What is the ARMS Index Currently Saying?

By: Henry To | Tue, Jun 20, 2006
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Dear Subscribers,

As some of you may know, my last day at my day job in Houston was officially last Friday - and we are now getting ready for our move to Los Angeles in mid-July. In shifting my position from being an actuarial to an investment consultant (besides now having the "legitimate right" to check stock quotes throughout the day), I will take on new professional responsibilities, such as helping develop investment policy, set asset allocation, and select money managers for pension funds, foundations, and endowments. Again, subscribers who are in the West Coast should feel free to drop me a line should you wish to. Fund managers in the West Coast who are interested should also contact me - as we are currently seeking to expand our database of fund managers (which we use as a basis for our money manager selections for our clients). As for the exact timing, we have pretty much settled on a relocation timeframe during the weekend of July 15th to 16th - which means I personally won't be able to write a commentary that weekend (which is good for those that claim - probably correctly - that I write too much). Therefore, I will most likely bring in a guest writer for that weekend. In addition, I may also bring in a guest commentator for the weekend prior to July 4th.

We entered a 50% long position in our DJIA Timing System on Thursday morning, June 8th at a DJIA print of 10,810. As mentioned in our last weekend's commentary, the author was getting ready to shift to a fully-invested 100% long position in our DJIA Timing System. We had been waiting for an oversold condition in the market to do so, and the market did not "disappoint." In a real-time email that we sent to our subscribers, I noted to our subscribers: "We have just shifted from a 50% long position to a 100% long position in our DJIA Timing System at DJIA 10,800. The NYSE intraday ARMS index just touched a hugely oversold reading of 2.46 while the VIX spiked up another 15%." Based on Friday's close of 11,014.15, our 100% long position in our DJIA Timing System is 209.15 in the green. Again, readers who are interested in our historical signals can see more (and learn about our rationale behind those signals) at our MarketThoughts DJIA Timing System page.

As of Sunday evening, June 18, 2006, this author has no intention of shifting our 100% long position in our DJIA Timing System - unless the decline over the last six weeks resume or accelerates. In terms of timeframe, we are definitely close to an intermediate bottom, but between now and that ever-elusive bottom, anything can happen (readers should note that stock market crashes come when the market is very oversold). For the first time in the history of this commentary, we will be placing a stop on our 100% position at our average entry point - 10,805 - in order to avoid the possibility of a crash. As this author will illustrate in the following commentary, however, we do not believe that the market will crash from current levels. In fact, chances are better than 50-50 that the market has put in an intermediate bottom last week at a DJIA print of 10,706.14 at the close last Tuesday.

As many of our long-time subscribers should remember, this author has been calling for a significant top in the world's markets since early this year. Since early May, many of the world's markets have literally collapsed - with the U.S. markets performing relatively the best (since it had declined the last). In a liquidity-challenged environment, U.S. denominated assets almost always perform the best - and precisely because of this reason, this author believes that the leadership will shift from international equities and commodities to U.S. assets (especially large cap stocks) going forward. That is, while it may continue to be fruitful to short copper or the Indian Closed End Fund (IFN), for example, this author would definitely not be shorting the S&P 500 or the Dow Industrials right now. Folks who continue to watch for a crash in either of these two indices may have to wait longer than usual - readers please stay tuned.

Readers who have been with us for awhile should know that this author uses the NYSE ARMS Index extensively as an overbought/oversold indicator in order to try to pinpoint market tops and market bottoms. The former is usually a thankless endeavor - as overbought/oversold and sentiment indicators are usually not that great in trying to catch market tops (to try to catch market tops, spotting key divergences is usually the key). Market bottoms, however, are usually easier to predict, as bottoms tend to be formed over a shorter period of time since fear is a much greater emotion than greed. In developing the ARMS (or the TRIN) index, Richard Arms has discovered that the ARMS index works best as an oversold indicator - and the ARMS Index did not disappoint as it hit a very severe oversold level prior to the big rally in the Dow Industrials last Wednesday and Thursday. As an aside, the 1996 edition of his book "The ARMS Index" is a must-read.

