Let the Action Finally Begin

By: Henry To | Tue, Sep 6, 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 10,447.37 - giving us a respectable gain of approximately 168 points. The "real action" should start this week - as Wall Street traders officially come back from their summer vacations and as news of the aftermath of Katrina (such as the rising death toll, current estimated damages of over $100 billion, and continuing updates of the Gulf Coast energy infrastructure) continue to trickle in. It is this author's contention that the market has chosen to ignore all the negatives in the aftermath of Hurricane Katrina - such as the drain of liquidity caused by the estimated $100 billion in damages and rising energy prices - as well as the continuing drain of liquidity from Central Banks around the world and a potential slowdown in the housing market. Instead, the market is focusing on "positives" such as a potential halt in interest rate hikes (the Fed Funds futures is now only pricing one more 25-basis point rate hike between now and the end of December) and perhaps a building boom in the aftermath of Hurricane Katrina. While the action of the market over the last week is definitely impressive in light of Hurricane Katrina, this author is getting very wary - as most of our technical indicators are no longer oversold and as this cyclical bull market is getting very mature. For now, I still feel pretty comfortable with the 25% short position in our DJIA Timing System, as the Dow Industrials has continued to be the weaker index ever since the beginning of this cyclical bull market back in October 2002.

As I mentioned in our commentary last weekend, there was a "good chance" we were not publishing a Thursday commentary due to my partner, Rex, leaving for Hong Kong at that time. Instead, I had sent out a brief "ad hoc" update on the markets to our registered subscribers on Thursday morning. Please let me know if you had not received it.

Latest Market Poll: Please participate in our latest poll on the U.S. Housing Bubble. This week's question is: Is the U.S. housing bubble finally topping out? Please be objective and don't let our opinions change your minds! Also, note that a "slow down" does not mean U.S. housing prices will in general collapse from here. Rather, various commentators are just calling for a flattening of the recent appreciation in prices in markets such as Nevada, Arizona, California, etc. Please vote as well as let us know what your thoughts are by replying to our post in our discussion forum.

I want to begin this commentary by briefly discussing the recent price action in natural gas. In our July 31, 2005 commentary, we attempted to raise our readers' awareness on the fundamentals and investors' sentiment in natural gas, such as a potential shortage in domestic supplies as well as the fact that our natural gas infrastructure has not been designed to take delivery of a substantial amount of natural gas from overseas because of the lack of LNG terminals in this country. We also discussed the fact that most commentators have chosen to focus on discussing crude oil instead - when natural gas most probably have more solid fundamentals at least over the next three to five years. This is evident by the lack of articles regarding natural gas even as natural gas prices at the Henry Hub doubled from late 2002 - along with a lack of bullish sentiment as signaled by the Market Vane's Bullish Consensus. Moreover, natural gas prices have been lagging oil prices since early 2004. Judging from the following chart showing the month-end natural gas vs. crude oil prices, however, this is no longer the case:

Month-End Henry Hub Natural Gas vs. WTI Crude Oil Spot Prices (November 1993 to August 2005) - 1) Historically, natural gas prices have pretty much tracked crude oil prices here in the United States.  More importantly, the historical volatility in natural gas prices is far greater than that of crude oil (as noted by the wider movements in natural gas prices and by the two upside spikes at the end of December 2000 and February 2003).  A few weeks ago, I stated: 'Given the wide variations in weather patterns in recent years and give the tight supply situation, I think we are overdue for another such spike.'  This has now come true in light of the havoc wrecked by Hurricane Katrina in the Gulf Coast last week. 2) Natural gas prices no longer lagging after spiking over $4.50/MMBtu during August.

Since our July 31, 2005 commentary was published, the spot price of natural gas had spiked over $4.00/MMBtu, which is energy-equivalent to a $23/barrel spike in the price of crude oil! This author had been calling a spike in natural gas prices an "overdue event" but little did I know it will happen so quickly. Going forward, the demand/supply situation in natural gas is more precarious than the situation in crude oil, as we have previously outlined. Moreover, keeping track of the fundamentals and price action of natural gas is important - as the commodity is responsible for supply 24% of the country's energy needs on an energy-equivalent basis (vs. 40% for crude oil). While high oil prices may not tip the U.S. economy to the brink of a recession, a combination of high oil prices along with $15 to $20 natural gas will make it doubly potent - especially if bottlenecks develop around various pricing points in states such as New York and California. If we are to follow the 2000/2001 winter scenario, then $50/MMbtu gas at the New York Citygate - given a colder-than-expected winter - is not improbable. That being said, this author does not currently recommend going long natural gas in any way, as the commodity (along with oil) is definitely very overbought.

