First, I want to give you a high level overview of the current cyclical structure. The trading cycle last bottomed on July 1, 2003 at 8,871.20 on the DJIA. This cycle averages 39 market days and the ideal timing for the next low is between August 12, 2003 and August 29, 2003. A break below 8,871.20 should serve as confirmation that the trading cycle has topped. Such a break will also serve as confirmation that the larger 22-week cycle has most likely topped as well.
The next cycle of importance is the 22-week cycle. According to my work, this cycle should ideally bottom with the next trading cycle low which again is due between August 12, 2003 and August 29, 2003. Once this bottom is established the market will be poised for the next 22-week cycle to rally. It is the behavior of this rally that we must watch very, very closely. If this rally fails to take the market back up above the recent June high, then buckle up because the ride down into the seasonal low could prove to be a hard and fast one.
The seasonal cycle averages 1 year in duration. The last seasonal cycle bottomed in October 2002 at 7,197.49 on the Dow and at 767.50 on the S&P 500. The next seasonal cycle is ideally due to bottom in the 4th quarter of this year. The rally into the June high has managed to pull my monthly oscillators up to levels not seen since 1991. These oscillators have now turned down from these extreme levels indicating that the seasonal cycle has topped or is in the process of topping. Now let me add a few other technical and statistical facts to this cyclical picture and you will see that the downside risk could be enormous.
Commitment of Trade Data
In reviewing the COT data I find that the small investor is generally on the wrong side of the market at exactly the wrong time. At the market top in January 2000 the small investor was net long 23,828 S&P 500 contracts. The small investor continued to aggressively "buy the dips" all the way down into May 2002 at which time the small investor was net long 114,510 contracts. This represented the most net long contracts seen by the small investor since the bull market began. From this peak the small investor slowly began to lighten his load and by April 29, 2003 the small investor was 5,166 net short contracts. This was the largest net short position seen by these investors since the inception of the bear market. By June 3, 2003 the small investor had returned to the long side and as of July 10, 2003 the small investor is now holding 77, 490 net long positions. To the contrary, the smarter commercials went net short all on May 16, 2000 by a margin of 12,893 contracts. From that point these guys continued to build their short position as the market decline progressed. The maximum net short position occurred on March 8, 2001. From this point these guys remained short until March 25, 2003. The maximum long position was reached on June 20, 2003 at 18,446 contracts. As of July 10, 2003 the commercials have switched back to the short side at 38,667 contracts.
Without going through the details I can also offer you some information on the COT data for the NASDAQ. As of July 10, 2003 the small investor was holding 17,101 net long contracts. The all time high was seen on February 13, 2003 at 20,752 contracts. So, it is easy to see that the small guy is still extremely bullish and is within approximately 17% of his record net long position on the NASDAQ.
Now the real interesting thing here is the COT data for the commercials. On July 2, 2003 the alleged smart money was holding 19,603 net short contracts. This is an ALL TIME record level. As of July 10, 2003 the net short position had declined slightly to 17,882 contracts. This is still a larger net short position than was seen during the entire bear market decline into the October 2002 low.
The point here is that the commercials are historically on the right side of the market while the small investor is historically on the wrong side. If this historical indication holds, the small investor appears to be in for a shocker. Once the decline into the seasonal bottom begins, it could panic these small investors who have huge long position. Given the current high levels of sentiment, once the decline into the seasonal cycle begins it could spook the small investor. If these guys begin to sell, the decline could be far worse than anyone could image.
Sentiment
In my last posting on this site I talked about sentiment. In light of the current situation with the cyclical setup and the COT data, I feel that this information is worth a quick review. It is the sentiment levels that could really turn everything on its head here. CNBC has declared the new bull market and it appears that the vast majority is buying the story. Let's review the high points of the sentiment study that I posted on this site about a month ago.
On June 6, 2003 Investors Intelligence reported 58.7% bulls and only 16.3% bears. This is a ratio of 3.60:1. In light of this reading and combined with the fact that we have been hearing people say that sentiment readings don't work any more, I decided to do a little study on sentiment. First of all I found that we have to go back 16 years, to April 2, 1987 in order to see the ratio at these extremes. On April 2, 1987 the Dow Jones Industrial Average closed at 2,320.45. Over the next 13 years the bull market advanced 9,402.55 points and never saw this kind of bullishness. This single fact is beyond profound. Think about it, 13 years of the greatest bull market in history never produced this kind of bullishness!
The other interesting fact that I found surrounding sentiment was the duration of time that extreme sentiment readings can exist before the markets will actually turn. I looked at all Investor Intelligence readings going back to 1969 and I found that we have only had a dozen occurrences where ratio of bulls to bears has been at the 3.6:1 ratio or greater. I found that these levels could be seen for weeks or even months before the actual market turn finally comes to fruition. Therefore, I have to conclude that sentiment readings can not be used as timing tools. You can't expect to see the market turn just because sentiment has reached a given level. I believe that it is the impatient nature of people that leads them to erroneously conclude, "this time is different" because they perceive that a given indicator is not working as they believe it should. It is my view that we have to look at history and understand that these extremes take time to correct themselves. The truly interesting finding in this study revealed that if I tie extreme sentiment readings to cycles, the sentiment reading becomes much more meaningful. Each one of the extreme sentiment readings above 3.6:1 occurred at either seasonal or 4-year cycle tops. We are now moving into a seasonal cycle top and we may not have a 4-year bottom in place. No, this time is not different. History tells me that we are now setting up exactly like numerous other times from the past.
The other interesting finding was that in 1974, at the bear market bottom, Investors Intelligence reported 69.60% bears and 23.3% bulls. This is a ratio of 2.98 bears to each bull. Thus far, the highest ratio seen for this rally was on June 13, 2003. Bulls were reported to be 60.20 % and bears at 16.10% for a ration of 3.73 bulls for each bear. Now think about this, as for sentiment, we are currently at the exact opposite end of the spectrum from what was seen at the 1974 bottom and we have a seasonal cycle low due later this year.
In Summary
As we all know the market can do pretty much anything and it seems that it does it when we least expect it. However, at the present time, the cyclical structure combined with the sentiment readings and the commitment of trade data, create a unique and volatile situation. As we all know, all volatile situations don't end in a nasty way. My point is that some of the main ingredients for a nasty ending are at hand and we must be very very cautious of this potentially dangerous situation. The seasonal cycle low is due later this year and in light of the sentiment readings and COT data it could get nasty.
It is by way of my newsletter, Cycles News & Views, that I try to help people understand and time these important turning points. In the July issue of Cycles News & Views I have examined the current cyclical setup and the potential meaning for not only the stock market but also gold, bonds and the dollar. For more information on myself, the newsletter, subscriptions, other articles, interviews, subscriber reviews, etc. please go to www.cyclesman.com or call 318-342-9038.
21 July 2003