In particular, this author likes to use both the 10-day and the 21-day simple moving average of the NYSE ARMS Index as a gauge on how oversold or overbought the market may be at any point in time. Following is the daily chart showing the 10-day and the 21-day moving average of the ARMS Index vs. the Dow Industrials from January 2003 to the present:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - At their most recent tops, the 10-day and 21-day MA of the ARMS Index touched a level of 1.52 and 1.36, respectively. Both the 10-day and 21-day MAs have been very oversold and are still oversold, and suggests the market has or is close to at least making a ST bottom. At their highs, the market (per the ARMS Index) hasn't been this oversold since August 2004.

At their most recent peaks (June 12 and June 13, respectively), the 10-day and the 21-day moving average of the NYSE ARMS Index touched a level of 1.52 and 1.36, respectively - representing the most oversold readings since August 2004. To put this in perspective, the 10-day moving average of this reading - with the exception of the 2001 to 2001 bear market - rarely touches the 1.5 level, as can be seen from the following chart showing the 10-day moving average of the NYSE ARMS index from January 1949 to the present:

10-Day Moving Average of the NYSE ARMS Index (January 1949 to Present)

The red line on the above chart represents the 1.5 level of the 10-day moving average of the NYSE ARMS Index. As can been on the above chart, the 10-day moving average of the NYSE ARMS Index does not usually touch the 1.5 level. In fact, with the exception of the early 1950s and the bursting of the technology bubble during 2001 to 2002, there has been less than a dozen occasions during which this reading has touched or surpassed the 1.5 level. The first of the two most oversold conditions occurred during President Eisenhower's heart attack on September 24, 1955, while the second should be one which stock market students should be most familiar with - that of during Black Monday, October 19, 1987.

So Henry, what are you saying? Are you claiming this oversold condition in the NYSE ARMS Index is giving way to a significant bottom?

It is still too early to say, but I believe that we are now very close to a bottom, if we haven't already had one at the close on Tuesday of last week. That being said, there is no way to know how far the ensuing rally could go - but chances are that this will lasts for at least six to eight weeks. The chances of the market having already touched at least a ST bottom is further reinforced by the strong up day last Thursday, as the NYSE ARMS Index closed at a hugely powerful (on the buy side) reading of 0.19 (which was also confirmed by the fact that it was a Lowry's 90% upside day). Going back to the mid 1990s, there were only four prior instances when the NYSE ARMS index closed at a level lower than 0.25. As shown by the below chart, two of those readings were "blow-off days" while the remaining two readings gave us a significant bottom:

Dow Industrials vs. Instances when NY ARMS < 0.25 (January 1997 to Present) - 1) October 28, 1997: One Day after the October 1997 Bottom 2) July 5, 2002: Blowoff Day - Dow Industrials did not make a significant bottom until 18 trading days and 1,600 points later. 3) January 2, 2003: Blowoff Day - Dow Industrials did not bottom until two months and 1,100 points later.

Please note that three of these readings came in the midst of the great 2000 to 2002 bear market in technology stocks - and unless the bird flu hits Japan or Western Europe tomorrow, it is difficult to envision that the major market indices will continue to decline from current levels. In this author's opinion, October 28, 1997 may actually be a better comparison (and even better given that the October 28, 1997 bottom occurred while most of Asia was bottoming at the same time - similar to the situation today).

Perhaps a better comparison may be to look at such days (when the NYSE ARMS Index closed at a level lower than 0.25) prior to the mid 1990s. Following is the chart showing the Dow Industrials vs. days when the NYSE ARMS Index closed at a level lower than 0.25 from January 1984 to December 1992 (please note that there were no such readings during the 1993 to 1996 period):

More follows for subscribers...



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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