In last weekend's commentary, I had also mentioned that we will update our views on the housing market this weekend. The Office of Federal Housing Enterprise Oversight (OFHEO) updates its house price indices for the United States as well as for each individual state and the major Metropolitan areas of the country. Readers can refer back to our June 1, 2005 commentary for our first article on the housing bubble using OFHEO data, as well as to see an explanation of why we think claiming that there is no housing bubble on the basis of single-family home median prices is a seriously flawed analysis. That is, a housing bubble (similar to a stock market bubble) is defined only by price rises in certain areas of the United States - certainly not in the entire United States and is certainly not evident by only looking at median prices of single-family homes in the United States. This is consistent with the stock market bubble of the late 1990s - a bubble where only technology and telecom stocks participated while value and small caps stocks as a whole took a giant hit. If one had only focused on the "median price" of stocks (whatever that meant) during that time period, one would not have be able to detect a stock market bubble at all.

The 2005 2nd quarter house price indices were just release by the OFHEO on September 1st. Following is a chart showing the annualized quarterly appreciation in the OFHEO House Price Index for the hottest five states - as measured by the latest quarterly increase for all 50 states in the country:

Annualized Appreciation in Housing Prices of Selected States vs. the U.S. (1Q 1976 to 2Q 2005) - More of the same for now, as Nevada is still at the top of the rankings (out of all 50 States) when it comes to appreciation in housing prices for the 2nd quarter of this year.  For now, the housing market still remains red hot.  Subscribers should note, however, that all 'good things' will ultimately come to an end.  Subsequent to each period of significant appreciation , housing prices in all five states (with Hawaii being historically the most volatile) have always followed with significant declines or stagnation.

As mentioned in the above chart, Nevada still remains at the top, for now. However, all "good things" ultimately come to an end - and this time will be no different - not even for traditionally "hot" states such as Hawaii, California, and Florida. In fact, if history is any guide, the current housing bubble is definitely getting very stretched and should ultimately run out of steam sometime next year. This view is all the more evident when one looks at the following chart (a chart which we first introduced in our June 9, 2005 commentary):

Difference Between the Annualized Appreciation in Housing Prices of the Top 5 Hottest States vs. the U.S. (1Q 1976 to 2Q 2005) - Prices have always declined when both the annualized appreciation of housing prices in the United States and when the differential between the annualized appreciation in the top five U.S. States and the whole of the U.S. are at such elevated levels.  That being said, housing prices (in general) will most probably not crash.  Rather, real estate prices in most of the currently hot states will most likely underperform for years to come.

This chart shows the annualized quarterly appreciation in housing prices in the United States vs. the differential between the top 5 states and the United States at any given quarter. Historically, whenever the appreciation in both U.S. housing prices and the differential has been this high, U.S. housing prices have always subsequently stagnated or experienced a dramatic slow down in growth going forward. There is no reason to doubt that "this time will be different." (Collectively, the five most expensive words that investors have uttered since the Tulipomania in Holland in the 1630s.)

The weakness in the housing and homebuilding sector is further confirmed by the recent drop in lumber prices. Following is a weekly chart showing the near futures price of lumber from 2001 to last week. Please note that the lumber prices dropped to a fresh two-year low as late as ten days ago:

Lumber prices hit a fresh two-year low as late as ten days ago...

Combined with the recent weak action of the homebuilders with the five largest market capitalizations (with PHM, KBH, LEN, CTX, and DHI all trading below their 50-day moving averages), this author will have to conclude that the housing and homebuilding bubble is close to exhaustion - ironically, if Hurricane Katrina had not hit New Orleans early last week. Under the current scenario, the Fed Funds futures are now only pricing in one more 25-basis point rate hike for the rest of this year. If so, then the red hot growth we have seen in the United States housing market may extend for the rest of this year and into early next year (given that a significant amount of speculative investing has been done using ARMs). That being said, the current housing bubble (especially in states such as Arizona) is definitely on its last legs. Given that the current cyclical bull market is also maturing, this author is not too thrilled about the housing market in New York or New Jersey either.

I now want to skip the U.S. and talk about the Japanese markets instead. Since our studies have mostly been on the U.S. markets, I cannot claim to be an expert on the Japanese financial markets (in fact, I don't think anyone can lay claim to be an expert on the markets - not in this day and age). However, it is very notable and impressive that the Nikkei 225 has continued its relentless rally despite ever-rising oil and natural gas prices and despite a significant slowdown in monetary growth. Following is the chart showing the year-over-year growth in the Japanese monetary base (as well as the 2nd derivative) vs. the year-over-year appreciation in the Nikkei from January 1991 to August 2005:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to August 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 1.13% and represents the slowest growth rate in over 4 years! 2) Note that the second derivative (the rate of growth of the Japanese monetary base) is still in negative territory - although it turned up quite a bit since February. 3) Momentum of the Nikkei diverging from monetary growth...

