Market Overbought But Uptrend Remains Intact

By: Henry To | Wed, Jan 24, 2007
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Dear Subscribers,

As is described in the title of this commentary, the market remains "overbought" although the "uptrend remains intact." This has been the theme for at least a couple of months now - and has been a great lesson for folks who have been consistently calling a market top and had continued shorting into each new high. As of Sunday afternoon on January 21, 2007, this theme remains in place, although the market has definitely gotten less overbought (in the short-term) over the last couple of weeks or so. While there definitely are some danger signs, I do not believe the market is making an imminent top (although subscribers should remember that February is a seasonally weak month) just yet.

Before we continue with your commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,180.53 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,060.53 points

Some of our readers have specifically asked when we would exit our long positions in our DJIA Timing System - given the "profits" that we have made over the last four months or so. My answer: The U.S. stock market remains in a cyclical bull market, and until we see signs of a significant top, we are not scaling back just yet. Whether we will just scale back to a 50% long position or go short - this will depend on my future convictions. For now, those convictions are firmly in place for a continued run in this bull market. If, however, the Dow Industrials rallies 500 points within the next week or so (on weak breadth or weak volume), then we will scale back our long position to a 50% long position in our DJIA Timing System. Readers please stay tuned.

As of Sunday afternoon on January 21, 2007, 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 (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel, GE, and American Express. We are also bullish on Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been way overblown. We also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials. Moreover - judging by what we saw at the Consumer Electronics Show in Las Vegas a couple of weeks ago, there is a good chance we are now seeing a revival of Sony as a great global corporation (barring a global economic recession, the rest of this and the next decade will be known as the age of the emerging market consumer). We also continued to be very bullish on good-quality and growth stocks in general.

In the short-run, the major stock market indices still look strong, although readers who are long individual stocks will definitely need to watch out given that earnings reporting season is now ramping up (many individual stocks - even Apple and IBM - can get hit even should the market indices continue to rally). We are now probably at a stage where breadth in the stock market is narrowing - with the major indices being supported by a decreasing number of stocks as time goes on (such as during the April 1998 to January 2000 period). I believe those stocks will be the blue chip, large caps such as what I had mentioned about - such as Home Depot, Wal-Mart, Microsoft, GE, etc. As for the global stock market rally we have been witnessing over the last few years, I also believe that rally will narrow going forward - with the U.S. stock market being the stand-out. I also believe that energy has made a good short-term bottom, and that while energy should continue to struggle this year, the secular energy bull should remain intact - as long as there is no significant breakthrough in battery or solar energy in the next few years.

Let us begin our "market overbought but uptrend remains intact" commentary by reviewing the most recent action of the Dow Industrials vs. its Advance-Decline line. As subscribers may know, the A/D line has historically been a very reliable precursor of a significant top, although there have also been times when the A/D line and the actual index it represents topped out at the same time (although such instances are relatively rare). However, there have also been times when the A/D line is too early in calling a top, such as the topping out of the NYSE A/D line in April 1998 - nearly a whole two years before a corresponding top in the major indices such as the DJIA, the NASDAQ Composite, and the S&P 500.

Without further ado, following is a three-year chart of the Dow Jones Industrial Average vs. the A/D line of the DJIA, courtesy of Decisionpoint.com:

Dow Jones Industrial Average vs. the A/D line of the DJIA - Note that during the formation of the two prior tops in the Dow Industrials, the DJIA A/D line actually had already topped out two to four months before the DJIA had topped out. As a matter of fact, the DJIA A/D line was actually higher in late December 2004 than it was in May 2006 - which in retrospect was a huge red flag for the Dow Industrials. Given that the DJIA A/D line is now at an all-time high, the chances of the DJIA itself making a top soon is relatively remote.

