It is Time to be Careful

By: Henry To | Tue, Aug 30, 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 Friday at the close, the Dow Industrials stood at 10,397.29 - giving us a respectable gain of approximately 218 points. The coming weeks will be increasingly important, as the "summer vacation" for Wall Street officially ends the day after Labor Day Weekend (for our overseas readers, this starts on September 6th - the Tuesday after the Labor Day long weekend). The many commentators who were calling for the beginning of a bull trend were severely disappointed by the action last week - but short-term action aside, this author is getting increasingly wary about the housing market, the action of the Philadelphia Bank Index (it again broke through its 200-day moving average early last week), and of course, the continuing uptrend in both oil and natural gas prices. As I am writing this, more than one-third of all production in the Gulf of Mexico has been shut down - translating to a loss of over 500,000 barrels a day of light crude oil (just got word the figure may be closer to one million barrels a day of shut-in production). We wouldn't know the extent of the damage until early next week, but in the meantime, we should see another spike in crude oil prices.

I appreciate all the emails and feedback about our commentaries and website. Please keep them coming! We have been learning quite a bit from our subscribers and readers - market-related and non market-related, alike. Again, I apologize over my tardiness in responding to emails. My partner and I are currently in a transition phase. My partner, Rex, is moving back to Hong Kong (at least for awhile) later this week, and at the same time, we are transitioning to a subscription model. Please be patient. I will make an effort to respond to emails in due time. I am also very happy with the way that business is usually conducted in the United States. For example, I was very fortunate to be able to speak to Mr. Carl Swenlin (President of last Friday by telephone. He gave me much good advice and pointers for our website - as well as informing me how he made his start in the securities industry. This is unheard of in a country like China. Collaboration and cooperation is the key to success in the 21st century information age/knowledge worker economy, and as far as I know, Americans are still the best at it. If not, then our legal infrastructure and our set of intellectual property rights/laws usually offer us a great amount of protection - said protection which cannot be guaranteed in a country like China or India.

Please note that there is a good chance we won't be publishing a formal commentary on Thursday morning - as my partner is scheduled to leave Houston at that time. Most likely, I will be sending an "ad hoc" update of the market through my email at (Please also note that we will be shifting to a subscription model as of October 1st. However, we will also be offering a free 30-day trial subscription for all first-time subscribers (which does not include our current subscribers in our mailing list) and a discounted $39 six-month subscription for the first six months (i.e. between November 1, 2005 and May 1, 2006). From May 1, 2006 and onwards, an annual subscription to our commentaries will be $99 per year (with appropriate adjustments for a monthly or a six-month subscription)).

Here is a thought for this week - which is essentially a continuation of Thursday's morning commentary: Who is a marginal user of oil? In that commentary, I questioned the status of Indonesia - still officially an OPEC member despite the fact that the country is now a net importer of oil. As soon as we posted that commentary, the Bank Credit Analyst also posted a short daily commentary of their own. Moreover, Indonesia has now communicated her intention to raise prices and reduce fuel subsidies for her citizens next year (despite the danger of widespread riots in the country)- in light of the continuing onslaught of its currency (the government is forced to buy huge sums of dollars to pay for subsidized oil for their citizens) and the plunge in the Indonesian stock market. This question is important since the latest rise in oil is different in nature (okay, it is nearly always costly to say "this time is different" but I will say it anyway) - in that the latest rise is due to oversized demand combined with the lack of excess capacity, as opposed to a temporary restraint in supply during all the oil spikes during the last 35 years. While I believe the current price of $65 a barrel is a bit on the high side, I would not be surprised to see a sustained oil price of over $80 a barrel within the next three to seven years (barring a worldwide economic recession) - as we have highlighted many times over the last 12 months. The price of oil will only experience a downtrend if we have demand destruction - that is the reason why will continue to ask this question going forward.

