Claassen Research, LLC

www.ClaassenResearch.com

April 30, 2010

Thoughts on the Intermediate Trend

“It’s different this time.”…. those famous last words carved into the headstones of
thousands of lost investors of decades past. While we desire never to be caught with those words
leaving our lips, in truth every market cycle has something different than the previous. Equally
important, each market cycle shares similarities to one or more past bull or bear markets. Under
that pretext, to best understand the current market we should consistently ask ourselves; how is
this market environment similar to past markets and how is it different?

I thought it prudent to step back and re quiz myself on the above when I came to realize
from current readings that, after sixty weeks of advance resulting in a gain of over 80% in the
broad market, almost every market strategist and technician I know is bullish. In some cases
wildly bullish with comments like “…any market correction must be at least a year away” and “the
market is nowhere near a top”. …Wow. Now, I like bull markets, especially this one, and I hope it
will continue. But, I am at heart a contrarian. So when I see a crowd leaning too far in any one
direction, with growing enthusiasm, I cannot help but search for a counter argument to forewarn
and forearm myself against the surprised stampeding herd.

Many of the arguments for further market gains rest in historical norms of indicators used by
strategists for decades to measure the health of a bull market. Traders Narrative produced a well
written article that encompasses most of these indictors. In brief, the bullish arguments include:

1. The Advance Decline Line is at new highs, and it always declines before a Bull market high.
2. The percentage of stocks above their 50 day and 150 day averages is high, showing full
market participation in the rally.
3. The number of new 52-week highs continues to expand and is stronger than any time since
1982! Here, too, this indicator should begin to contract months before a market high.
4. As long as small cap stocks are leading, the market is in fully bullish mode.
5. Historical measures of supply and demand are too bullish for a market to peak.
6. Breadth is more bullish than at any time in the last twenty years.

For the most part, the above are different measures of breadth. It is true that historically
many, if not most bull markets peak after a prolonged period of breadth erosion. However, not all
bull markets end so gracefully. What I will present in these pages is a basis for why it may be
unwise to expect a graceful end to the current rally, and why market strategists should not be
enthusiastically expecting the market to continue higher until sometime after their indicators have
warned of its potential demise.

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How is this market different than past markets?

When I first spoke of the coming secular bear market in the very late 1990’s, a period when
an investor’s idea of diversification was owning Intel, Cisco, AOL and Akamai in three different
accounts, I was greeted with the verbal equivalent of tomatoes. I believe by now we can all agree
that the current environment is very different than a secular bull market. Our economic growth is
fragile and our markets are not experiencing a prolonged period of earnings and P/E expansion,
driven from an historical low base, as required for a multi decade advance.

Our current market is also not driven by typical business growth. Yes, the percent returns
of fundamental valuations are up from last year’s very deep trough, but still far shy of past years
and the levels needed to support employment growth. (The Fed is not keeping rates low for
entertainment purposes.)

The gorilla in the room is the Federal Reserve. We all know this cyclical bull market is
liquidity driven. The unprecedented level of U.S. and global liquidity pumped into the economy
make this cyclical bull market “different” than the bull markets that ended in 1929, 1968, 1987,
2000 or even 2007. As the dissenting FOMC Governor Thomas Hoenig is trying to warn,
somehow somewhere, excess liquidity always finds its way into the markets. We have seen this in
Japan since 1993 as each cyclical bull market is fueled by a new round of quantitative easing, then
comes to an abrupt halt. The same can said for China’s Shanghai Index, which advanced 108%
from October ’08 to August ’09.

As a side note: After a 108.76% return off its October ‘08 low, the Shanghai Index is off
about 18% from its August ’09 high and has struggled in a roughly sideways pattern since then.
While many investors view the weak performance as a leading economic indicator for the US,
another possibility is that China’s equity market is enduring the same “investor rotation” as did the
US market in 2000. Readers may remember that US equities peaked in 2000 as the internet
bubble burst, and the investment of choice switched from equities to real estate. Money flowing
from the equity market drove the real estate bubble higher for another five to seven years
(depending on your local). Although the US economy did experience a relatively minor recession
from March through November 2001, it wasn’t until the real estate bubble burst that the economy
fell into the current Great Recession. With China’s rising real estate prices and declining equities,
it appears to me that a similar scenario is unfolding; money is simply moving from equities into
real estate. But, that is a discussion we can detail at another time.

How is this market similar to past markets?

If we define the current environment as a cyclical bull market within a secular bear trend,
what are the similar time periods with which we can compare?

