The Strength

by David Yu

John Steinbeck's "The Grapes of Wrath" was the first thing came to my mind when I saw millions of hurricane evacuees from the south pushing their vehicles, pausing for food, water, and fuel, and camping along the way. It was quite disturbing and surreal seeing these dust-bowl like images happening in our country today in the hurricane belt. Adding to that was the news that a generation of farmers, who grew up in California leaving the barn door open, has started locking up diesel tanks and gas pumps as thieves invent new ways to siphon fuel from farm equipments.

With increasing intensity of the tropical storms, I know, unfortunately, we've not seen the last of it yet. These surreal images had me worried about the long-term socioeconomic impact of the potential permanent displacement of a large population as well as the lasting environmental impact on the Gulf of Mexico's ecosystem. And, I hope I'm not the only one worrying about these probable long-term issues that may shape the future landscape of our country.

Meanwhile, in the short-term, I know there's plenty of worrying. Last week, it was interesting to see the floor traders (and perhaps computer traders around the world) keeping their eyes on every turn of Hurricane Rita on the Weather Channel when the market had already priced in the full effect of Rita and moved on (see my 9/22/2005 Thursday Update). Their myopic view may give the market a little pop early this week. But, the market should continue its due course as soon as the reality sinks in. One reality is that we might have written off the uptrend of the crude oil price too soon.

It's probable that the recent softening of the crude oil price was caused by the logistic problems of transportation and refining rather than the fundamental shifts of the supply and demand. Based on data provided by EIA (Energy Information Administration), our daily imports of crude oil since January 2004 averaged approx. 10.12 million barrels. In the table below you can see the crude oil imports exceeded this average all the way through the week of Sep. 2, 2005, when Hurricane Katrina hit the Gulf coast. It declined to 9.128 million barrels for the week ended Sep. 09, but then it went back up to 9.832 million barrels the very next week. That's an increase of 77%. This indicates the slowdown in the imports of crude oil was most likely a temporary setback caused by the transportation gridlock and the diminishing refining capacities.

In addition, technical chart indicates that crude oil price was bent but not broken yet. Chart 1 below shows the possible formation of a Head & Shoulders bearish reversal pattern, but it's yet to be completed. The neckline support (yellow highlight) has not been violated yet. The price has to drop below $62 and stays below in order to confirm this technical breakdown. Until that happens, the higher-low and higher-high trending of both the RSI and the CCI (Commodity Channel Index that identifies cyclical commodity trends) continue to indicate undiminished strengths in crude oil.

Chart 1

The stock market, however, shows no such strengths. One visible sign of weakening is evident in the equity fund's weekly net cash flows. You can see on Chart 2 below that, for the week ended Wednesday, 9/21/2005, there's a Net Cash OUTFLOW of $24 million in the Equity Funds, excluding ETF's. Backing out ETF's leaves us with just the equity funds that invest in stocks. This makes it more relevant to our analysis of the stock market.

You can also see the increasing net cash inflow (red curve staying above zero) from the end of May through most part of July. That correlates with the time frame of the prior market rally. And, when it changed from INFLOW of $2.639 billion for the week ended 8/3/2005 to OUTFLOW of $959 million for the week ended 8/10/2005, the rally was over. This was one reason I called August 3, 2005 The Day The Summer Rally of 2005 Ended. Unless billions of dollars suddenly rush into the equity funds this week, the market is not likely to have the strength to mount any meaningful rally.

Chart 2
Data Source: AMG Data Services

And to analyze the market strength further, let's take a look at my market strength indicator. Chart 3 is one of the proprietary indicators that I use for market timing.  This indicator does not take into account the price movement. It measures primarily the internal strength of the market. Sell signals were given when the polynomial curve crossed below zero (red circles) on this chart, and Buy signal was given when the curve crossed above zero (blue circle). Please see my latest Thursday Update for more details.

After the back-to-back minor up-days on Thursday and Friday, my Market Strength Index began to turn upward. This shows some improvement of the market strength, but it's not strong enough to move into the positive territory (above zero) yet. And the occurrence of this improvement prior to Hurricane Rita's landfall confirms that the market had already looked beyond Rita while the traders were staying behind and watching TV. Incidentally, I've no idea where this index is headed next. I was a little surprised to see it turning upward on Friday after this index dropped down on a 60 degree angle on Thursday. But as long as it stays below zero, it indicates a general weakness in the market's internal strength.

Chart 3

And, so, until the decline in crude oil imports becomes permanent, the crude oil price breaks down, the equity fund net cash inflow surges back up, and my Market Strength Index moves above zero, I'd maintain my bearish bias.

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