Market Now in Dangerous Zone

By: Henry To | Tue, Feb 28, 2006
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Dear Subscribers,

The latest issue of Business Week contains a huge cover story on private equity - discussing many recent deals as well as the fact that it is now "the place to be" for MBA graduates. And I have to now wonder: Is the private equity bubble about to burst? Note that CALPERS (California Public Employees' Retirement System) have already ratcheted down their investment allocation to private equity deals back in October of '05 - with the head of the fund declaring that private equity was "in a bubble." Leverage in many deals is now enormous, with historically high valuations to go along with them. If our 2006 mid-cycle slowdown scenario holds true, then many of these deals will literally fall apart. By the way, here is some tongue-in-cheek humor for the week.

This is a repeat from last weekend's commentary: For readers who are currently still long on individual stocks, I highly recommend reading the latest two-part interview of Paul Desmond on - President of Lowry's Reports. In the latest interview, Desmond discusses the art of picking stock market tops - which as this author has mentioned before - is inherently much more difficult than picking bottoms. In the two-part interview, Desmond discusses that we may be on the verge of a major top, and that the next few weeks of stock market action will be crucial for the bulls. To get a copy of Lowry's original report (cost $10), one can do so by surfing over to the Lowry's research studies page. Note that this author does not have any personal or business relationships with Lowry's reports at this time. The conclusion of the latest Lowry's research confirms with the divergences that we have been seeing and that we have been discussing over the last few weeks.

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. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (11,061.85), our position is 191.85 points in the red - but again, given that the market is now showing signs of a classic "blow off" top, this author is betting that this position will ultimately work out. Going forward this week, I would not be surprised to see some more strength early in the week, but I believe that such strength should be sold. If we do see some more on Monday or Tuesday, then this author will "break tradition" and go 75% short in our DJIA Timing System. Such a position is a very bold move on our part - but since both the financial markets and the stock markets of the world are showing signs of a classic top - this author is willing to stand both the criticisms and the volatility. Let me be clear: We are still in a secular bear market. The era of disinflation that supported a secular increase in P/E ratios during the 1980s and 1990s ended in 2000. It does pay to be a trend follower most of the time, but not when bullish sentiment is rampant and not when the market is hugely overbought and showing many signs of divergences. This author is now choosing to take such a stand.

In our many commentaries over the last few weeks, I discussed the many divergences in the current stock market - citing the recent "market top" study done by Lowry's Reports, as well as relative strength of the Bank Index, the retail HOLDR (RTH), the weakness of the McClellan Summation Index in the Dow Industrials during 2005, the further deterioration of our MarketThoughts "Excess M" (MEM indicator), the flattening/inverting yield curve, and the continuing weakness of the commodity currencies (AUD, NZD, South African Rand) with the exception of the Canadian dollar. At the same time, complacency is now at extremely high levels, as evident by record low emerging market spreads, record low option premiums (as exemplified by the historically low VIX and the record low Merrill Lynch MOVE Index), and extremely high bullish sentiment in our three popular sentiment indicators as well as the Conference Board's Consumer Confidence Index. And if that wasn't enough, the amount of leverage in the world financial system is now at unprecedentedly high levels - as evident by the exponential increase in derivative volumes on the CME, the CBOT, and the ICE. The growth in derivative trading in East Asia has been the most notable. Derivative contract trading on the Korean stock indices surpassed $12 trillion in the third quarter of 2005 - surpassing trading in U.S. domestic stock index derivatives for the first time in history. According to the BIS, total derivative trading on all international exchanges totaled $357 trillion during the third quarter of 2005, or approximately six times the world's annual GDP. This is further evident with the explosion of LBO and private equity deals - and more recently, with the resumption of the Yen carry trade. All of this - combined with global tightening liquidity conditions - make this a very dangerous market to be long of at this point. From a macro standpoint, all eyes should now be on the Bank of Japan (and the Yen, since most of the borrowing nowadays is done in Yen) as well as the Canadian dollar.

Of course, just with any "top calling," timing is of the essence. I have previously commented that trying to time a top is inherently difficult. Studies discussing divergences (similar to Lowry's), bullish sentiment, leverage, etc, definitely do help - but market tops typically take a significantly longer time to form - frustrating both bulls and bears alike. I'll admit that our January 18th and January 19th signals to go short the Dow Industrials (for a total of a 50% short position) were too early, but recent developments have further convinced me that we are in the midst of forming a significant top. I have previously discussed divergences, leverage, bullish sentiment, and tightening global liquidity, so I will start this commentary off by citing a somewhat unrelated indicator - that of the short interest outstanding on the New York Stock Exchange. Following is a monthly chart showing the NYSE short interest vs. the Dow Jones Industrial Average from November 15, 2000 to February 15, 2006:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to February 15, 2006) - For the month ending February 15, 2005, total short interest on the NYSE decreased 423 million shares to 8.07 billion shares - representing the lowest short interest on the NYSE since February 2005. The huge 423 million decrease in short interest represents the biggest decline on record - while the three-month rate of decrease of 8.32% represents the greatest rate of decrease since September 2003. This does not bode well for the stock market going forward.