As we have mentioned over the last few months, the growth of the Japanese monetary base has been dramatically slowing down since the end of 2003. In fact, the latest year-over-year growth in the Japanese monetary base now only stands at 1.13% - which represents the slowest growth rate since January 2001! And we all know what happened afterwards… especially given that the momentum of the Nikkei has been diverging from monetary growth for the last several months. Moreover, virtually all the buying of Japanese equities so far have been foreign buying, and foreigners have been burned more often than domestic investors in Japan for the last 15 years. That being said, the valuation of Japanese equities are by far the cheapest compared to valuations in the U.S. and in the Euro Zone, and given the huge lead in various polls of the current reform-minded Japanese Prime Minster Junichiro Koizumi in the upcoming September 11th election, investors definitely have something to cheer about. So while this author does not believe this is a good time to initiate positions in Japanese equities, I do not believe this is a good time to short either. There will be better opportunities coming up - especially if the U.S. experiences an economic slowdown in the wake of a weak housing market, high energy prices, and a build-up in the domestic savings rate, etc.

Let's now turn to the most recent action of the stock market. While the stock market action during the latest week was impressive in the wake of Hurricane Katrina, this author believes that the bulls who are already calling the bottom of this stock market may be getting ahead of themselves. At this point, it is still too early to put a price on both the monetary and emotional damages caused by the hurricane - along with the lingering effects of the disaster on global liquidity and energy prices going forward, etc. Instead, this author believes that the market has chosen to focus solely on the possibility that the Fed will only hike the Fed Funds rate by one more time this year from the current 3.50% to 3.75%. Readers should be reminded that the halt in the rise of the Fed Funds rate in the face of an economic slowdown isn't exactly bullish news. Don't forget that the market declined for another 21 months after the Fed started easing in January 2001.

Let's now take a look at the most recent market action 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 September 2, 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 rose 50 points while the Dow Transports declined 14 points - a respectable performance given the damage and emotional havoc wrecked by Hurricane Katrina on the Gulf Coast last week.  Looking at the above chart, however, it is obvious that both of these Dow Indices are still mired in ST downtrends - no matter what the bulls say.  Despite the fact that the action of the market appeared 'respectable' last week, my guess is that the bears will win out over time, as I believe the global drain in liquidity (including a drain in liquidity caused by Hurricane Katrina) should overcome the current bullishness caused by an expected halt in the Fed Funds rate sometime this year.  I am still relatively comfortable with our 25% short position in our DJIA Timing System.

For the week ending August 26th, the Dow Industrials and the Dow Transports rose 50 points while the Dow Transports declined 14 points - capping off a very newsworthy week but an otherwise non-eventful week in the stock market. Last week, this author declared (which, I will emphasize, is always dangerous) that while the Dow Transports has been very resilient in light of record high oil prices, the Dow Transports will decline in due time. I still stand by this prediction. Not only will gasoline prices continue to feel upward pressure (given that 880,000 barrels of refining capacity is expected to be offline for weeks if not months) but the transportation infrastructure to and from New Orleans (the fifth largest port in the world in terms of volume) has also suffered. Case in point: Yellow Roadway, a Dow Transports component, had 20 trucking terminals in the affected areas - some of which have definitely been destroyed.

For now, both the Dow Industrials and the Dow Transports are still mired in short-term downtrends - suggesting we have not seen the end of this decline yet. Moreover, we are always reluctant to initiate any long positions whenever Wal-Mart (WMT) makes a new 52-week low - which it promptly did last Friday at the close.

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 declined slightly from 5% to negative 6% in the latest week.  While this represents a somewhat oversold condition, please keep in mind that the four-week moving average is still 'only' at negative 0.3% - nowhere near as oversold as the negative 21.5% reading for the week ending April 15, 2005.  For now, this author believes that the downtrend remains intact - and we will definitely need a more oversold reading in the AAII survey before we will cover our 25% short position in our DJIA Timing System.

During the latest week, the bulls-bears% differential in the AAII survey experienced a slight downtick back below the zero line - declining a reading of 5% to negative 6%. While the weekly reading is definitely oversold, readers should keep in mind that the four-week moving average is only sitting at negative 0.3% - a reading which is nowhere near as oversold as the negative 21.5% reading we obtained for the week ending April 15, 2005 (just as the major market indices made a ST bottom). For now, the downtrend remains - and again, 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 finally "taking a detour" from the readings of the last few weeks. What do I mean by that? Well, it looks like that the latest reading from the Investors Intelligence Survey is finally confirming the AAII survey: For the week, the Bulls-Bears% differential in the Investors Intelligence Survey declined from a reading of 31.8% to 23.8%:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey plunged from 31.8% to 23.8% in the latest week.  While the weekly reading is no longer overbought, the four-week moving average is still relatively overbought at 32.6%.  For comparison purposes, the four-week moving average was at 21.3% for the week ending April 15, 2005.  Again, this author does not suggest initiating any long positions until this reading reaches a more oversold level.

