A Market Slowdown Still Looms

By: Henry To | Wed, Mar 29, 2006
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Dear Subscribers,

I would first like to take this opportunity to welcome David Korn's subscribers who will (fortunately or unfortunately) be getting a glimpse of this author's writings for the first time. David has been a guest commentator on MarketThoughts.com in the past and I am very honored that he invited me to be a guest commentator for him this weekend. Hopefully, I will not disappoint. David's style of writing is a little bit different to mine - as I like to use a lot of charts in my writings. Because of this, this guest commentary will be delivered to David's subscribers via PDF format. For readers who cannot see the charts, I have made the following commentary as readable as possible without having to go back and reference the charts. Let's now cut to the chase.

We switched from a 25% short position to a neutral 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 (11,279.97), this position is 409.97 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. We then added a further 25% short position on Monday afternoon (February 27th) at a DJIA print of 11,124 - thus bring our total short position in our DJIA Timing System at 75%. We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 - giving us a gain of 89 points. This latest signal was sent to all our subscribers on a real-time basis.

In our mid-week commentary two weeks ago, we stated that we will remain 50% short in our DJIA Timing System until at least the March 28th Fed meeting. Whether we were slightly early or not, this was not to be - as we subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275. This was also communicated to our readers on a real-time basis. For readers who did not receive this "special alert," please make sure that your filters are set appropriately. Our new position was also published in our Subscribers' area of our website that very night. For newer and David's subscribers: please refer to the following page (MarketThoughts subscribers only) or email me for an explanation and the purpose of our DJIA Timing System.

The current story of the market does not dramatically change from the story that we have been telling for the last couple of months. Sure, the leverage has come down a bit (I will discuss margin debt later in this commentary), short interest increased slightly from February, and there are now signs that the Fed will finally stop its rate hike campaign in June, but overall, the story still holds.

So, Henry - just what is the story? While I am personally not a fan (and I bet many of you are not as well) of "top-calling," this author believes precisely that this cyclical bull market is now in the midst of topping out. I have gone through many of these issues in our previous commentaries, but for David's subscribers and for our newer readers, I will go through this "laundry list" of things again - and provide updates as appropriate. I will also discuss a new indicator (the leading indicator of the OECD leading indicators - see below) that this author is adopting - as well as a final update on margin debt and on NYSE short interest.

The gauge of how strong a particular stock market is can usually be measured by looking at the internals of the market - such as using breadth and volume, etc. As a bull market ages, the breadth of any further rallies tend to narrow in focus. That is, the action tends to occur in fewer and fewer stocks - as exemplified by a topping out of the NYSE A/D line or in the declining number of new highs vs. new lows. Sometimes, such a decline is not that obvious (as opposed to the topping out of the A/D line in the spring of 1928 and in April 1998, 18 and 21 months prior to the top in the Dow Jones Industrial Average, respectively) - especially during a cyclical bull market that is mostly focused on small cap and mid caps stocks. Readers should note that this is precisely what we have been experiencing - as according to Ibbotson Associates, small caps have outperformed large caps by approximately 130% since 1999. Following is a table I have posted in our commentary previously - chronicling the periods in the U.S. stock market when small caps have outperformed large caps (note that data for 2005 will be updated soon):

Periods of Small Cap Outperfermance in the U.S.

The average small cap outperformance since 1928 lasted a little over five years resulting in a 129% outperformance over large cap stocks. Looking at the table, there are two notable tops that come to mind which occurred at the same time as the NYSE A/D line topped out - those being the 1946 and 1976 bull market tops. The 1968 market top came close as well, with the NYSE A/D line failing to confirm the top in the Dow Industrials only by a slight margin.

My point is: We all know that the NYSE A/D line just made a new all-time high as recently as last week - but history has shown that there does not need to be a divergence in the NYSE A/D line before the major market indices top out. This is especially true if we have been in a small cap bull market - such as the one we have been experiencing since 1999.

In a small cap bull market that we have been experiencing, it is better to gauge the current internals of the bull market by looking at the number of new highs vs. new lows on the NYSE. The following three-year chart, courtesy of Decisionpoint.com, shows the number of new highs vs. new lows along with a 10-day differential of new highs vs. new lows on the NYSE:

NYSE New Highs and New Lows - 1) The NYSE had less than 200 new highs on the most recent rally in both the Dow Industrials and the NYSE Composite. 2) The NYSE 10-day differential of new highs vs. new lows has been on a declining trend ever since January 2004!

As indicated on the above chart, the NYSE 10-day differential of new highs vs. new lows has been on a declining trend ever since January 2004 - more than two years ago. Moreover, the number of new highs on the NYSE failed to break the 200 mark even in light of the most recent rally in both the NYSE Composite and the Dow Industrials. This is all the more ominous for the major market indices given that the NYSE had as many as 450 new highs in late January of this year, and as many as 600 new highs during the December 2003 to January 2004 period.