As discussed in the above chart, the Dow Industrials A/D line is still making all-time highs as we speak - suggesting that the Dow Industrials Average is still nowhere close to making an all-time high. Over the last few years, a significant top in the Dow Industrials has usually been preceded by the topping out of the DJIA A/D line by at least a couple of months. Should the DJIA A/D line top out next week, this would probably mean a continuation of the rally of the Dow Industrials to at least mid to late March (for an earlier reference, the top of the Dow Industrials in January 2000 was preceded by a top in the DJIA A/D line in May 1999 - a lead time of eight months!). Readers please stay tuned.

The second item on the list is relative valuations - a theme which I have been harping on for the last five to six months, including in our September 28, 2006 commentary and our November 26, 2006 commentary. As I stated in that commentary (and in previous commentaries), we have been utilizing the Barnes Index (please see our March 30, 2006 commentary for a description) as a measure of relative valuation between the two most important asset classes with money managers and investors today - that of equities and bonds. Following is the chart courtesy of Decisionpoint.com plotting the weekly values of the Barnes Index vs. the NYSE Composite from January 1970 to the present:

Barnes Index vs. the NYSE Composite from January 1970 to the present

The Barnes Index got as high as 67.60 in early May 2006, as we discussed in our May 7, 2006 commentary ("Playing the Probabilities"). At the time, I stated: "In our past commentaries, I discussed that we will not enter the "dangerous zone" (the zone when cash/bonds start to become attractive relative to equities) until we hit the 65 to 70 level on the Barnes Index. As of last Friday at the close, the Barnes Index finally entered the "dangerous zone" when it registered a reading of 67.60 … Of course, a huge decline isn't imminent here - especially given the fact that the market has gone on to make higher highs until the Barnes Index touch the 90 level (or even higher such as August 1987, April 1998, and January 2000) in 1981, 1983 and 1990. But today's reading of 67.60 is consistent with the level made in the 1973 top, as well as the January 1980 top (which occurred in conjunction with the top in gold and silver prices). One should at least expect a significant correction here - especially given the continuing rise in long bond yields and the fact that Fed still has at least one more Fed Funds rate hike to go on May 10th."

In retrospect, we did manage to get our "significant correction" - and the Barnes Index has been instrumental in calling that. As of last Friday at the close, however, the Barnes Index closed at 61.60 - still too far on the low side to be calling a significant top just yet. Moreover, as a cyclical bull market matures, valuations have typically continued to rise - typically surprising everyone as it continues to rise, even the most bullish of traders. Because of this, I would not be calling a top - even a short-term one - until the Barnes Index has reached a higher level than what we witnessed on May 7, 2006. Instead of the 65 to 70 "dangerous zone" that we discussed earlier last year, I am now revising this "dangerous zone" to 70 to 75. As for the ultimate top in this cyclical bull market, I would not be surprised if the Barnes Index rises to the 100 level (or over) before we see the death of this current bull market.

The third and final item (for this weekend's commentary anyway) reinforcing the view that the cyclical bull market isn't over yet is the NYSE Short Interest Ratio. Without further ado, following is a weekly chart showing the NYSE Short Interest Ratio vs. the Dow Industrials from January 1994 to the present:

NYSE Short Interest Ratio vs. Dow Industrials (January 1994 to Present) - The latest NYSE SI ratio rose from an already high reading of 6.3 to 6.8 in the latest month. With this latest spike, the NYSE SI ratio is now at a high not seen since September 2006, and prior to that, July 1998 - suggesting the likelihood of higher equity prices ahead.

Note that since this cyclical bull market began in October 2002, a spike in the NYSE short interest ratio has always led to a subsequent rally in the stock market. This was true as recently as September 2006 - when the NYSE short interest ratio hit 7.0 - a level not seen since July 1998. As mentioned above, the latest ratio of 6.8 is now at a high not seen since September 2006, and prior to that, July 1998. Given the high short interest ratio, chances are that the market will continue its rally going forward - and the Dow Industrials should make a new all-time high over the next few weeks.

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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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