Top Calling Remains a Thankless Job

By: Henry To | Thu, Jul 6, 2006
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What's New: For folks who are thinking of starting a hedge fund or who just want to be a successful long-tem investor, I would highly recommend reading Barton Biggs' latest work: "Hedge Hogging." It is also a very easy and entertaining read - even though the book does lack some structure. Please see our latest review of the book in our Favorite Books section. Finally, we would like to hear from our readers what your favorite books are. Please let us know by posting your personal choices in the "Favorite Books" section of our discussion forum.

Dear Subscribers,

This author is taking this weekend off and will be heading over to Austin, Texas for some R&R before coming back to Houston to celebrate July 4th. Therefore - instead of taking Friday afternoon off (which I always like to do after a hectic week as it gives me time to earn some hard-earned rest and to reflect on the events over the past week), I am actually writing this right after the close on Friday afternoon. I will be leaving Saturday morning to Austin and so this commentary should arrive at your computer by Saturday evening (since our webmaster, Rex, also needs time work his magic on the horrible formatting in MS word). I apologize, but this will be a somewhat abbreviated commentary. I will come back "with a vengeance" after I have had time to do some reflection and R&R in Austin.

Again, July will be a crazy month for us as both my fiancé and I will be relocating from Houston to Los Angeles. Most likely, we will need to bring in a couple more of guest writers to fill my spots for the weekend of July 15th to 16th and July 23rd to 24th. I will attempt to send you some "ad hoc" emails in between - with probably an abbreviated mid-week commentary on the morning of July 20th. Don't worry - I will continue to monitor the markets while I am on my road trip as well as respond to emails while I am not driving.

We entered a 50% long position in our DJIA Timing System on Thursday morning, June 8th at a DJIA print of 10,810. We then became more aggressive and shifted to a fully 100% long position on the morning of June 12th. 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 11,150.22, our 100% long position in our DJIA Timing System is on average 345.22 points 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 Friday evening, June 30, 2006, this author still has no intention of shifting our 100% long position in our DJIA Timing System - especially in light of the powerful rally last Thursday. Again, there is a good chance that the market had already hit an intermediate bottom at a DJIA print of 10,706.14 at the close on June 13th. At the same time, however, this author recognizes that anything can happen in the markets - especially given an over-eager Fed and continuing tightening from both the ECB and the BoJ - and as such, we have placed a stop on our 100% position at our average entry point of 10,805. Our stop loss point of DJIA 10,805 was initially set in order to avoid the possibility of a crash (a possibility which was quite real a mere two weeks ago). But as I mentioned last week, "the time window for a crash is getting narrower by the day. If the market does not exhibit any significant weakness by early this week, then chances are good that the market has already hit an intermediate bottom." Given the strength in the major market indices in the latest week, this author will conclude that the June 13th low represented a significant short-term and intermediate-term bottom for the stock market - but in the meantime, we will just leave the stop out there anyway (with an intention to change it next week).

In last weekend's commentary, we stated that the long bond was starting to become a "buy," given a benign interest rate environment in the Japanese bond market (the 10-year JGB had a 70% correlation to the 10-year U.S. Treasury over the last six to seven years), a slowing U.S. economy, and the fact that the yield of the 30-year long bond (at 5.26%) was at its highest level since July 2004. At the same time, however, we also stated that as always, "timing is of the essence," and while we believe that buying the long bond was starting to become an attractive idea, we also felt that it wasn't the perfect time just yet for the following three reasons:

  1. The fact that the Fed wasn't done with its rate hike campaign yet. Such a move should also exert continuing upward pressure on the yield of the long bond - as has been the case for the last six months. Moreover, yield curve flattening trades among hedge funds are no longer popular - and in fact, chances are that the hedge funds are now betting on a steeper yield curve and will thus continue to sell the long bond as long as the Federal Reserve is hiking.

  2. Sentiment of the U.S. long bond is not overly pessimistic at this stage, as exemplified by the Rydex Bond Ratio (bearish assets on bonds divided by bullish assets on bonds) and the latest Commitment of Traders Report on the U.S. Treasury bond futures.

