Looking for a Market Catalyst

By: Henry To | Wed, Nov 14, 2007
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(November 11, 2007)

Dear Subscribers,

Note: Please participate in our latest poll. The question is: What is the probability of a US recession in the near future? Comments are also welcome, as always.

First of all, I would like to welcome our new subscribers to the MarketThoughts family. Since the end of last month, traffic to our website has increased over 40% on a daily basis. Participation in our MarketThoughts.com discussion forum has increased as well. I am especially happy about the latter since many of my best ideas come from you, our subscribers, and having a forum to discuss and swap trading and investment ideas (or to air concerns about my commentaries) is essential - especially as the world's financial markets continue to become more globalized and sophisticated by the day. Again, I just want to say "thank you" for all your ideas, time, and participation. Without you, there will be no MarketThoughts.

Let us begin our commentary by first providing an update on our four most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

4th signal entered: 50% short position October 4, 2007 at 13,956, giving us a gain of 913.26 points as of Friday at the close.

As of Sunday evening, November 11th, we continue to remain 50% short in our DJIA Timing System. Aside from the NYSE McClellan Summation Index, the NYSE ARMS Index, and the S&P 500's percentage deviation from its 200-day moving average, many of our technical indicators are now approaching a "fully oversold" status. However, subscribers should keep in mind that during the midst of a panic, stock prices tend to experience their greatest declines towards the end of the panic (the most extreme case was October 19, 1987, when the Dow Industrials declined 22.6% (even though the market had already reached a highly oversold level the previous Friday), and would ultimately decline a further 7% on October 20th before reversing to close 6% higher than the previous day's close.

Given our quick gains in our short position in our DJIA Timing System over the last couple of weeks, and given the current oversold conditions in the stock market, my current goal is to cover our short position in our DJIA Timing System should one of the following two conditions be met over the next few days (warning: A major rally on Monday would invalidate this position):

  1. An intraday decline in the Dow Industrials of more than 400 points;

  2. An intraday NYSE ARMS Index reading of 2.5 or higher.

Should we decide to cover our 50% short position in our DJIA Timing System (to essentially go neutral), we will, as always, send a real-time email to our subscribers informing you of such a decision. Note that the two previous conditions are merely "guide posts" at this point, and should not be construed as "set in stone." The shift in our position will not be official until an actual email goes out.

Before we go on to the "gist" of our commentary and discuss potential market catalysts for a stock market reversal, subscribers should remember that a sustainable stock market rally could only emerge out of a "reasonably" oversold condition. The term "reasonably oversold" is different for every market and time period. For example, during the current bull market that began in October 2002, the market had been able to enjoy a sustainable rally subsequent to every 7% to 9% correction in the S&P 500, as evident by the subsequent higher highs in most major market indices (including the Philadelphia Bank index and the American Exchange Broker/Dealer Index) , as well as the NYSE A/D line. Given the market action over the last few months, however, it is obvious that the mid August lows were not sufficiently oversold to attract enough buyers for a sustainable rally going forward. That is why - especially over the last couple of weeks - I have stated that there was a good chance that we will revisit the mid August lows. As of Sunday evening, November 11th, I still stand by this position, but as I have mentioned before, there is a good chance we will cover the 50% short position in our DJIA Timing System should we: 1) experience an intraday decline of more than 400 points in the Dow Industrials, or 2) experience an intraday NYSE ARMS Index reading of 2.5 or higher.

Aside from the mid August lows, this author would also like to see more oversold readings in the global stock market, especially the UK market, and any other markets that are heavily tilted towards the financial sector (such as Switzerland and Hong Kong). An appropriate indicator for the various stock markets around the world that we have developed is our "global overbought/oversold indicator" - an indicator that we first discussed in our August 2, 2007 commentary (actually, it placed in the beginning of a guest commentary from Bill Rempel). In that commentary, I stated that the purpose of the model is to help our subscribers keep track of all the international market indices and new international ETF products being developed out there today. The inner workings of this global overbought/oversold "model" are rather simplistic. For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages. Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998. This way, we are comparing apples to apples and can control for country or region-specific volatility.

