Stock Market Breadth Continues to Improve

By: Henry To | Thu, Oct 19, 2006
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Dear Subscribers,

Important Announcement: This author has just published a book review on Stephen Drobny's "Inside the House of Money." This book is a must-read for any trader/investor alike. A great lesson in the psychology of trading successfully in the long-run as well as a great update on the world of "global macro" hedge fund investing as it is playing out in the world today.

On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 - which is now 575.51 points in the black. On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505. That position is now 455.51 points in the black. Real-time "special alert" emails were sent to our subscribers informing them of these changes. Subscribers can refer to our DJIA Timing System page on our website for a complete history of our DJIA Timing System signals.

As of Sunday afternoon on October 15th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. We are also very bullish on good-quality, growth stocks - as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). Moreover, the breadth of the U.S. stock market has improved substantially over the past week, while many international, non-commodity based stock markets have also been performing strongly over the past week. At this point, the stock market is very overbought on a short-term basis, but that is to be expected in the early stages of an extended rally. While it may be tempting to take quick short-term profits here, I urge our readers not to get "cute" and to try to time this market on a short-term basis. I assure you - no trader on the face of this Earth can do this successfully on a consistent basis - not Jesse Livermore, not Bernard Baruch, not George Soros, Stanley Druckenmiller, and not even Steve Cohen of SAC Capital - who have actually just recently sworn off short-term trading (effectively forever) in his fund.

Let us now get on with our commentary. I would first like to start with: "What makes a good financial market newsletter writer?" Obviously, a newsletter writer that makes you money in the long run, right? For a newsletter that is not focused on individual stocks, the best service a writer could do is to write to his/her subscribers in "diary form." By that, I mean a style where the author communicates to his readers in the most candid way - not only documenting his current views, but also his mistakes and what would lead him to change his views, his fears, his thoughts, his conjectures, and his opinions. In doing so, he needs to be clear that what he writes is usually merely an opinion - an opinion that is formed by studying (somewhat scientifically) history and what has changed in the financial markets in the last few years or in the last decade. No matter how convinced you are, there is always a chance you could be wrong. And given that there is always a buyer for every seller in the stock market (and vice versa), there is always a good chance that one can be wrong no matter what the conviction level is.

A good newsletter writer always does a "post-mortem" on his trades and calls on market direction - no matter whether they made or lost money. In short, a newsletter writer should come up with analyses and writings such that his life depended on it. It should be cold-bloodedly honest and accountable. When the market goes against you, it makes no sense to be calling the market "irrational," or if the stock market is rallying, "a sucker's rally." It does not do you or your subscribers any good (especially if they are paying subscribers). That is a huge cop-out - and one that no newsletter subscriber should tolerate.

I am writing all this because I "have been there, done that." I know that most folks really do not care if a newsletter writer calls a GDP or a trade deficit number correctly (unless they are speculating on GDP futures). What they want to know is: Is the stock market going up? And if so, what kind of industries will perform well going forward? Moreover, as an employee in corporate America, will my skills still be of value to my employer in the near future? If not, what can I do now to start a business or to secure myself, and my family? For folks who have been wrong on the stock market since mid-August and are now calling this rally a "sucker's rally," it is truly a cop-out. As I mentioned in our October 1, 2006 commentary, "This cannot be any further from the truth, as according to the ICI, U.S. equity mutual funds actually experienced an outflow of $3.7 billion in August. Moreover, from May to August of this year, the outflow of U.S. equity funds was $23.1 billion - representing the highest four-month outflow since a $71.4 billion outflow from July 2002 to October 2002. In other words, the folks that have been propping up this stock market has been the private equity investors and the hedge funds (not retail investors) - and most likely, the suckers that [folks are] referring to were the folks selling stocks (similar to the folks who sold during July to October 2002), not the folks buying stocks!" And for folks who are still doubting this view, we now have another piece of evidence: The number of management buyouts (MBOs) has been increasing at a blistering pace since the beginning of this year. In other words, the ultimate insiders (even more so than private equity investors or even Warren Buffett) are leveraging their own balance sheets to buy out their own companies and to take them private. Such buyouts are in an entirely different universe of its own. I definitely would not label these folks as "suckers" unless I happen to be Fed Chairman Ben Bernanke and am thinking of raising the Fed Funds rate by 75 basis points later on October 25th.

Since we initially went 50% long in our DJIA Timing System on September 7th, we had argued and presented many pieces of "evidence" that this current rally is sustainable and that the stock market was making a significant bottom from July to mid-August. The one missing factor was breadth - even though I had stated that it did not really matter since 1) We are now in a bull market for large caps, and 2) Initial rallies off of sustainable bottoms can sometimes be narrow in scope. However, I also stated that while breadth "did not matter" early in the game, it is essential that breadth should improve at some point down the road. And right on cue, the breadth of the U.S. stock market enjoyed a substantial improvement in the last week - not to mention the fact that many stock markets around the world (those that do no depend on commodities such as the Australian, the Canadian, the Russian, or the Arabian stock markets) have also been making new 52-week highs.

Following is a three-year chart courtesy of showing the action of the unweighted (or equal-weighted) S&P 500 vs. the S&P 500. Please note that the action of the unweighted S&P 500 has been lagging the performance of the market-cap weighted (the true) S&P 500 until early last week, but has since made a new all-time high:

Weighted vs. Unweighted S&P 500 Index 3-Year

The fact that the unweighted S&P 500 has just made an all-time high suggests that the rally in the S&P 500 has not just been restricted to the mega-caps in the S&P 500. Rather, it has been broad-based - as exemplified in the outperformance of the unweighted S&P 500 over the true S&P 500 ever since this cyclical bull market began in October 2002. The significant improvement in U.S. stock market breadth can also be witnessed in last week's rally of 2.7% in the S&P 400, 3.0% in the S&P 600, 4.4% in the Philadelphia Semiconductor Index, 1.4% in the Dow Jones Utility Index, and 1.9% in the Dow Jones Transportation Index. To top it all off, the number of new highs vs. new lows in the S&P 600 has also been making new rally highs, as shown by the following chart of the S&P 600 vs. the 10-day moving average of the new highs vs. new lows differential on the S&P 600 (again, courtesy of

S&P 600 Small-Cap New Highs and New Lows - Last week’s 3.0% rally in the S&P 600 went a long way in improving the breadth in the U.S. stock market... At the same time, the number of new highs vs. new lows in the S&P 600 also made a new rally high - confirming both the rally in the S&P 600 and the rally in the broader stock market...

As stated on the above chart - not only did the S&P 600 made a new rally high, but breadth in the S&P 600 improved substantially as well - thus confirming the latest rally in the broader stock market. Note that we are also seeing similar improvements in breadth in both the S&P 400 and the NASDAQ Composite as well.

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. 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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