  3. Given that this author is intermediate-term bullish on the stock market, I just cannot envision a scenario where bond yields will just decline from current levels at the same time the stock market is rising.

As of Friday evening, June 30, 2006, the above still holds true. While the Fed may already be finished with its last rate hike at a Fed Funds rate of 5.25% (the futures market is pricing in a 64% chance of another 25 basis point hike on August 8th), it is difficult to see the yield curve flattening significantly from current levels - given that this author is only envisioning a slow-down scenario and not an outright recession. Also, sentiment of the U.S. long bond still hasn't gotten to the extremely oversold yet, and finally, there is a very good chance (especially in light of last Thursday's rally) that June 13th represented a significant short-term or intermediate-term bottom in the stock market - paving the way for a still-higher yield going forward for the long bond.

Reading the many commentaries and looking at the various sentiment indicators over the last day, there still seems to be a lot of experts and other investors who are skeptical of the current rally. As a matter of fact, many of these bears who are still skeptical are actually still quite confident that the current bull market has already topped out at its early May cyclical bull market highs. At the May closing highs, the Dow Industrials hit 11,642.65 while the S&P 500 hit 1,325.14. As of the close on Friday, the Dow Industrials is sitting at 11,150.22 while the S&P 500 is sitting at 1,270.20 - a mere 4.2% and 4.1% from their highs, respectively. In the short-run, the markets can and will do anything and 4.2% isn't that difficult for the market to overcome - especially if second-quarter earnings surprise on the upside. Given that so many commentators are now claiming that the top has already come in early May, this author wouldn't be surprised if the major market indices surpass those highs before finally making a significant top.

For now, no one really knows when these markets will top out - time-wise or point-wise. All we can do is to continue to monitor signs of an imminent top - such as relative valuation between stocks and bonds, the strength of commodities, overbought/oversold indicators, and our most popular sentiment indicators.

Valuation indicators are good - but generally, these are horrible in timing. Overbought/oversold and sentiment indicators are generally pretty good at predicting bottoms, but also not that reliable when it comes to timing market tops. In general, there is usually a significant lag time between when the market gets overbought and when it finally tops. As for commodities, the only useful place for our purposes is to use them to see if the Federal Reserve will continue to tighten at the August 8th meeting. The first two days after the rate hike haven't been too good to the bulls in this regard - given the strength in both energy and metal prices immediately after the latest rate hike. Should commodities continue to rise next week and stay strong until August 8th, then the chance of another rate hike will be very real.

While this author believes that the latest inflation "scare" is overblown, and while I believe the U.S. economy is now slowing down significantly (as exemplified by the ECRI leading indicator and the weakness of the U.S. housing market) to justify a pause on August 8th, readers should keep in mind that it is important for the new Fed Chairman, Ben Bernanke, to establish his reputation as an inflation targeter/fighter in his very first rate hike campaign. While a relatively benign CPI reading later this month may very well do the trick for most of us, it is important to keep in mind that many other folks are watching the commodities as a sign of potential inflation, especially the price of gold and crude oil. Should the price of gold rise back to above $700 an ounce and should oil stay at current levels come August 8th, then there is a very good chance that the Fed will hike again on August 8th. For now, we will just have to wait - as there are now rumors flying that the European Central Bank may hike its refi rate again as soon as next Thursday. How commodities react to the ECB meeting will also be very important leading up to the August 8th meeting. For now, the Eurodollar market is pricing in a 64% chance of a 25 basis point hike at the August 8th meeting.

