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Do or Die Time for the Market

(August 15, 2004)

Dear Subscribers and Readers:

The stock market has certainly experienced some emotional times last week - with events such as ever-rising oil prices, the earnings of CSCO, HPQ, DELL, and WMT and the specter of terrorist attacks and the upcoming elections constantly in the spotlight.  Despite the current emotional times, the Dow Industrials was actually up 10 points while the Dow Transports was up 0.84 points for the week.  The Nasdaq Composite, meanwhile, was down 19 points for the week - I will get to the Nasdaq Composite later in this analysis.

For now, let's talk about the favorite topic on everyone's minds - that of high oil prices.  Before we begin, let's take a look at the chart of the Dow Industrials vs. the Dow Transports:

Daily closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to August 13, 2004) - Immediate support for the Dow Industrials is still at around the 9,750 level. During the latest week, the Dow Industrials was actually up 10 points while the Dow Transports was up 0.84 points. Both indices desperately need a rally here in order to avoid a futher plunge.

The fact that the Dow Industrials was up 10 points and the Dow Transports was up 0.84 points for the week (despite oil rising over $2.50 a barrel in the same timeframe) can be interpreted both ways - a sign of bullish strength or a sign of denial by the bulls.  The author believes that it is the former but one thing is for sure: we are definitely up for some interesting times ahead in the next couple of weeks. 

Now, let's discuss the topic of rising crude oil prices.  While pure technical analysts would frown at the use of fundamentals or news in analyzing the stock market, I will attempt to do a little bit of that in this commentary.  The recent decline of the stock market may not be a direct function of the recent rise in oil prices, but it is definitely a function of the recent rising fear in investors' psychology.  This rising fear in investors' psychology has definitely contributed to the recent decline in the stock market.  Because of this, the author believes that most of the decline recently has mostly been about high oil prices.  Following is a daily candlestick chart of the September 2004 contract in light crude oil as of the close last Friday:

Light Crude Oil - The recent bottom in crude oil prices also corresponded to the recent top of the major market indices. A greater than $10 rise in oil prices in six weeks - despite the ending of the summer driving season, a rise in Fed Funds rate and a slowdown in the Chinese economy.

While the author believes that the long-term fundamentals of oil is bullish, a parabolic rise in oil prices over the last six weeks is probably a reflection of the huge speculation by hedge funds and retail speculators on the long side more than anything else.  The current supply/demand situation has been overshadowed by events such as the uncertainty of YUKOS, the Venezuelan referendum, and the potential of sabotage of Iraqi pipelines by extremist groups in that country.  On the contrary, there has been no slowdown in Russian oil production (in fact, the supply of oil in Russia has historically exceeded its potential to export the oil out of the country) and the Venezuelan referendum is being conducted as I am writing this commentary.  Moreover, the United States government has been refilling the Strategic Petroleum Reserve even as oil prices have risen (in turn contributing to a further rise in prices).  The Chinese government is also pursuing the same policy.  Once their quotas are satisfied, this bullish pillar of oil prices would in turn disappear.  The current demand/supply situation simply does not support $46 a barrel basis the September 2004 contract, as exemplified in the following chart (dated August 13, 2004) from the Bank Credit Analyst:

U.S. Crude Oil Inventories (LS, Inverted) vs. West Texas Intermediate Crude Oil Price (RS)

Please note the historical correlation between U.S. crude oil inventories (inverted) and West Texas Intermediate crude oil prices.  Please also note the most recent divergence - the most recent case was the divergence in late 1998, when the crude oil price plunged to $10 a barrel while inventories stayed relatively low.  Speculators who purchased crude oil futures or energy stocks at that time made a fortune in the next two years.  The most recent divergence is also an extreme case which should ultimately result in plunging oil prices - when a parabolic rise in any asset class corrects, it usually corrects in a big way.  Inventories should also stay relatively high going forward once the U.S. is done filling up its Strategic Petroleum Reserves and as the summer driving season is about to end.  This should ultimately be bullish for the stock market if recent trends hold.

The final chart in our crude oil analysis shows the historical relationship between the American Exchange Oil Index and the S&P 500 since August 1983.  The American Exchange Oil Index is a price-weighted index and is described by the American Exchange as an index "designed to measure the performance of the oil industry through changes in the prices of a cross section of widely-held corporations involved in the exploration, production, and development of petroleum."  The following table lists the components of the Oil Index and the percentage makeup of each component:

Table of the components of the American Exchange Oil Index and the percentage makeup of each component.

