The Most Vulnerable Sector

By: Henry To | Tue, Nov 15, 2005
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Below is an extract from a "subscriber's only" commentary originally posted at on 13th November 2005.

Dear Subscribers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. For now, we are completely neutral and in cash. While the market has quickly become overbought since the bottom in late October, it should be noted here that the short-term uptrend continues to remain intact. While this author does not recommend committing substantially on the long side based on our longer-term indicators (such as our MarketThoughts "Excess M" indicator), a couple of our short-term indicators are actually flashing bullish signals - the current overbought conditions in the market notwithstanding. We will go into the necessary details later in this commentary.

In last week's commentary, we discussed the notion of whether the retail investor was "showing his hand" with regards to his bearish views on the U.S. Treasury long bond. We concluded that based on retail investor sentiment and fundamentals (including the fact that any inflationary pressures in the economy was unfounded), the long bond was oversold and was due for at least a bounce, if not a resumption of its long-term uptrend. This author stills stand by this view. In the short-term, however, anything goes. Should the yield of the 30-year Treasuries spike to a yield of over 5%, however, then this author would most likely be buying some Treasury bond futures for his own account. As always, please note that this should not be construed as explicit investment advice.

Readers may ask why we haven't gone 100% long in our DJIA Timing System since the late October lows. First reason: The market quickly got away from us and became very overbought very quickly, although that did not stop us from covering our 25% short position. Second reason: Based on our longer-term monetary and overbought/oversold indicators, any bounce from the late October lows was most likely not going to be too sustainable, similar to many of the rallies we have witnessed over the last 22 months. Final reason: Ever since January 2004, the "tape" has been very divergent in nature and that divergence has continued to hold true. Just witness the action of WMT (the retailers), Dell, KO, IBM, the financials, and the recent action of the homebuilders and you will see what I mean. The Dow Industrials - which is the index that forms the basis of our timing system - has been one of the weakest major market indices since January 2004. Given the weak relative strength of the Dow Industrials since January 2004, this author believed that any subsequent bounce in this index should be subdued. And so far, this has been the case. As of Sunday, November 13, 2005, we are still completely neutral in our DJIA Timing System.

Like I mentioned, however, the short-term uptrend remains intact. However, anyone who is choosing to invest or speculate on the long side should be very selective - both in individual stocks and individual sectors. Okay Henry, so what you are saying? Are you saying this is a good time to buy stocks?

I believe we are now in the late stages of the cyclical bull market that began in October 2002. Moreover, our MarketThoughts "Excess M" (MEM) Indicator has been progressively getting more bearish - and continues to be more bearish by the week. That means that anyone who is choosing to go long here is not only fighting the Fed, he/she is also getting on the bandwagon after many of his/her fellow investors have already gotten on the same bandwagon (on the long side). That being said, a couple of relatively powerful short-term indicators (well, I guess at least one of them anyway, as you will soon see) are telling us that the current environment is still somewhat conducive to owning stocks - as least for the next couple of months anyway. At the very least, I do not think anyone should be aggressively shorting the market here.