So Henry, how do you think the anticipation of the Fed's policy on August 8th will affect the market for the foreseeable future? I will try to make this as simple as possible (for both the reader and for myself). Right now, the market has priced in a 64% chance of a 25 basis point hike at the August 8th meeting. Should commodities continue to be strong in the next six weeks, there will be no doubt that the Fed will hike yet again. In other words, any strength in gold or oil in the coming weeks will serve to keep a lid on the stock market. Make no mistake, however: This author believes the market is now in an intermediate uptrend - and so while further rises in commodity prices should serve to put a lid on the stock market, this does not necessarily mean that the market will tank from current levels (unless the price of crude oil hits $80 a barrel, for example). But with the exception of crude oil, commodity supplies around the globe are now plentiful - given the huge decrease in gold and copper demand in China and India and given the plentiful natural gas inventories. Whatever investment demand for commodities is remaining after the Fed is done with its rate hike campaign, this author believes that it will be "taken care of" by a series of ECB and BoJ rate hikes. Moreover, the tightness in the crude oil market is expected to ease a little bit later this year - even assuming current economic growth estimates in the U.S, Europe, and China holds true. Because of this, there is a good chance that the Fed Funds rate will top out at 5.5% on August 8th, if it hasn't done so already. Folks looking for a 6% Fed Funds rate going forward will be disappointed.

By far, the most important timing indicator of a top in the stock market is divergences, divergences, and divergences. For example, the NASDAQ Composite had already topped out in early April in the last rally, and the historically-reliable Dow Utilities had already topped out in early October of last year. The NYSE McClellan Summation Index had also been making lower highs since February of this year. For folks who were watching the international markets, many of the Middle Eastern markets either topped out last year or earlier this year. For now, the market remains okay, but going forward in this rally, readers should continue to monitor for such divergences. Following is a three-year chart courtesy of Decisionpoint.com showing the lower highs in the NYSE McClellan Summation index:

NYSE McClellan Oscillator (Traditional)

Again, this author believes that the June 13th bottom represented a significant intermediate-term bottom in the stock market - something I have been discussing for the last couple of weeks and that was further confirmed by the powerful Lowry's 90% upside day last Thursday. Assuming that the current rally is as strong as the rallies we have seen over the last two years, this should take the NYSE McClellan Summation Index back to the downtrend line as shown in the above chart. From there, it is going to take a little bit of time before this market finally tops out. This is probably the most optimistic scenario. In the worst-case scenario, we may see a test of the NYSE Summation Index back to the 1000 level (the red-dotted line) and then see the market plunge from that level (finally ushering the 10% correction we have been waiting for). Such a scenario is not out of the question - as there is now a noticeable shift in leadership from the small/mid-caps to the large caps in the U.S. stock market in recent weeks (whenever there is a change of leadership, it has always been preceded by a significant correction).

So Henry, are you saying that we may hit another all-time high in the Dow Industrials before we see the next significant top in the stock market? Like I said before, anything is possible in the stock market - and in the stock market, the "impossible" or "improbable" usually occurs more often than one thinks. Moreover, it has been nearly 6 years and 6 months since the last peak in the Dow Industrials when it peaked at 11,722.98 on January 14, 2000 (on a closing basis). Following is a table showing the longest time periods between successive highs in the Dow Industrials. Note that there are only three other time periods in the history of the Dow Jones Industrial Average that are longer than the current drought:

DJIA Study: Longest Time Periods Between Successive Highs

If the Dow Industrials does not surpass its January 14, 2000 high in another three months, then you could in a way argue that this current secular bear market in equities (especially U.S. large caps) has already surpassed the February 1966 to December 1974 secular bear market in duration. Of course, from the January 11, 1973 peak, the Dow Industrials would take another 9 years and 10 months to surpass that peak again, but please keep in mind that during that time period, we witnessed the second oil embargo, the monetizing of commodity inflation which eventually resulted in a 15% inflation rate, the American loss of the Vietnam War, and the international debt crisis in 1982 (which threatened to take down many of the world's largest commercial banks, including Citigroup). With the exception of "Peak Oil" (which this author doesn't totally buy into) or the continuing demise of the Euro Zone as an economic force (see our last commentary: "Spain - One of the Weakest Links in Europe"), there are current no signs of any impending fiscal or financial crisis that would rival those of the mid 1970s to early 1980s. But keep in mind that this author does not see a new bull market emerging anytime soon - given the lack of an oversold condition (historically speaking compared to other major stock market bottoms such as October 1990 or October 2002) on June 13, 2006.

 


 

Henry To

Author: Henry To

Henry K. To, CFA
MarketThoughts.com

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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