Let's now expand this thought further. In that commentary, I also mentioned the status of U.S. domestic airlines. Are they a marginal user of oil? Perhaps, but I am guessing not. Sure, airliners like Delta and Northwest (disclosure: we are currently short Northwest Airlines as of this writing) would most probably file for bankruptcy if oil is to see a sustained price of $70 a barrel, but they would only be entering Chapter 11 bankruptcy. That is, there will be no significant liquidation of capacity to speak of. Airliners as a group would still have no pricing power, while Delta and Northwest Airlines will have both entered a less costly structure - thus further intensifying the competitive nature of the airline industry. Essentially, the union workers and the pensioners at these companies will be subsidizing the future passengers of these two airliners - possibly resulting in even lower airfares and an even higher jet fuel price for the entire industry. Nothing like the law of unintended consequences. We will continue to expand our thoughts on this question as time goes on - both in our commentaries and in our discussion forum.

In our commentary last Sunday, we discussed the fact that despite the short interest at the New York Stock Exchange is now at an all-time high, both the short interest ratio and the 3-month rate of increase (at 1.73% vs. a 10.79% increase as of May 15, 2005) were not sufficient enough to call a sustainable bottom. To a certain extent, the latest short interest data from the NASDAQ (which is usually released a week later than the NYSE data) is also confirming the NYSE data, as outlined in the following chart showing total short interest on the NASDAQ vs. the value of the NASDAQ from September 15, 1999 to August 15, 2005:

Nasdaq Short Interest vs. Value of NASDAQ (September 15, 1999 to August 15, 2005) - Short interest on the NASDAQ increased 73 million shares in the latest month and is now very close to its all-time high of 5.84 billion shares (a record made two months ago).  Short interest on the NASDAQ now totals 5.82 billion shares.

In fact, while the short interest on the NYSE is at an all-time high, short interest on the NASDAQ is still 20 million shares short - suggesting a less oversold condition on the NASDAQ than the NYSE despite the relentless rise of short interest on the NASDAQ over the last six years. We will keep our subscribers updated on both the short interest on the NYSE and the NASDAQ - but for now, our short interest indicators are still not on the side of the bulls. Moreover, short interest data is only updated once a month - so we will not do another update on short interest at least for another three weeks.

Speaking of an oversold condition, we continue to believe that the U.S. Dollar Index is at an oversold condition and will continue to rally in the months ahead - as discussed in our August 14th commentary and as indicated by the amount of foreign reserves held in the custody of the U.S. Federal Reserve. Historically, the return of the U.S. Dollar Index has had a significant negative correlation to the growth in foreign reserves. In our July 3rd commentary ("Our U.S. Dollar Index Revision") - with respect to foreign reserves held at the Fed - we stated that: "If one thinks about it carefully, this makes logical sense. The decrease of foreign reserves at Federal Banks means that either foreigners are demanding more U.S. dollars or that the supply of U.S. dollars is shrinking (or both), which in turn should increase the value of the U.S. dollar relative to most major currencies, such as the Euro, the Yen, the British Pound, and the Korean Won." Following is a monthly chart showing the historical relationship between the annual change in the U.S. Dollar Index vs. the annual rate of growth in foreign reserves (second derivative):

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

Please note that the right axis (the axis showing the annual rate of growth in Foreign Reserves) is inverted. And therefore, given the historical relationship, the blue and green line should be converging with one another. While this relationship has not held since the end of last year, this author believes this will once again hold true in due time. Thus, while the recent rally in the U.S. Dollar Index may have overshot itself (it has already risen 10% since the beginning of this year), I believe it will surpass the 90 level (and stay above it) within four to six months. For those who are planning a European trip but who are discouraged by the costs of vacationing in Europe, it will only get better going forward (as of this writing, I believe the U.S. dollar should continue to rise throughout 2006).

For the readers who have too much time on their hands, I believe the closing remarks made by our outgoing Federal Reserve Chairman, Alan Greenspan, at the Jackson Hole symposium is a must-read (okay, probably none of you much time but please read it anyway). I intend to do an update on the real estate market and industry in the United States in next weekend's commentary, and in light of that, I find the following paragraph from Greenspan particularly interesting: "The surprisingly high correlation between increases in home equity extraction and the current account deficit suggests that an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports, and a corresponding improvement in the current account deficit. Whether those adjustments are wrenching will depend, as I suggested yesterday, on the degree of economic flexibility that we and our trading partners maintain, and I hope enhance, in the years ahead."