So what are those indicators? Long-time readers should recall that I have utilized (on-and-off) the NYSE Specialist Short Ratio as a thorn on the bears' side over the past 12 months. Subscribers who want a refresh can read about it in our November 7, 2004 commentary (which contains an illustration of the implications of a historically low NYSE Specialist Short Ratio) as well as in our May 15, 2005 commentary. Here is an excerpt from the November 7, 2004 commentary just to make things simpler: "The specialist short-sale ratio is published each week and represents the percentage of all shares sold short during that week by the NYSE specialist firms - who are the brokers appointed by the NYSE to maintain orderly markets in individual stocks traded on the NYSE. The NYSE specialist short-sale ratio may not represent the bullishness or bearishness of professional traders, but it is definitely representative of the bullishness or bearishness of the public - as these specialists are generally forced to short-sell when the public is bullish (and thus buy stocks) and to buy when the public is bearish. The historically low readings we are currently experiencing in the specialist short-sale ratio represent huge bearish sentiment of the public - as this indicates that the specialists are not forced to do much short-selling in order to maintain the integrity of the stock market." Moreover, the weekly NYSE Specialist Short Ratio has been a very good leading indicator of the total short interest on the NYSE. The fact that this is still making all-time lows as we speak tells us that NYSE short interest ending November 15, 2005 (which should be released later this week or early next week) most probably made another record high - which has nearly been always bullish (since this bull market began in October 2002) from a contrarian standpoint:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to November 11, 2005) - 1) The 8-week moving average of the NYSE Specialist Short Ratio made another RECORD LOW READING in the latest week - now at a reading of 13.78%.  The fact that this indicator has continued to decline tells us that short-selling in the NYSE continues to be rampant - and most likely will result in another record high in short interest this month. 2) Reading also bottomed out a full three weeks after the significant early August 2004 bottom.  This used to be the lowest reading ever in the history of the NYSE, but this has been totally 'blown out of the water' by the readings since May 2005.

The fact that the eight-week moving average of the NYSE Specialist Short Ratio is at 13.78% is nothing short of amazing. For comparison purposes, the eight-week moving average of the NYSE Specialist Short Ratio touched a low of 29.95% on November 10, 1944 - which preceded a rise of 30% in the Dow Industrials over the next 12 months, and a rise of 43% over the next 18 months. Such a low reading did not occur for another 38 years - when on July 16, 1982, the eight-week moving average Specialist Short Ratio touched 30.75%. What followed was even more explosive - as not only did the DJIA surged 30% over the next six months, it ultimately rose a staggering 54% before an intermediate top was registered. The only instance when this indicator erred was on January 6, 1984 (when the 8-week moving average of the Specialist Short Ratio touched a low of 30.92%) - the Dow Industrials proceeded to decline nearly 20% in the next two months (however, the Dow Industrials traded at the top of its 52-week range immediately before we got this reading). Readers should note, however, that the DJIA had recovered this loss by the beginning of 1985, and that over the next 18 months, the DJIA rallied another 110% before finally surrendering to the October 1987 crash. Again, the two other low readings (32.21% on July 27, 1984 and 31.65% on July 5, 1996) that occurred had hugely bullish implications.

Based on the current readings of the NYSE Specialist Short Ratio and assuming that historical precedents hold true, there could be some explosive action in the NYSE in the short-run, even as our monetary and valuation indicators continue to be flashing bearish signals. That being said, it is very difficult to argue that the NYSE Specialist Short Ratio has not outlived its usefulness, primarily because of the following three reasons:

  1. In today's environment, short-sellers are not constrained to retail investors anymore - all the more given the huge amount of assets that have poured into hedge funds over the last few years. Hedge funds are generally more sophisticated and not subject to emotional swings. Moreover, a significant amount of short positions are for hedging, and not for outright speculative purposes.

  2. A significant amount of trading being done on the New York Stock Exchange is now done electronically, and not through specialists any longer. This has a direct effect of decreasing the numerator in the NYSE Specialist Short Ratio, and subsequently the absolute level of the NYSE Specialist Short Ratio, since the denominator of the Ratio is not affected. This is the number one reason why the NYSE Specialist Short Ratio has relentlessly decreased over the last few years.

  3. The total amount of short interest on the NYSE is still only at 2.5% of all outstanding shares on the NYSE - hardly a precursor to a general short squeeze.

This will most probably be the final time that we will cover the NYSE Specialist Short Ratio on the MarketThoughts website (since it is now very close to having outlived its usefulness), although this is definitely something for bears to be careful about given historical precedents. This author would just like to "lay it out" for our subscribers, so to speak, given that this ratio has been bothering me (given that our indicators have been flashing bearish signals) for the last few months.


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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