As mentioned in the above chart, total short interest on the NYSE for the month ending February 15, 2006 declined 423 million shares - a record monthly decrease. Over the last three months, NYSE short interest decreased 8.32% - the highest rate of decrease since September 2003. Given the maturity of this cyclical bull market, this does not bode well for the stock market going forward. Should there be a general market decline, there will be much less support than what we have previously experienced. Please note that the NASDAQ short interest data will be released sometime this week. I will report this data to you as soon as I have it.

Subscribers should also know that we have always been fans of using both the relative strength of the Bank Index and the Retail HOLDRS (RTH) as leading indicators of the stock market. From both a fundamental and historical standpoint, consumer discretionary stocks have also tended to lead the stock market. Using consumer discretionary stocks as a leading indicator is all the more important in this cyclical bull market, since the recovery from the 2001 recession has very much been consumer-driven. Below is a weekly candlestick chart showing the AMEX Consumer Discretionary Select Sector SPDR (XLY) and its relative strength vs. the S&P 500 from January 2002 to the present (courtesy of

AMEX Consumer Discretionary Select Sector SPDR (XLY) and its relative strength vs. the S&P 500 from January 2002 to the present - The absolute level of the XLY peaked in January 2005 and has been making lower highs ever since. We are now again at a strong resistance level.

As mentioned on the above chart, the absolute level of the XLY peaked in January 2005 and has been trending down and making lower highs ever since. More importantly, the relative strength of the XLY vs. the S&P 500 also peaked in January 2005 and is now in fact at the lowest level since March 2003. Historically, the consumer discretionary sector is an "early cyclical" and thus is a very good leading indicator of the stock market, especially since this cyclical bull market has mostly been consumer-driven. The top ten holdings (in order of percentage makeup) of the XLY are Home Depot, Time Warner, Comcast, Lowes, Viacom, eBay, Target, Disney, McDonalds, and News Corporation. Other notable holdings include Carnival, Starbucks, and Best Buy. As a matter of fact, this author is now watching Starbucks and Best Buy like a hawk, as these two stocks have been two of the hottest stocks (with still very compelling growth stories) in this cyclical bull market and is still near or at all-time highs. Once either Starbucks or Best Buy takes a hit, this cyclical bull market in all likelihood will be over. Note that Best Buy announces its next quarterly earnings report on March 30th, with Starbucks reporting on May 3rd.

In our mid-week commentary ("What the Investment Folks are Really Saying"), I noted that historically, the global commodity currencies (such as the Australian Dollar, the New Zealand Kiwi Dollar, and the Canadian Dollar) have been great leading indicators of both the OECD and the U.S. Conference Board set of leading indicators. I also discussed that aside from the Canadian dollar, the world's major global commodity currencies (the list previously mentioned as well as the South African Rand) has most likely topped out and is now in a cyclical decline. It now looks like that the decline of these global commodity currencies is now being confirmed by both energy prices and the action of the metals. Readers who are more or less in tune with the markets should know that crude oil prices pretty much topped out in January (at a slightly lower high than the immediate post-Katrina high) and that natural gas prices topped out in mid-December of last year, but what about the base metals? I have previously discussed that copper prices have most probably topped out - given rising inventories and historically high bullish sentiment in the commodity in the last 12 months. As a matter of fact, the Market Vane's Bullish Consensus for copper hit 95% on February 6th, and was at 90% as recently as February 9th - suggesting that virtually all shorts have been squeezed from the commodity (it is interesting to note that copper failed to rally despite the production stoppages at Freeport's Papua mines last Wednesday).

More importantly, the cyclical bull market in two other important base metals - aluminum and zinc - also seems to be ending as well. The following chart shows the daily cash price of aluminum traded on the London Metals Exchange from January 2002 to the present. Please note that from the bottom in October 2002 to the most recent top in January 2006, the price of aluminum has risen by over 100%. More significantly, from September 2005 to the top in January 2006, the price of aluminum rocketed higher by over 55%. Unless the U.S. economy experiences 1970s style inflation again, or unless folks buy into the "peak aluminum" argument, the most recent rise of aluminum from September 2005 to January 2006 is most likely a "blow off top":

Daily Cash Prices of Aluminum at the LME (US$ Per Ton) (January 2002 to Present) - Spot Price of Aluminum bounced somewhat in the last two days but the rally since September 2005 looks like a blow off top to me...

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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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