the most throughout the last 18 months has been the Market Vane's Bullish Consensus - in that it never really got that oversold (readings of 50% and below) during the many corrections that we saw over the last 18 months (one of these days, I will do a detailed analysis of this indicator to see if something like this has occurred before). Let's now take a look at this reading:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading jumped from 62% to a whopping 67% in the latest week.  Okay, the Market Vane's Bullish Consensus is now overbought, but note that this indicator actually got very overbought (with a reading of 70%) in the early and middle part of November 2004, and yet the rally still continued.  We will be watching this indicator very closely in the weeks ahead.  What has continued to baffle me is that this indicator never really got that oversold (with a reading of 50% or lower) during the many corrections over the last 18 months or so.

The latest reading of 67% represents a huge jump from last week - and the Market Vane's Bullish Consensus is now overbought any way you look at it. However, please note that this reading actually touched the 70% level (twice) during the early to middle part of November 2004 - and the market subsequently continued to rally for the next four to six weeks. The fact that this overbought reading isn't being confirmed by either the AAII survey or the Investors Intelligence Survey should make the bulls feel more comfortable with the current rally.

Last week, we discussed that the total short interest on the NYSE is now at another all-time high - and that I will update our subscribers on the short interest on the NASDAQ in this weekend's commentary. Before I go on, I want to devote a couple of sentences to the NYSE Specialist Short Ratio - which I have discussed over the last several weeks. In brief: The 8-week moving average of the NYSE Specialist Short Ratio just made another all-time low (declining from 20.07% to 19.19%) - which, I believe, has bullish implications going forward. Please note that this is more of a secondary and longer-term indicator. In the meantime, the market can and will do anything, but the huge level of short interest on both the NYSE and the NASDAQ is unprecedented and will definitely "backfire" on the shorts should a sustainable and general market rally get underway.

Following is a monthly chart showing the latest short interest on the NASDAQ vs. the level of the NASDAQ Composite:

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to May 15, 2005) - Short interest on the NASDAQ increased 107 million shares in the latest month and is now again at another  all-time high.  The most recent four-month increase of 675 million shares is also the largest four-month increase in short interest in the history of the NASDAQ.  Short interest on the NASDAQ now totals 5.72 billion shares.

Another significant increase in short interest on the NASDAQ in the latest month - with a huge 107 million share increase to 5.72 billion shares, another all-time high. At some point, the bears will regret having shorted so many shares on both the NYSE and the NASDAQ, but like I said, in the short-run, the market can and will do anything to surprise the most investors/traders.

Conclusion: Our position still remains - continue to overweight U.S. equities - specifically, the major brand names/large cap growth stocks. We will continue to avoid commodities, financials, and to a lesser extent, homebuilding stocks. Companies that engage in the China (e.g. Wal-Mart) or India trade (e.g. IT outsourcing) should also be avoided at this point. The continuing slowdown of our Global Diffusion Index should further crush commodity prices in the weeks ahead, although I would not currently go as far as to call an upcoming recession. The US$ will continue to rally until get it gets to the 90 to 95 range. Richard Russell of the Dow Theory Letters just mentioned that the HUI is a "buy," but I have argued otherwise (and I have been arguing this for the last two months). I believe the recent up-tick in the HUI (along with the CRB and oil) is only just that - an up-tick and nothing more. All three have bounced and are currently doing a back-kiss with their 50-day moving averages - which I don't believe they will successfully penetrate. Moreover, Mr. Russell has failed to mention that the 50-day moving average of the gold price is about to cross below its 200-day moving average - which has historically been a very potentially bearish development.

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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