If the housing boom has indeed ended, then there will be difficult times ahead for both the U.S. consumer and consequently, for countries that depend on the U.S. consumer, such as Japan, South Korea, and China. The shrinking of the current account deficit will further assist the ascent of the U.S. dollar in 2006 - but at the same time, may trigger a financial crisis in a country such as China. Moreover, a relatively recent study by the IMF states that: "Housing price busts were associated with output effects about twice as large as those of equity price busts. The worse case output effects exceeded those of equity price busts by a substantial margin. Moreover, the slowdown after a housing price bust lasted about twice as long." In other words, the "wealth effect" (or contra-wealth effect or however one wants to label it) from a housing price decline will have a significantly larger impact on the U.S. economy than the bursting of the technology bubble during 2000 to 2002. This is not surprising since 40% of all new jobs created during the last four years are either directly or indirectly related to the real estate industry. If the housing market is to slow down, then there will be adverse consequences ahead. This author believes our subscribers and readers should definitely keep track of the major homebuilding stocks going forward.

Let's now turn to the markets. As I stated in the conclusion of our Thursday morning's commentary, some of our technical indicators are now approaching "oversold status" - and none is more apparent than the NYSE ARMS Index - a technical indicator which we really have not updated our readers on since mid-April. Following is a daily chart of the 10-day and 21-day moving average of the NYSE ARMS Index vs. the Dow Jones Industrial Average from January 2003 to last Friday:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - 1) The 10-day MA of the ARMS Index hit a relatively high level of 1.281 on Friday at the close, slightly surpassing the resistance line dating back to late March 2004.  In a more 'normal' correction within a bull market, this will be 'normally' good enough for at least a ST bottom - but this author believes that 'caution' is now the key. 2) Did the 10 DMA of the ARMS just break resistance?

The 10-day moving average of the NYSE ARMS Index is currently at 1.281 (which is slightly lower than the 1.321 reading we got at the close on April 28th) - a moderately oversold reading and a reading which is usually good enough to act as a buy signal during a typical bull market. Given the fact that we are at the tail-end of this cyclical bull market, however, we are asking for our readers to be cautious here. More importantly, there is a reasonable chance that the 10-day moving average of the NYSE ARMS Index may have just broken the resistance line dating back to March 2004. If so, readers should be prepared to see some rough waters ahead.

We will update our overbought/oversold indicators for our readers in the coming days ahead - including the most recent action of the Rydex Cash Flow Ratio. Let's now take a look at the most recent market action by with the following daily chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to August 26, 2005) - 1) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials! 2) For the week, the Dow Industrials and the Dow Transports declined 161, and 51 points, respectively.  Last week, I stated that 'despite the fact that these two popular Dow Indices are still mired in ST downtrends, many analysts are still calling for higher prices ahead - which is bearish in itself.'  The action over the last week was definitely disappointing for the bulls, but anything can happen this week - as this is the quiet week (thus low volume) before Wall Street comes back from vacation.  The bulls may be happier this week, as the IPO calendar is pretty much non-existant (thus, less supply of shares for the market) but for now, I am still relatively comfortable with our 25% short position in our DJIA Timing System - especially in light of a one-third cut in oil production from the Gulf and a continuing clampdown on liquidity by the Federal Reserve and most Central Banks around the world.

For the week ending August 26th, the Dow Industrials and the Dow Transports declined 161 and 51 points, respectively. While the Dow Transports is still very resilient in light of record high oil prices, this author is going to jump ahead (which is always dangerous) and predict that the Dow Transports will decline in due time. Ever since the primary non-confirmation of the Dow Transports by the Dow Industrials in early March of this year, we have been skeptical of the sustainability of this rally, and this author is getting increasingly wary. The slowdown in the housing boom and now Hurricane Katrina is now reaffirming our relatively bearish views.

