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Looking for a Rebound Rally

(May 23, 2010)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 12 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145; the DJIA Timing system is now in a 50% long position.

I am still under the weather, so this commentary will be short.  I apologize for the inconvenience.

To put it briefly at the close last Thursday the U.S. stock market plunged to a very oversold level, both on a short and intermediate term basis.  As can be seen on the following chart (courtesy of Decisionpoint.com), the percentage of stocks on the NYSE that were above their 20-EMAs and 50-EMAs declined to its most oversold level since early March 2009:

With global equities at an immensely oversold level, and with the VIX having spiked up over 10 points on Thursday, we were bracing for more downside on Friday and into Monday.  Subscribers should know that all crashes start when the market has already become severely oversold.  The fundamental (European sovereign debt crisis, etc.) and technical (no one has yet figured out what happened in the 1,000-point intraday crash on May 6th) backdrops were all there as well.

Fortunately for the bulls, the market opened down on Friday but quickly strengthened.  Investors were willing to take more risk, as evident in the relative strength in financial and retail stocks.  Panic also subsided, with the VIX declining 3.5 points by the time we shifted to a 50% long from a completely neutral position in our DJIA Timing System at a DJIA print of 10,145 (the VIX would eventually decline 5.69 points for the day).  The fundamental backdrop also improved, with the German legislature passing the €750 billion package, and with the Euro strengthening.  All in all, it looks like the market has put in a short-term bottom.  I am thus looking for the stock market to rebound over the next couple of weeks.  Whether that develops into a more sustainable rally will depend on both the fundamental backdrop and the future technical action of the stock market.  For now, we will stay 50% long in our DJIA Timing System, although we may shift back to a neutral position or even a 100% long position in the days ahead depending on the future action of the market.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2007 to the present:

For the week ending May 21, 2010, the Dow Industrials declined 426.77 points, while the Dow Transports declined 246.14 points.  With last week's decline, the market has sunk to its most oversold level since the cyclical bull market began in early March 2009.  In light of this severely oversold condition and with Friday's uptick probability suggests that the market will rally in the next couple of weeks.  That is why we went 50% long in our DJIA Timing System.  Whether this rebound develops into something more sustainable will depend on the subsequent fundamental backdrop and technical action.  However, at this point, I still don't believe the European sovereign debt crisis is over unless the European Central Bank starts seriously hitting the printing presses.  That is, even should the market rally over the next few weeks, I still expect a tough summer.  For now, we will remain 50% long in our DJIA Timing System, and will either shift to a neutral or 100% long position depending on how the market action pans out.

I will now continue our commentary with a quick discussion of our popular sentiment indicators those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators decreased from a reading of 15.6% to 12.5% for the week ending May 21, 2010.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

After rising for 9 weeks in a row, this reading has now declined three weeks in a row to 12.5%.  Despite the three-week decline, this reading remains relatively overbought.  As a result, I do not currently expect the inevitable bounce to be sustainable, despite the stock market's immensely oversold condition.  However, we will let the future action of the market dictate out position.  In addition, given the challenging liquidity environment and the build-up in complacency over the last six months, I am no longer confident that we will end 2010 with a new cyclical bull market high.  For now, we will remain 50% in our DJIA Timing System.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

For the week ending May 21, 2010, the 20 DMA declined from 11084 to 98.7.  The 20 DMA has plunged nearly 35 points over the last three weeks and is now at a historically oversold level.  However, the 50 DMA is still at a neutral level.  Given that our other sentiment indicators are still at neutral to overbought levels, chances are that any bounce that emerges this week will be short-lived in nature perhaps two to six weeks at the most.  Nonetheless, whether we go 100% long or back to neutral in our DJIA Timing System will depend on both the future technical action of the market, as well as the fundamental backdrop.  For now, we will remain 50% long in our DJIA Timing System.

Conclusion: While the Euro Zone's sovereign debt crisis has not been resolved, both the market action and the developing fundamental backdrop at the end of last week is definitely conducive for a rebound rally over the next two to three weeks.  This includes the 5.69-point easing of the VIX on Friday, the positive divergence in the Euro, the market bounce off of Friday's low (accompanied by a highly oversold condition), and the passage of the €750 billion bailout bill by the German legislature.

As mentioned, I expect any rebound to last two to three weeks.  Given the challenging liquidity environment and the rise in investor complacency over the last six months, I expect the stock market correction to reassert itself sometime this summer.  Again, this should not be a surprise, as the €750 billion bailout bill it does not change the fundamental problem of over indebtedness of the Euro Zone in general.  In particular, while the short-term refunding risk is off the table, the long-term solvency problems remain in place, especially as it pertains to the PIIGS countries.  With our electronic trading systems now in question, I also expect investors to get more panicky should another correction materialize further down the road.  For now, we will stay 50% long in our DJIA Timing System, although we may shift back to a neutral or even a 100% long position should our technical and sentiment indicators tell us to.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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