The same commentary from the AAII survey applies to the Investors Intelligence Survey - as the latest reading of 23.8% from the Investors Intelligence Survey is still not oversold enough to signal a sustainable market bottom. This is evident when one looks at the four-week moving average of the bulls-bears% differential - which is currently at 32.6% vs. a 21.3% reading for the week ending April 15, 2005. At the very least, the weekly reading will need to decline to near the 15% before this author will be willing to initiate any long positions or to even close out our 25% short position in our DJIA Timing System.

As for the Market Vane's Bullish Consensus, it is actually still at a pretty overbought level (on a moving average basis), even though the latest reading has again declined - from 63% two weeks ago to 62% as of last week:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus inched down again from 63% to 62% in the latest week - while the ten-week moving average of this reading declined slightly from 67.1% to 66.3% - which is still very much in overbought territory.  This is definitely a red flag for the bulls, given that the Market Vane's Bullish Consensus is still in a downtrend and  had reversed from a highly overbought level.

Again, the current weekly reading of 62% and the ten-week moving average of 66.3% is also not oversold enough for this author to confidently initiate any long positions in the market for now. At the very least, this author would like to see a sub-60% reading before doing so. Given the phase of this cyclical bull market, however, the ideal reading will be a reading below 55%. For now, we are relatively comfortable with our 25% short position in our DJIA Timing System - all the more so given that the Dow Industrials has been the one of the weakest indices since the beginning of this cyclical bull market back in October 2002.

Finally, let's turn to another sentiment indicator - one which we find has been useful in the past but which we haven't updated in two months. Following is the monthly chart showing the Consumer Confidence Level from the Conference Board vs. the Dow Industrials from January 1981 to August 2005:

Monthly Chart of Consumer Confidence vs. DJIA (January 1981 to August 2005) - 1) Significant run up in Consumer Confidence prior to the October 1987 Crash 2) Rounding top in early to Fall 2000 prior to the 2000 to 2002 bear market 3) Huge run up and top prior to the Fall 1998 Crash 4) Consumer Confidence still over 110 prior to the May to July 2002 Crash 5) From a contrarian standpoint, the August Consumer Confidence reading of 105.6 (which represents a near three-year high on this index) definitely does not bode well for the stock market going forward.  This author is looking for a reading below the November 2004 reading of 90.5 before we can most probably enjoy a more sustainble uptrend going forward - especially given the maturity of this cyclical bull market.

Historically, the level of consumer confidence has worked well as a contrarian indicator (as well as an oversold/overbought indicator) - even though this is only updated monthly and even as traders react bullishly (at least initially) to a high reading in the level of consumer confidence, and vice-versa. The most recent August reading of 105.6 (released on August 30, 2005) is definitely on the high-end - suggesting that the public is still too optimistic and definitely not indicative of a sustainable bottom in the stock market (and certainly not consumer spending). As I mentioned in the above chart, I will probably not budge from our relatively bearish position until the level of consumer confidence declines closer to the 90 level.

Conclusion: I apologize for the long commentary this weekend. Hopefully, our readers will be able to get a better glimpse of what this author is currently thinking about with regards to the stock market as well as the domestic housing market and economy. This author is inherently cautious - and it definitely shows in this latest commentary - no matter whether one is discussing the domestic housing market, the Japanese stock market, or the domestic stock market. For now, this author is betting that investors are not seeing the total disastrous picture and aftermath of Hurricane Katrina - instead choosing to focus on the potential halt in interest rate hikes sometime in the next few months. The loss of New Orleans as a strategic port is definitely important - not to mention the continuing lingering effects on crude oil and natural gas production (as well as refining capacity) in the Gulf Coast area. Has this sunk in for individual investors yet? My guess is "no" - even as AMG Data Services announced a $1.4 billion outflow in domestic equity funds for the week ending August 31st.

Meanwhile, the consolidating action of last week has rendered some of our technical indicators less oversold - such as the NYSE ARMS Index that we discussed last week as well as the NYSE McClellan Oscillator. Sure, the Rydex Cash Flow Ratio is still very oversold at 0.94, but no bear can have it his or her way all the time. At the very least, the upcoming week promises to be full of action - as Wall Street traders are expected to be out in force after having been away on summer vacation and as we continue to find out the extent of damages and economic impact caused by Hurricane Katrina. For now, we are still relatively comfortable with our 25% short position in our DJIA Timing System, and we will not look to cover this short position until the market gets more oversold.


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. 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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