Let us go back and review our Global Overbought/Oversold Model as of August 15, 2007:

Global Overbought/Oversold Model as of August 15, 2007

All the percentile rankings highlighted in yellow in the above table represent rankings below the 15th percentile - which is consistent with a reading that is more than one standard deviation below the mean (note that this is a true standard deviation calculation based on historical data and does not assume that returns are normally distributed). That is, relative to the historical % deviations of the same country or region, the current % deviation is more oversold than 85% of its readings going back to December 1998. Not surprisingly, there were many cells highlighted in yellow at the most recent bottom on August 15th - with the bulk of these being in the developed countries, and Latin America. On a trailing one-month basis ending August 15th, the only investable countries (both developed and emerging) that were up were Jordan (+0.3%), Venezuela (+0.4%), and Morocco (+2.7%).

The month-end updates for August, September and October of our "Global Oversold/Overbought Indicator" can be found in our September 2nd, September 30th, and November 1st commentaries, respectively. Let us now fast forward to November 9, 2007:

Global Overbought/Oversold Model as of November 9, 2007

Note that the number of cells that are highlighted in yellow (readings that more oversold than 85% of all readings going back to December 1998) is much less than what we witnessed at the last bottom on August 15th. More specifically, there are only 5 countries/regions that are oversold on any of the timeframes that we track - those being the MSCI World Index, North America, Belgium, Ireland, and Sweden. Moreover, there are countries in the Asian Pacific, Latin America, or in the Emerging Markets category that are currently oversold. The countries in those regions that come the closest to being "oversold" are (in order): Mexico, Chile, Pakistan, Japan, and Pakistan.

At the very least, this author wants to see a "yellow reading" in either the United States or the UK stock market before we could claim the market is "fully oversold" - i.e. oversold enough for a sustainable, global, stock market rally going forward. For now, we will remain 50% short, but will most likely cover our short position should the market continue to sell off during the upcoming week.

In terms of "cash on the sidelines" as an impetus for a sustainable rally going forward, one measure that has been particularly useful is the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500. I first got the idea of constructing this chart from Ned Davis Research - who had constructed a similar chart for a Barron's article in late 2006. Following is an update of that chart showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to October 2007:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to October 2007) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio rose to 20.32% at the end of October, due to the latest surge in money market fund assets, and hitting a high not seen since October 2003. Over the longer run, a reading of over 20% is definitely on the high side and should be supportive for stock prices over the next 12 to 24 months. That being said, that does not mean that this ratio cannot go higher (it stood at 19.45% on August 31, 2001, right before the September 11th plunge) - but at some point over the few months, the market will present us with a great buying opportunity.

While the ratio between money market fund assets and the market cap of the S&P 500 is not a great timing indicator - what it does show is the amount of "fuel" for a sustainable stock market rally going forward. Note that the October 31st ratio of 20.32% is now at its highest since October 2003. Such a reading is relatively high on a historical basis and should be supportive for stock prices over the next 12 to 24 months. However, over the short-run, the stock and financial markets can do anything. For example, it is interesting to note that this ratio hit a high reading of 19.45% on August 31, 2001, and yet, this ratio continued to hit highs after highs as investors fled into money market assets in the midst of the September 11th attacks, the Enron scandal, the Worldcom, and Global Crossing bankruptcies, etc. This ratio would ultimately not top out until September 30, 2002, when it hit a 20-year high reading of 27.69%. Finally, subscribers should also note that money market fund assets have been growing at over 30% in recent weeks - a rate that is definitely not sustainable - especially since the Fed (despite slashing the Fed Funds rate by 75 bps over the last couple of months) remains relatively tight, as evident by the dismal growth of the St. Louis Adjusted Monetary Base over the last 12 months. In other word, while it is likely that stock prices will be higher 12 to 24 months from now, it is not a given, and will highly depend on the viability of both the US and European financial sectors going forward.

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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