Bank Index Breaking Down Further

By: Henry To | Fri, Aug 19, 2005
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Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. As of yesterday at the close, the Dow Industrials stood at 10,550.71 - giving us a slight gain of approximately 65 points. As we stated in last weekend's commentary, there are no new signals this week - while the "strong" performance of HPQ is quite reassuring for the bulls, judging from the Dell and Cisco reports (along with disappoint guidance from Wal-Mart ) over the last two weeks and given continuing high fuel prices (natural gas as well as crude oil prices), it now looks like technology spending is again weakening after an encouraging run since April earlier this year. Moreover, as we will show later in this commentary, the monetary tightening continues - and the actions of bank insiders are confirming this bearish development. Again, readers should continue to tread carefully in this still-overbought market.

Please note that has just revised their calculation method of both the Rydex Asset and Rydex Cash Flow Ratios - resulting in a less oversold condition in both of these indicators. claims their revised method now gives us a more accurate gauge of investor sentiment. For example, the Rydex Cash Flow Ratio (cumulative flows into bear funds plus money market assets divided by cumulative flows into bull funds) is now at 0.89 - down from an old reading of 1.03 just a couple of days ago.

This author will try to do more work on Japan in the following week - given that the Nikkei has now broken out of his 18-month range by surpassing the 12,000 level. Please note that the latest buying spree has all been foreign buying, as both Japanese retail investors and institutions have been a net seller of equities over the last couple of months. Historically (in the last 15 years or so), foreign buyers have usually been bad timers when it comes to the Japanese stock market. It is difficult to imagine that they will be correct this time, given continuing monetary tightening in Japan, the aging demographics, and the lack of structural reforms in the domestic economy (which is much less efficient than the American economy) so far. Readers please stay tuned.

I will aim to keep this commentary as brief as possible - but please keep in mind that this will be a very important commentary. Ever since the break down of the Philadelphia Bank Index approximately six months ago, I have warned of an impending liquidity crunch - either in the domestic economy (such as the bankruptcy of airlines, auto manufacturers, or a slowdown in consumer spending) or in emerging markets (such as a Chinese slowdown or the potential blowup of a hedge fund). The key is to focus on the marginal consumer - either a marginal consumer of credit or of energy. For example, the lower and lower-middle class of the U.S. definitely fits this bill, as the savings rate is now effectively zero and as the distribution of wealth in this country continues to widen. The dismal guidance offered by Wal-Mart in its latest earnings report can certainly attest to that.

Recent price action in the Philadelphia Bank Index has just gotten more bearish - as the relative strength of the Bank Index vs. the S&P 500 (please see our January 17, 2005 commentary for our original analysis of the bearish implications of a breakdown in the Bank Index) just made another new low as of the close last Friday. The following weekly chart shows 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 approximately six months ago and and has stayed down since - with the exception of a back-kiss off the same line 16 weeks ago.  More importantly, the relative strength of the Bank Index made another new low last week - the lowest level since September 2002.  The threat of a liquidity crunch is now very high - given the monetary tightening around the world and given continuing high energy prices.  The cyclical bull market in U.S. equities is now very much in danger.

Given the above chart, it is not difficult to see that liquidity conditions are continuing to get tighter - especially given that the Federal Reserve has signaled that they will continue to hike the Fed Funds rate - barring a LTCM-style crisis - for the rest of this year. The following July 25th chart courtesy of the Bank Credit Analyst suggests that insiders from the financial industry is also in agreement, given the recent explosion in insider selling from the sector:

Financial Sector: Insider Sell/Buy Ratio

Quote from the Bank Credit Analyst commentary: "Sellers remain aggressive and buying has virtually evaporated. The insider sell/buy (S/B) ratio has soared, and does not validate recent firmness in relative stock performance. While it is true that financial insiders remained heavy sellers until well after relative stock performance troughed in 2000, this seemingly lagging behavior likely reflects two key events. First, there was a fear that the Fed would not act to protect growth, as interest rates were only first slashed in early-2001, even though the broad corporate sector was on the verge of its worst ever post-war crunch. Second, the collapse in tech stock prices lifted all non-tech groups. Now, Fed Chairman Greenspan remains intent on pushing short-term rates higher, and financial insiders are paying heed. The bottom line is that the downside risks to financial sector relative share performance remain high and underweight positions are still recommended (with the exception of the insurance group, which was upgraded to neutral)."

A declining liquidity situation is never good for the equity markets. Nowhere is this better reflected than the recent dismal growth in M-3. Please note that the 52-week percentage change in the 20-week moving average of M-3 has recently again dipped below its 40-week moving average. The 52-week percentage change in the 20-week moving average is now 4.81% - the lowest reading since May 2004.

52-Week % Change in M-3 (20-Week and 40-Week Moving Averages) vs. DJIA (January 1, 1982 to August 1, 2005) - M-3 growth peaked in late 2001 and early 2002 and has continued to decline (with the exception of a slight 'bump up' in late 2003) since that time.  Please note that the recent uptick in M-3 does not even register on this chart - as well as the fact that the 20 WMA has now again declined below its 40 WMA.

While there may be some "monetary overhang" from the liquidity creation days during 2001 to 2002, readers should take heed that stock prices continued to tank throughout 2002 - thus probably negating some of that liquidity "explosion" during that period. Moreover, this "monetary overhang" most likely just spilled over to the housing, energy, and emerging markets. Retail investors are still very reluctant to purchase stocks here - and liquidity conditions (along with demographics) are going to "prevent" them from further bidding up the equity markets in the months ahead.

Coincidentally, the latest margin debt data (as of the end of July 2005) has just been released by the New York Stock Exchange. Despite the breakdown of the Bank Index, despite the bearishness of financial insiders and executives, and despite a continuing slowdown in monetary growth, retail investors are still choosing to speculate and to ignore all these bearish signs. This is evident by the fact that margin debt held in the custody of NYSE board members jumped over $10 billion last month - the biggest increase in margin debt since November 2004. More importantly, the total margin debt outstanding is now at its highest level since November 2000! Following is a chart we haven't shown in awhile - a chart showing the Wilshire 5000 vs. the amount of cash in both cash and margin accounts vs. the levels of margin debt:

Wilshire 5000 vs. Cash and Margin Debt Ratios (January 1997 to July 2005) - NYSE margin debt outstanding increased over $10 billion in July - the biggest increase since November of last year (total margin debt is now at a level not seen since November 2000!).  Cash levels, however, continue to decline.  Cash levels as a ratio of margin debt and the Wilshire 5000 are now at lows not seen since Nov. 2000 and Jan. 2001, respectively.

Moreover, the cash levels in both cash account and margin accounts are now dangerously low - with cash levels as a ratio of margin debt and the Wilshire 5000 at lows not seen since November 2000 and January 2001, respectively. In a general stock market decline, there will be not much of a cash cushion, and the amount of leverage now "in the system" is a little bit on the high side - suggesting the potential for a severe decline should stock market participants choose (or forced) to de-leverage themselves during a general stock market decline.

Conclusion: Given that the economic recovery since 2001 has mostly been about the housing industry (including mortgage consulting and financing) and the financial services industry, I would definitely pay heed to the breakdown of both the Philadelphia Bank Index, the recent explosion of insider selling in the financial sector, and the continuing decline in M-3 growth in the United States. Moreover, on a more micro level, the liquidity in both cash and margin accounts are now getting dangerously low - a red flag that is further exacerbated by the amount of leverage now "in the system." It is now not a good time to go long - let alone go long on margin.

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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