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Top likely?

(February 27, 2002)

The upside continues for the Dow-with the index closing in on its January 4 closing high of 10,259.7. On any close above that level we will need to reevaluate our position. At best, a decline from there most probably will not bottom until two or three months from now, pushing our initial projection of a bottom well into May. All April put positions should be sold if the Dow closes above that level. At worst, the Dow will continually make new post-September 2001 highs and pull the Nasdaq and S&P along for the ride as well-crushing all short positions.

That being said, we don't believe that will happen. The picture below says a thousand words:

DJIA Price and NYSE Volume Information (November 1, 2001 to February 27, 2002)

Since the near breakdown of the Dow in early February, trading volume has been declining steadily in the latest rally. Moreover, since our last update, trading volume has trended even lower even in the midst of the latest rally. Higher prices need to be supported by higher volume, period. What this clearly shows is a lack of interest in the market-no huge buying nor selling.

So why did the market shoot higher in recent weeks? We maintain most of it is short-covering. Short-covering rallies can be sudden and vicious, but they could just as easily end tomorrow. Recent rallies have been a perfect fit of the short-covering scenario (at least in the Dow). Vicious rallies out of nowhere all on poor breadth and low volume. I believe Richard Russell described the situation very well-stating that when the Dow failed to break down in early February, all the hedge funds that have gone short were forced to cover. Clearly the market is rallying because there is a lack of selling, not because there is an abundance of buying. Once the short-covering rally ends, look out below.

In our last comments, we stated that of the 30 components in the Dow, 15 have broken down and 15 have been making new highs or close to making new highs. The Dow rallied quite a bit this morning mainly because the 15 stocks that have broken down were bouncing (e.g. IBM and JPM). Once the bounce ended, the Dow started declining.

Because of this, we believe that in order for the Dow to rally, some of those 15 stocks that have broken down need to form bottoms from here and turn around and start rising. What is the probability of that happening? What is the probability of that happening and what is the probability that the other 15 stocks continue to make new highs? We believe these events are not likely. These 15 stocks that have broken down are technically nowhere near forming a bottom. And the advance of the other 15 stocks is looking tired, at best.

Instead, we believe we are close to seeing a breakdown in some of the 15 stocks that are still making or close to making new highs. Who could they be? We mentioned Home Depot (HD) in our previous comments. As you know, they reported earnings Tuesday before the market opened. Their counterpart, Lowe's (LOW), reported Monday before the market opened. Let's take a look first at LOW's latest chart:

Closing Price of LOW and Volume Information (October 1, 2001 to February 27, 2002)

Since the dip in mid-January, LOW has been rallying on declining volume. Enough to push it up more than 10% but how long could it last if volume doesn't increase? As the chart shows, not very long. The spike in volume since two days ago was due to the release of its earnings report. Even the volume of that one day could not surpass the volume in mid-January. Moreover, it seems likely that the upside momentum has been broken, with convincing declines in the last two trading sessions. We believe there are three main reasons:

  1. The rally had already exhausted itself and all it needed for it to start declining was a trigger
  2. The downgrade of the stock yesterday (due to valuation concerns) provided the first trigger
  3. The huge decline in new home sales provided the second trigger

Now let's take a look at the chart of HD:

Closing Price of HD and Volume Information (October 1, 2001 to February 27, 2002)

See the nice correlation? Exhaustion of rally, overvaluation, and a plunge in new home sales. Moreover, housing starts statistics released last week was quite misleading. Seasonally adjusted, housing starts rose 6.3%-- the strongest in two years, while non seasonally adjusted data showed an actual decline of 16%! So the actual number (as opposed to the imaginary number) is significantly lower.

So the question is: Will HD be next? We are not sure, but it seems to be the most likely candidate. If HD does indeed start breaking down, then the majority of the components in the Dow will then have broken down, and most likely, the downtrend will resume. We believe it is only a matter of time.

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