Let's now take a look at our most popular sentiment charts - starting with the Bulls-Bears% Differential readings in the American Association of Individual Investors Survey vs. the Dow Industrials:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey rose slightly from negative 11% to 5% in the latest week.  While last week's reading of negative 11% signaled a pretty oversold situation, this author does not think that reading reflected the bottom in terms of market sentiment.  Moreover, the fact that the latest AAII survey reading experienced a positive bounce despite a declining market suggests to me that individuals are still buying into the decline - which is historically a good indicator that the current downtrend will continue.  Again, we will continue to stay 25% short in our DJIA Timing System.

During the latest week, the bulls-bears% differential in the AAII survey experienced a slight uptick - rising from negative 11% to positive 5%. Was the 11% reading of last week an indication of a bottoming in bearish sentiment? This author will argue "No" - as our other sentiment indicators were not confirming this relatively oversold reading. More importantly, the fact that the AAII survey experienced a positive bounce despite a declining market last week suggests to me that individuals are still buying into the decline - which is historically a good indication that the current downtrend will continue. Finally, readers should keep in mind that the most severe declines in the stock market have occurred while the AAII survey is in an oversold condition.

The Bulls-Bears% Differential in the Investors Intelligence Survey is still not confirming the oversold condition in the AAII survey as of late last week - which in all probability signals a continuation of the current downtrend. For the week, the Bulls-Bears% differential in the Investors Intelligence Survey declined slightly from an overbought reading of 34.8% to a still-overbought reading of 31.8%:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) -  The Bulls-Bears% Differential in the Investors Intelligence Survey declined slightly from 34.8% to 31.8% in the latest week.  Last week, I stated that: 'My guess is that this survey will confirm the oversold condition of the AAII survey in due time - suggesting lower prices within the next few weeks.'  The fact that this reading remains at a moderately overbought reading of 31.8% further suggests this will be the case.  Again, combined with the 'reassurance' of further hikes in the Fed Funds rate and given still-high oil prices, I would say that we are pretty comfortable with our 25% short position in the DJIA Timing System.

Again, my comments with regards to this indicator remain the same as last week. My current guess is that this reading will continue to decline until it gets to a more oversold condition - thus signaling lower prices ahead. For now, we will still relatively comfortable with our 25% short position in our DJIA Timing System.

With regards to the Market Vane's Bullish Consensus sentiment indicator - again, our comments remain the same from last week. Last week, I stated: "Readers should keep in mind that the Market Vane's Bullish Consensus has been the most "correct" sentiment indicator out of our three sentiment indicators since January 2004 - in that the Market Vane's Bullish Consensus never really got too oversold during the March 2004, May 2004, August 2004, October 2004, and April 2005 ST bottoms - thus signaling relatively weak rallies ahead. This has definitely proven true - contrary to the very oversold readings that we were getting from both the AAII and the Investors Intelligence Surveys during most of those ST bottoms."

As of last week, the Market Vane's Bullish Consensus is also still at a relatively overbought level. Look no further than the chart below:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus inched down from 64% to 63% in the latest week - officially ending the streak of consecutive overbought readings dating back to late May .  The ten-week moving average of this reading declined slightly from 67.7% to 67.1% - suggesting that bullish sentiment have turned.  This is definitely a red flag for the bulls, given that the Market Vane's Bullish Consensus is just reversing from a highly overbought level.

More importantly, I am further convinced now that the Market Vane's Bullish Consensus has now reversed from a highly overbought situation and is now trending down - suggesting lower prices ahead. Throughout the last 20 months, I have often mentioned a "preferred oversold reading" of 50% or lower before we should commit on the long side in a substantial way. So far, that has not happened. The lowest reading we have seen during that period of time was "only" 56% in mid-August 2004. Nonetheless, the current reading of 63% is nowhere near that level and thus definitely is not indicating a sustainable bottom here.

Conclusion: While the market is getting increasingly oversold, most of our technical indicators are still not oversold enough for us to commit on the long side. In fact, the fundamentals (such as a potential top in the housing market, a tightening Fed, etc.) are still suggesting lower prices ahead. With Wall Street officially coming back from "summer vacation" after Labor Day Weekend in about a week, it is time to be careful. For now, we are still relatively comfortable with our 25% short position in our DJIA Timing System. The only bull market that we like in the coming months is the current rally in the U.S. Dollar Index - and nothing more.

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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