Continue to Overweight U.S. Equities

by Henry To
May 22/05

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Since the Dow Jones Industrial Average blew through resistance at 10,400 on Wednesday evening, most of the major indices spent their time last Thursday and Friday consolidating their gains made during the early parts of the week. For the week, the Dow Industrials was up 331.79 points (3.27%) while the Dow Transports was up a whopping 218.79 points (6.43%). The message this week does not change from last week and neither does it change from our message two weeks ago. Continue to overweight U.S. equities with a focus on large cap growth and the major brand names. I have previously recommended stocks such as KO, SBUX, MRK, HDI, YHOO, EBAY, and INTC (I will discuss MRK later in our commentary). As of Sunday evening, May 22nd, this recommendation does not change. We should also continue to underweight commodities, mining stocks, and emerging markets. Our bullish views on the U.S. dollar also do not change. In fact, the U.S. dollar just made a high last Friday at the close. Our ultimate upside target for the U.S. Dollar Index is still somewhere in the 90 to 95 range.

Apart from the usual Dow Industrials vs. the Dow Transports and the sentiment charts that we will show you in this commentary, we will also provide you an update (along with our views) on the latest NYSE short interest data along with NYSE members' margin debt data. These were both updated by the NYSE late last week. For now, let's go ahead and take a look at the daily chart of the Dow Industrials vs. the Dow Transports:

Given the huge rally and the short-term overbought conditions in both the Dow Industrials and the Dow Transports at the end of last week, it will be very normal to see more of a consolidation phase in both of the Dow indices this week. The trader in us may ask: "Should we sell our stocks right here and wait for a dip before buying back those stocks again?" The more nimble traders can probably do it, but of course, I am not a nimble trader and chances are most of you who are reading this are not either. Even one of the greatest traders of all time, Jesse Livermore, did not advocate trading one's stocks during a bull rally such as the one we are currently having. Please also keep in mind that even though the major indices may currently be consolidating - the individual stocks that you are holding may continue to go up in a bullish environment. Are we currently in an overbought short-term condition? You bet we are - but that doesn't mean individual stocks (or even the major indices) cannot continue to go up, as exemplified by the following chart from Decisionpoint.com:

The above charts show the percentage of stocks on the NYSE above their 200-day exponential moving averages, 50-day EMA, and 20-day EMA, respectively. These charts can be quite reliable in telling us how overbought or oversold the stock market is currently. As you can see, my favorite technical indicators are, by far, overbought/oversold indicators. Right now, the percentage of stocks about their 20-day EMAs and 50-day EMAs are 66.84% and 55.55%, respectively. This mean the market as represented by the NYSE is now slightly overbought, but as one can see from the early November 2004 experience, the market can rise much, much further even when it is overbought. Bears please take heed. If one is waiting for exhaustion, then we definitely are not there yet.

Actually, on a more intermediate-term basis, the market is really not that overbought. This becomes more obvious when one looks at the following three-year chart of the NYSE McClellan Summation Index (the chart second from the bottom):

As one can see, the NYSE Summation Index (traditional) has only hyst crossed the 1000 line. Per the NYSE Summation Index, we are actually still in a slightly more oversold condition than where we were during the early August 2004 bottom. The NASDAQ readings are similar - the only differences being that the current NASDAQ readings are slightly more oversold than the NYSE readings and that the NASDAQ Summation Index actually bottomed out in early August instead of mid-May 2004. Unless a huge hedge fund "blew up" over the weekend, I believe that there is more upside to go.

Readers may recall my buy recommendation of MRK from approximately three weeks ago and from another reiteration as late as last week. So far, it looks like the Bank Credit Analyst agrees with me - as shown from a short commentary that the Bank Credit Analyst published late last week. Following is the relevant chart reproduced from that commentary:

The Bank Credit Analyst is basing their buy recommendation on drug stocks on both fundamentals and technicals - the latter being that the relative price of the drug stocks (relative to the S&P 500) are breaking out of their 40-week moving average after making a base out of a very oversold situation. Historically, MRK has been one of the best-managed and most admired drug companies. In a way, one just needs to take a leap of faith when it comes to investing in MRK right now - not unsimilar to what investors went through when they were buying IBM in the early 1990s.

Let's now discuss short interest. Readers who didn't fall asleep last week should have read my long paragraph on the NYSE Specialist Short Ratio and what the potential implications are. Well, the 8-week moving average of the NYSE Specialist Short Ratio actually declined further this week - to another record low reading of 20.07%. The 8-week moving average of this reading is about to decline below 20% - something unprecedented in the history of the New York Stock Exchange. While the market can decline further from here - bears may not want to wait around with their short positions if historical precedents holds true. I will not be showing this chart again this week, primarily because I will be showing another chart - probably more important since the latest NYSE short interest data was released just late last week. Following is a monthly chart showing NYSE short interest vs. the Dow Jones Industrial Average:

As noted on the above chart, total short interest on the NYSE increased 149 million shares this week, bringing the total short position to another all-time high of 8.57 billion shares. Over the last three months, short interest has increased 10.8% - the largest three-month increase since September 2002. This doesn't necessarily have to be bullish, as long as the professionals (i.e. the specialists) are doing the shorting - but with the 8-week moving average of the NYSE Specialist Short ratio now at another all-time low, bears will again need to be very, very careful here.

