DJIA Timing System Going Short

By: Henry To | Fri, Jul 15, 2005
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Dear Subscribers and Readers,

We switched from a 50% long position to a completely neutral position in our DJIA Timing System on the morning of June 13th at DJIA 10,485. With the exception of the NYSE ARMS Index (the 10-day moving average is currently at 1.08), most of our technical indicators are still too overbought. In fact, a few of our technical indicators are at levels which haven't been witnessed for the last six months. The "recovery rally" from the London terrorist attacks is most probably a mere bounce - given the market was actually in an overbought condition prior to the terrorist attack. Again, please note that the market also quickly recovered after the 3/11 Madrid attacks last year - but subsequently underperformed again. Our position of a continuing correction and then a "blow off" rally sometime in the next two to four months is still very much in effect.

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Out of all the rallies we have been witnessing over the last 18 months, this latest rally from last Thursday seems to be one of the weakest rallies among them. First of all, this rally started from an overbought condition - and second of all, I am now seeing divergences everywhere and very bullish sentiment among retail investors (as an aside, the AAII Survey is now showing 58% bulls and 14% bears - a Bulls-Bears% differential of 44%) thinking that we are already at the "blow off stage" - despite the fact that the market never got too oversold in mid April and despite the fact that we are still seeing very dismal volume on all the exchanges. We believe that the intermediate trend is still down - and therefore, we will shift to a 25% short position in our DJIA Timing System as soon as feasible - most probably as early as Thursday morning. We will send our subscribers a "Special Alert" as well as posting it on our discussion forum once we have initiated our 25% short position.

I would like to begin our commentary by discussing the various divergences I am currently seeing. Nowhere is that more straightforward and obvious than three of the major indices that most investors keep track of - that of the S&P 500, the Dow Industrials, and the Dow Transports. Following is a very simple and straightforward Yahoo! Chart showing the relative performance of the S&P 500 vs. both the Dow Industrials and the Dow Transports over the last 12 months:

While the S&P 500 is in the midst of making a new high, both the Dow Industrials and the Dow Transports are still very far away from their early March highs - a very significant divergence by the two major Dow Indices!

I almost kicked myself for posting such a simple graph, but I think the above chart paints a very powerful picture. The fact that no other major commentator has mentioned such a divergence (despite its simplicity) is amazing - but from a contrarian standpoint, makes this divergence doubly authoritative. Please note that such a "double divergence" has not occurred in the markets since the cyclical bull market began in October 2002.

This divergence can also be seen in the latest action of the NYSE McClellan Oscillator. Following is a two-year chart - courtesy of Decisionpoint.com - showing the most recent divergences of the NYSE McClellan Oscillator and the NYSE Composite Index. Note that the action of the NYSE Composite has also been tracking the action of the S&P 500 very well in recent times:

Please note that the last three series of negative divergences (see the down arrows below) in the NYSE McClellan Oscillator has all preceded a significant decline in the NYSE Composite.  Therefore, readers should take heed the most recent divergence in the NYSE McClellan Oscillator - the downtrend will be confirmed once it has declined into negative territory. This negative divergence is all the more authoritative given that the Summation Index is now overbought as well.

Like I mentioned in the above chart, please note that the three most recent series of negative divergences in the McClellan Oscillator (a higher high in the NYSE Composite accompanied by a lower low in the NYSE McClellan Oscillator) were all followed by a significant decline in the stock market - will the most recent negative divergence suffer the same fate? Probability suggests that it would - and the downtrend will be confirmed once the NYSE McClellan Oscillator declines into negative territory - made all the more authoritative given that the NYSE McClellan Summation Index is now at a very overbought level.

Recently, there has also been some talk of the Philadelphia Bank Index - that the action of the Bank Index is still very strong and thus there are no impending lending crisis (whether it is domestically or in emerging markets) - for now. However, as we have been mentioning for the past four to five months, our analysis shows otherwise - as the relative strength of the Bank Index vs. the S&P 500 had already broken down approximately four to five months ago. Following is a weekly chart of the relative strength of the Bank Index vs. the S&P 500 from February 1993 to the present:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1) The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards.2) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 3) Relative strength of the Bank Index finally broke through support convincingly 21 weeks ago and and has stayed down since - with the exception of a back-kiss off the same line 11 weeks ago.  The threat of a liquidity crunch continues to be profoundly high - and despite the rise of the Bank Index in the last week or so, the negative picture is still in place.

Please note that the relative strength of the Bank Index violated its support line (a support line that dates back to over two years ago) approximately four to five months ago - and is still currently vacillating below this support line - despite the rally of the Bank Index over the last week or so. Coupled with the fact that the Fed is still hiking the Fed Funds rate, I will need to conclude that we are still more in a bearish scenario than a bullish scenario.

I would like to spend a paragraph discussing the Nikkei - as there has also been renewed optimism over the Japanese stock market in recent days. They may very well be correct but please note that despite the most recent upsurge, the Nikkei is still more than 200 points below its 52-week high. In fact, the Nikkei has been stuck in a trading range of 10,500 to 12,000 ever since the beginning of 2004. The monetary conditions in Japan aren't too impressive to write home either, as the growth rate of the Japanese monetary base has slowed down at a "blistering" pace since the end of 2003. Following is a chart showing the year-over-year growth rate and the change in the growth rate (second derivative) of the Japanese monetary base vs. the year-over-year appreciation in the Nikkei from January 1991 to June 2005:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to June 2005) - 1) Note that Japanese money growth has been plunging since the end of 2003 and has thus far shown no signs of letting down.  In fact, the YoY growth is now at 1.74% and represents the slowest growth rate since February. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) is still in negative territory - although it turned up slightly in June. 3) Momentum of the Nikkei is now rolling over...

The year-over-year growth of the Japanese monetary base has now declined to 1.74% - the lowest since February and prior to that, April 2001. Please note that while the change in the growth rate of the monetary base has ticked up slightly in June, it is still in negative territory - suggesting that the Japanese monetary base should continue shrink going forward. The momentum of the Nikkei is nothing to write home about either, as the year-over-year appreciation of the Nikkei is now in negative territory.

Conclusion: The negative divergences, the hugely bullish sentiment, and the world monetary conditions are still signaling bearish implications for me - despite the most recent price action in some of the major stock market indices. Hopefully, our message remains clear - the ST trend (two to three months) remains down. We will be going 25% short in our DJIA Timing System sometime today.

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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