When Will the Selling Stop?

By: Henry To | Fri, Dec 21, 2007
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(December 16, 2007)

Dear Subscribers,

As I mentioned in last weekend's commentary, I will be leaving for Houston, Texas, this Tuesday to visit my friends and family and will not be back in Los Angeles until January 3rd. Most likely, you will be getting my "ad hoc" comments as opposed to my usual, verbose commentaries! At this point, I cannot guarantee a "full blown" commentary next weekend (it is the weekend before Christmas, after all), but I will try to work as hard as I can - especially given the recent volatility and day-to-day swings in the stock and financial markets. Note that this week's mid-week commentary will come from guest writer Rick Konrad, as usual. I am definitely looking forward to spending some time on R&R - hopefully, this will fully prepare us to tackle the markets in 2008. While I believe that 2008 will be the toughest market to navigate since the early days of 2003, I also believe that a great buying opportunity lies ahead in the US stock market.

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 616.15 points as of Friday at the close.

As of Sunday evening, December 16th, we remain 50% short in our DJIA Timing System. As we discussed in our commentaries over the last three weeks, there are several reasons for our continued bearish stance, despite the impressive rally in the major market indices from the most recent bottom on November 26th. These arguments remain in place. For example, as we mentioned in our commentary two weeks ago, TrimTabs, one of the most bullish publications over the last few years (who also "got it right" during the 2000 to 2002 bear market, as well as catching the summer correction of 2006) has continued to be bearish on the US stock market, citing, among other factors, a) a decline in personal income growth, leading to less discretionary spending and less savings going into brokerage and retirement accounts, b) an IPO and secondary offering backlog totaling over $35 billion, one of the largest backlogs we have seen in this bull market, despite the fact that many large companies are choosing to list on other non-US exchanges, and c) a virtual freeze on cash acquisitions, given the recent LBO cancellations and lack of new LBO announcements (which is not surprising given the current credit crunch). This continues to hold true. In addition, the technical picture has further deteriorated with the Lowrys 90% downside day that we witnessed last Tuesday. To top if all off, the US (and most of the world's) stock market is still not oversold on any of our technical indicators - thus signaling there is further downside to go over the next several weeks.

So Henry, what technical indicators are you looking at?

I am looking at the "usual candidates" that I track on a daily basis. These include: 1) the NYSE ARMS Index, 2) the NYSE Common Stock Only and "Classic" McClellan Oscillator and the Summation Index, 3) new highs vs. new lows on both the NYSE and the NASDAQ, 4) the percentage of stocks above their 20 EMAs, 50 EMAs, and 200 EMAs on both the NYSE and the NASDAQ, 5) the average stock on the S&P 500 relative to their 52-week high/low range, and 6) the Euro-Yen cross rate as a general indicator for the Japanese Yen carry trade. At the same time, I am also continuing to trade our usual sentiment, liquidity, and global economic indicators.

As I said, none of our technical indicators is yet flashing a "very oversold" signal. Given the weak upside breadth and volume that we witnessed during the post November 26th bounce, and given the strong downside breadth and volume last week, probability now favors more downside in the major market indices over the next several weeks. So when will our technical indicators flash a "buy signal," or at the very least, a signal to cover our 50% short position in our DJIA Timing System?

Let us start with the NYSE ARMS Index - an indicator that has aided me immensely in calling for oversold bottoms since we began writing our commentaries, has been the NYSE ARMS index. Following is a daily chart showing the 10-day and 21-day MA of the ARMS Index vs. the daily closes of the Dow Industrials from January 2003 to the present:

10-Day & 21-Day ARMS Index vs. Daily Closes of DJIA (January 2003 to Present) - While we did get some very oversold readings in most other technical indicators during November, this was not confirmed by either the 10 DMA or the 21 DMA of the NYSE ARMS Index, which both hit a high of only 1.14 on November 26th. At the very least, I want to see a 10-day reading that is on par with the early to mid August readings, or around 1.5 before covering our short position and going long.

As of Friday at the close, the 10-day and the 21-day NYSE ARMS Index closed at 1.19 and 1.13, respectively. This is still a far cry from the oversold readings that we got in early to mid August, let alone the immensely oversold readings we witnessed during late February and early March of this year - which represented the most oversold reading since during the October 1987 crash. At the very least, I want to see a 10-day reading that is on par with the early to mid August readings, or approximately 1.5, before covering our 50% short position in our DJIA Timing System and potentially going long.

Another indicator that does not yet suggest "capitulation" among retail and professional investors (mainly hedge funds) alike is the NYSE Common Stocks Only McClellan Oscillator and the McClellan Summation Index. Following is a three-year daily chart showing the NYSE CSO McClellan Oscillator, the Summation Index, and the NYSE Composite, courtesy of Decisionpoint.com:

NYSE Common Stocks Only McClellan Oscillator

There are two strikes against the stock market bulls from the above chart. First of all, the NYSE CSCO Summation Index - at a reading of -264.02, is still far above the oversold readings that we have gotten over the last three years. Secondly, the NYSE CSO McClellan Oscillator has just turned below the zero line (now at -20.45) - confirming that the stock market is now again in a new downtrend. At this point, I would most likely not cover our 50% short position in our DJIA Timing System (or potentially go 50% long) unless or until the McClellan Summation Index sells off to a reading below -500, or at least to a reading similar to the oversold readings that we have gotten over the last three years, such as April 2005, October 2005, June 2006, and August 2007. As an aside, if the McClellan Summation Index sells off to a reading of -1,000 or below, then the stock market - per this indicator - would be as oversold as the stock market was during October 2002. Such a reading would most likely take the Dow Industrials below 12,000.

I now want to move away from our usual technical indicators and discuss our "cash on the sidelines" indicator. This indicator - the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 - had been particularly useful as a gauge how oversold the US stock market really is - as well as how sustainable a current rally may be. 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 (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to November 2007:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to November 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 21.63% at the end of November, due to the latest surge in money market fund assets, and hitting a high not seen since September 2003. Over the longer run, a reading of over 20% is 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 in 2008, the market will present us with a great buying opportunity.

As of Friday at the close, the market cap of the S&P 500 is at a level similar to where it was on November 30th - and thus the above chart remains a good indicator, despite the sell-off we experienced last week. Note that 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 November 30th ratio of 21.63% is now at its highest since September 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 100 bps over the last few months) remains relatively tight, as evident by the dismal growth of the St. Louis Adjusted Monetary Base over the last 12 months (in fact, the St. Louis Adjusted monetary base actually registered a decline from end of August to the present). In other words, 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.

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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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