The weekly chart of the relative strength between the Oil Index and the S&P 500 follows:

Relative Strength (weekly chart) of the Oil Index vs. the S&P 500 (August 1983 to Present) - Huge resistance for the relative strength of the Oil Index at current levels!

As of the last few weeks, the relative strength of the Oil Index vs. the S&P 500 is near a high not seen since late 1994, when the S&P 500 was still trading below the 500 level.  We are now at a historically heavy resistance point - and given the reasons I have mentioned in my commentary, I don't believe that this resistance level can be broken at this time.  Bulls of oil prices can point out that we are now in a reverse "heads and shoulders" pattern in the midst of confirming, but if we are to follow historical precedent, relative strength may take over two years to break out even under the bullish scenario.  With relative strength encountering heavy resistance - and coupled with the fact that the Oil Index has also been weak in the last few weeks - I don't believe the currently high oil prices are sustainable.  Further confirmation can be seen in the current trading in the oil futures contracts, as the September 2005 contract is trading at $5 lower, while the September 2006 contract is trading at $8 lower than current prices.

So much for oil prices, let's now look at the technical condition of the market.  In a "Special Alert" that I sent to my subscribers last Thursday night, I quoted the following from an article: "Stocks are likely to rebound, at least for a while, if one obscure indicator, reflecting the investment patterns of an important Wall Street constituency, proves as accurate a forecasting tool as it has for the last 60 years. The buy signal comes from the eight-week moving average of the weekly New York Stock Exchange specialist short-sale ratio. The ratio fell on July 23 to its lowest level, 22 percent, since at least 1943, when reliable records of the indicator were first compiled. That means specialist firms -- brokers appointed by the exchange to maintain orderly markets in individual stocks, often by buying and selling shares themselves -- accounted for about 22 percent of all N.Y.S.E. shares sold short in the eight weeks through July 23. Selling short is a way to bet on declining prices, and the lower the ratio, the less short-selling the specialists are doing compared with other investors."

Since that time, I have done extensive research to see when the market experienced similar readings in the specialist short-sale ratio.  The lowest reading (prior to the most recent readings) of the 8-week moving average of the specialist short-sale ratio was November 10, 1944 - when the ratio touched 29.95%.  The Dow Industrials subsequently staged a rally of over 30% in the next 12 months.  The second lowest reading came on July 16, 1982 when the ratio touched 30.75%.  Again, the implications were bullish and the Dow Industrials subsequently staged another rally of 30% -- this time in a period of six months instead of twelve months.  The only instance when this indicator erred was on January 6, 1984 (when the 8-week moving average of the specialist short-sale ratio touched a low of 30.92%) - the Dow Industrials proceeded to decline nearly 20% in the next two months (however, the Dow Industrials traded at the top of its 52-week range immediately before we got this reading).  Two other low readings (32.21% on July 27, 1984 and 31.65% on July 5, 1996) that occurred had hugely bullish implications.  Using this indicator, the law of probability states that we are probably near a bottom - but most importantly, that the cyclical bull market is not over yet and that higher prices are still in store.

Bottom line: The author still stands by the fact that we are in a cyclical bull market.  It is interesting to note that there were 243 and 198 new lows on the Nasdaq on Thursday and Friday, respectively, even as the Nasdaq was some 20 points below the close on the Friday before last (when there were 262 new lows on the Nasdaq).  Such a divergence during a highly oversold situation we have now is a bullish divergence.  Moreover, reported a weekly outflow of $1.25 billion from equity funds ending August 11th - the highest outflow probably since March 2003 and which usually acts as a great contrarian indicator - especially in a cyclical bull market.  The liquidity indicators that I follow are still bullish (I will give a more detailed update in next week's commentary).  For now, there may be another plunge to a low of DJIA 9500 and a Nasdaq print of around 1700 given the downside momentum (we should take this one day at a time) but longer-term investors should stand pat.   Please keep in mind that during bull markets, corrections tend to be short and deep - and thus if the market does not continue to accelerate into the downside by Wednesday or Thursday of this week, then the window of opportunity for bears may be quickly running out.

Signing off,

Henry K. To, CFA

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