Certainly, Japan’s equity market from 1992 is filled with liquidity driven cyclical bull
markets to which we might compare the current market rally. Unfortunately, we have very little
data other than price and volume. Thus, almost all we can say is Japan’s bull markets during the
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90’s averaged about 50 weeks with 50% returns. But here, I would note that the tops of these
rallies were consistently an inverted “V”, not the rounded tops of which most current market
participants expect. The inverted “V” tops suggest there was very little warning, if any, of the
change in trend.

Nikkei 225 1990-2003 Weekly

We might also look at the US market during the previous secular bear from 1968-1982.
Here, a simple examination of the Advance Decline line shows an environment nothing like what
current market participants expect. Remember the Nifty Fifty? Market breadth peaked in 1959
and fell precipitously from January, 1966 to January, 1975. It should also be noted that the cyclical
bull market peak of September, 1976 was not preceded by a top in the Advance Decline Line. To
the contrary, the Advance Decline Line peaked in July, 1977, ten months later. Since the Advance
Decline Line is a measure of breadth, we can conclude that breadth did not behave in a “typical”
manner for an entire decade of the last secular bear market, and could not have forewarned
investors of the cyclical changes in trend. That alone should question what we currently perceive
as normal behavior for some indicators. But, this empirical evidence of “abnormal behavior” is
just a side note compared to more recent and pertinent data.

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 S&P 500 with NYSE Advance Decline Line 1960 – 1980 Weekly

The first chart below is of the NYSE Composite during the period just before and after the
September, 2000 bull market peak. In the bottom panel of the chart I have the NYSE Advance
Decline Line, above that the Percent of Issues Above their 150 Day Average and in the next panel a
10 Day Average of Breadth (Advancing Issues / Total Issues) and its 150 Day average (red).

One can say that the Advance Decline Line led the market top. In fact the Advance Decline
Line peaked in the second quarter of 1998, before even the 1998 bear market. It was kind of a
long lead time to suggest its declining trend helped market timing. It appears that when coupled
with the 1960’s, we can say that the Advance Decline line’s behavior as a leading indicator is not as
infallible as many believe. But what I find most significant and possibly more relevant to the
current situation, is that the NYSE Advance Decline Line bottomed as the NYSE Composite was
forming its high, and began to climb in December of 2001. Yes, breadth was rising as the broad
market declined.

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 NYSE Composite 1998 -2003 with Breadth Indicators.

Just in case the Advance Decline Line is giving us an “off” signal, let’s look at the Percent of
Stocks Above their 150 Day Average. The Percent Above indicators are valuable because they are
really a measure of the breadth of momentum. A stock can show up as a negative on an Advance
Decline Line because of a bad day, but if it remains above its 150 Day average it can be considered
in a long term uptrend, its 50 Day average can represent an intermediate trend etc. Thus, this
indicator measures the percent of stocks with positive momentum and trend over various time
periods. Here, too, in the case of the market decline from the September 2000 peak, the percent
of stocks in a long term uptrend rose from a low in the first quarter of 2000 to over 80% more than
a year into the bear market!

The next indicator on this chart is the 10 Day Breadth, also called Breadth Thrust. This is a
simple measure of the percent of stocks advancing. In red, I have illustrated this indicator’s 150
Day average. Certainly, if a bear market meant that most stocks were declining, this indicator
wouldn’t be showing us more advancing issues. But it is. The percent of Advancing Issues
gradually increased until about the same time that the Advance Decline Line and Percent Above
150 Day Average Peaked.

How can this happen? It’s illustrated in the next chart.

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 NYSE Composite 1998 -2003 with the S&P 600 and Breadth Indicators

The chart above of the NYSE Composite and indicators is identical to the first except we
have added the S&P 600 Small Cap Index in orange. While the broad market was declining from
2000 to 2002 there was a stealth bull market in small cap stocks. One need only think of the
number of components in the Russell 2000 Small Cap Index relative the S&P 100 Large Cap Index
to understand there are a lot more small cap stocks in the NYSE Composite than large and mid cap
stocks combined. Small cap stocks are the engine of market breadth.

This was a very unique situation, and what made it unique is what makes it similar to
today’s market. But the market strategist or investor looking for breadth erosion to signal the end
of a bull market, or for Small Cap stock performance to falter, or the Percent of Issues Above their
150 Day Average to weaken would not have been able to identify the end of the bull market until
after the fact. Even the measure of New 52 Week Highs in the chart below peaked after the
market, not before. And Lowry’s measure of demand, the Buying Power Index, posted its all time
high in May of 2001 and a secondary test of that high in May of 2002 consistent with the peaks in
the small cap stock index. How can a measure of investor demand continue to climb for a year
and a half into one of the worst bear markets in decades? I believe the answer is in the chart
above.