From a margin debt standpoint, the bulls have also gotten very cautious. Following is a monthly chart showing the Wilshire 5000 vs. the change in margin debt from January 1998 to April 2005:

The rise in margin debt has been dying down since January of this year - which is a good long-term sign for the bulls (unless we are now in both a cyclical and a secular bear market - which I don't think we are). In fact, the latest one-month decline in margin debt represents the largest such decline since July 2002 - which as most readers should remember, represents one of the darkest months in recent stock market history.

In terms of sentiment, it looks like the bulls have finally lightened up and gotten more positive after the three-day rally from Monday to Wednesday of last week. That being said, the three popular sentiment indicators that we look at every week are still pretty oversold. Interpretation: There should still be a bit more of a rally to go (another three to four weeks) at the VERY LEAST.

By far, the most significant development occurred in the bulls-bears% differential in the American Association of Individual Investors (AAII) Survey. The one-week reading ticked up slightly higher - from a negative 5% reading last week to a positive (finally) 10% reading this week. This is a very positive development for the bulls, as the market historically has had its worst declines during the time this one-week reading is in negative territory. Finally, the 10-week moving average of the AAII survey is at negative 9.8% - a highly oversold reading - the likes of which we have never seen since the negative 11.7% reading registered on April 2, 2003. Such a reading implies that we are still very oversold in the intermediate term and thus still have more of a rally to go:

The bulls-bears% differential in the Investors Intelligence Survey actually declined slightly last week - from 18.2% to 17.6%. The 10-week moving average of this reading is now at 20.0% - the lowest such reading since the 16.98% reading registered on May 14, 2003:

Given that the Investors Intelligence Survey is still in pretty oversold territory (relative to the readings of the last two years), probability also suggests that the rally has more room to run before we encounter anything like "exhaustion." I would not be too worried here until we get start readings of over 35% or even 40% (which we got in late December of last year).

As for the Market Vane's Bullish Consensus - well, I admit - this survey has been consistently bothering me week after week mainly because of its consistently high readings since late December of 2003. Not once had this survey "corrected" to the 50% level that I was hoping for in all the corrections over the last 18 months. Oh well, Henry, you can't have everything, so for now, we will just settle with the following:

As noted on the above chart, the Market Vane's Bullish Consensus increased from 61% to 62% in the latest week - still an oversold condition RELATIVE to the readings of the last 18 months. At this point, I would not be too concerned with the bullish readings in this survey until we start getting readings in the high 60s or even a reading of 70%.

Finally, some of our readers may have missed this post from our discussion forum last week. Why am I bearish on oil in the short-run? The relevant chart can be found at the link to the Energy Information Administration (EIA) provided but here is the relevant chart reproduced below:

As one can see from the above chart, oil inventories are now significantly higher than even the top end of its five-year average range. A further decline in oil prices for most of this summer is now a given, especially given the "blowoff" in prices that we had earlier this year (when a significant amount of demand was destroyed).

Conclusion: Our position does not change from our position on Thursday morning and nor from position as of last weekend. We will continue to overweight U.S. equities - specifically, the major brand names/large cap growth stocks. We will continue to avoid commodities, financials, and to a lesser extent, homebuilding stocks. Companies that engage in the China (e.g. Wal-Mart) or India trade (e.g. IT outsourcing) should also be avoided at this point. We will again take a look at the Philadelphia Bank Index on Thursday morning but for now, I am still very worried about a possible credit crunch scenario happening later this year. And as I have said before: In a globalized world such as ours, I am getting increasingly worried about a possible "domino effect" not unlike that of the 1997 Asian Crisis and the 1998 Russian, Brazilian, and then the LTCM crisis. Similar to 2004, I still believe 2005 will be a very difficult year - with no significant trend until we either get a hedge fund "blow-up" or a credit crisis somewhere in the world where everyone is caught the wrong way. Again, while this current rally should still have more room to go, I am also not getting complacent until we get a "fully oversold" situation hopefully sometime later this year.

Best of luck to our subscribers in the coming week! Don't forget to participate in our new MarketThoughts.com poll!

Signing off,

Henry K. To, CFA
MarketThoughts.com

Independence Capital Management, LLC. is the investment advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by Independence Capital Management, LLC. The mission of Independence Capital Management, LLC. is to provide the highest level of performance, service, integrity and education to our readers. This involves providing insights into the factors that will affect the stock market and individual stocks - helping our readers to maximize returns in favorable investment climates and protecting assets in unfavorable climates.

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