As I have discussed before, the failure of the hottest sectors in this cyclical bull market to participate in the most recent rally - the homebuilders, Google, and Apple - is also an indication that this cyclical bull market is getting "long in the tooth." More importantly, the latest "blow off" rally of cyclical stocks such as Boeing, Caterpillar, and the domestic airlines can only mean two things - that either we are in the beginning of a new bull market or that we are near the end of the current bull market (cyclicals tend to rally both in the early stages of a bull market and in the final "blow off" rally - similar to what semiconductors did in the October 1998 to March 2000 period). No points for guessing what this author is looking for!

In a way, the deteriorating internals of the stock market is also a reflection of declining global/stock market liquidity - as less money is devoted to the majority of issues and as the level of speculation is further focused on a few selective sectors or issues. Make no mistake: Global liquidity has declined for awhile and is continuing to do so. Readers who have been with us for awhile know that this author likes to measure liquidity by looking at the relative strength of the Philadelphia Bank Index vs. the S&P 500, as well as the shape of the domestic yield curve. In addition to these two indicators, this author has previously developed another liquidity indicator - which I have named the "MarketThoughts Excess M" indicator - or "MEM" for short. Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary (this commentary is available for free), but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has just stopped publishing M-3 statistics, this author will present a modified version of this indicator the next we discuss monetary liquidity. For now, however, the latest weekly statistic is updated enough for our purposes. Following is a weekly chart showing our MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-3 from April 1985 to the present:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-3 (April 1985 to Present) - 1) Markets did well during the 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade! But now, the BoJ is tightening as well... 2) Speculators continues to be aggressive in the face of the Fed reining in the monetary base. Our MEM indicator perked up slightly from a bottom of negative 4.42% seven weeks ago to negative 4.07% in the latest week - but is still at its lowest since Jan 2002. This does not bode well for the markets going forward.

While our MEM indicator has perked up slightly from a low of negative 4.42% seven weeks ago to negative 4.07% in the latest week, readers should keep in mind that this indicator is still firmly in negative territory and is in fact, still at a low not seen since January 2002 (and we all know what happened afterwards). More importantly, the willingness of the private sector to speculate (and for commercial banks to lend) in the face of Fed and global central bank tightening is definitely a red flag. Historically, it has not been a good idea to fight the Fed, and this time should be no different. After all, wasn't it just three years ago when folks were stating that the Fed was "pushing on a string" and that interest rate cuts would have no discernible effect on the stock market or economy?

I would now like to take some time and discuss our opinions on the yield curve. When looking at the historic shape of the yield curve, this author prefers taking the difference between the Fed Funds rate and the 30-year government bond; as such a measurement takes into account the yields across the entire spectrum of the yield curve. In our December 15, 2005 commentary ("Yield Curve Continues to Flatten"), we discussed the implications of a flattening/inverting yield curve, as well as why it may have outlived its usefulness. However, we also concluded that even though the yield curve may have somewhat outlived its usefulness, it was still nonetheless an indicator to take heed, given its role as an excellent leading indicator of the stock market since the Russian, Brazilian, and LTCM crises during late 1998. In our December 22, 2005 commentary ("Flattening Yield Curve: Does the Stock Market Care?"), we further extended our yield curve analysis back to January 1975 and concluded that while the implications of a flattening/inverted yield curve has changed somewhat in the last 30 years, one thing does not change. I will now quote from our December 22, 2005 commentary:

History has shown that a flattening or an inversion of the yield curve is usually a precursor to a financial crisis somewhere in the world - said target being an area (either geographically or a particular asset class) which has seen the most speculation prior to the inversion. While the forecasting significance of the yield curve may have lessened over the years (as we discussed in last Thursday's commentary), this does not mean we should not be careful, unless one thinks that "things are truly different this time." Moreover, while chances are that this "excess speculation" hasn't occurred in the U.S. stock market (except perhaps in U.S. mid caps and small caps), that does not mean any emerging market crisis will not impact the valuation of U.S. stocks in an adverse way - especially during a general "flight to safety" scenario similar to what occurred during the Fall of 1998. However, please keep in mind that it is this author's contention that we are still in a secular bear market in U.S. equities (similar to the secular bear market of 1966 to 1974) - and so despite a relative lack of speculation in the U.S. stock market in recent years (relative to the housing, commodity, and emerging markets), I would not be surprised if the inversion of the yield curve (decreasing risk-taking) is followed by a general liquidation of U.S. equities.

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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. 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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