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 NYSE Composite with New 52 Week Highs and Lows 1999-2003

What does the bear market of 2000-2002 have in common with the current rally?

The answer: excess liquidity provided by the Federal Reserve.

Remember Y2K? As the clock ticked closer to the end of the century many individuals and
businesses were in a near panic, afraid that the computers we have grown to rely on will not
function when the clock struck 12:00 am on January, 2001. In order to ensure a functioning
financial system the Federal Reserve distributed $80 billion in funds in the fourth quarter of 1999,
compared to $23 billion a year earlier, in addition to special options that allowed excess liquidity
for January, 2000. After the Y2K issue was declared a non event, the Federal Reserve moved to
take back as much liquidity as it could. But, there is no way the Federal Reserve can prevent the
effect of excess liquidity echoing somewhere in the economy.

The Y2K fear was not the only event that resulted in the Federal Reserve pumping liquidity
into the economy during the 2000-2002 bear market. We can never forget the tragedy of
September 11, 2001. As a result, the Federal Reserve once again pushed emergency liquidity into
the system in order to ensure its smooth function. In all the Fed injecting approximately $81
billion into the government securities markets, loaned approximately $46 billion from the discount
window and executed a series of currency swaps with the European Central Bank, the Bank of
England, and the Bank of Canada totaling an additional $90 billion.

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 Between the Y2K fears and the September 11th tragedy approximately $275 billion of
excess liquidity was fed into the system. It’s a number that pales in comparison to the liquidity
provided as a result of the recent Credit Crisis, but it’s still a lot of money. As noted earlier;
somehow somewhere, excess liquidity always finds its way into the markets. Considering that in
the middle of the greatest bear market decline in nearly three decades and eight months after the
2001 emergency liquidity, the S&P 600 small cap index made a new all time high. I suspect that
some excess liquidity found its way into speculative small cap issues. As a result, the market
breadth indicators, the Advance Decline Line, New 52 Week Highs and measures of demand all
pointed to a broad market bull that didn’t exist. Breadth measures showed the market to be
stronger than the indexes could possibly portray as the advancing masses of low priced small cap
securities overpowered their large and mid cap counterparts. Can you imagine what those
breadth indicators would have looked like if all this occurred during a bull market? Perhaps that’s
what they look like today.

Conclusion

As stated in the opening paragraph; to best understand the current market we should
consistently ask ourselves; how is this market environment similar to past markets and how is it
different?

A characteristic of virtually every bull or bear market is to continue in one direction until
sometime after the majority of participants are convinced the trend is sustainable. With
bullishness of both individual investors and market strategists at extremes it is time to ask
ourselves “how can this market fool the most people?” Should we really expect it to simply
continue higher until sometime after the indicators so many analysts are watching give a sell
signal? Although past examples of liquidity driven rallies are limited, they consistently illustrate a
sharp inverted V top indicative of a change in trend with little warning.

The intent of this writing is not to discredit select technical indicators; I have faithfully used
these indicators and others for decades. Rather, it’s to offer a reasonable alternative explanation
of the extreme bullishness in indicators designed to measure the breadth and sustainability of the
market. In doing so, we also open doors to alternative scenarios that can help us identify how this
market rally may end. What if stocks begin their decline due to more difficult earnings
comparisons, but the Fed stays accommodative? Can we have a repeat of 2000-2002 bear market
in large and mid cap stocks with small caps leading? I would suggest the best method to avoid any
pitfalls related to the possible effects of excess liquidity and small cap stocks is to monitor the
market by sector, industry, or capitalization segment rather than the focusing on the entire NYSE
and expecting the market to follow.

My view is there is little doubt that the current record positive breadth is a result of the
excess liquidity provided by the Federal Reserve to combat this Great Recession. I also do not
doubt that when this bull market ends, the crowd will greet the initial decline as another buying
opportunity. Even more, there will be a select few who will hold onto the belief that the bull
market is alive long after its demise because of the indicators they are so faithfully watching.
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The information contained in this publication was prepared from sources believed to be reliable, but is not guaranteed
and is not a complete summary, or statement of all data pertinent to an investment decision. Opinions may change
without notice. This report is published for informational purposes only and is not to be construed as a solicitation or
an offer or recommendation to buy or sell any financial security. Trading and investing involves risk and past
performance may not be an indication of future performance. Claassen Research, LLC and its author accept no liability
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All rights reserved. © 2010, Claassen Research, LLC.

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