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A Quick Update

(August 1, 2010)

Dear Subscribers and Readers,

I am feeling under the weather this weekend so I will provide a quick update – I promise to come back with analyses that are more detailed in our upcoming mid-week commentary.  I hope all our subscribers had a great 2nd half of 2010 so far!

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; giving us a gain of 320.94 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

Since our commentary last weekend, the technical conditions of the U.S. stock market has continued to improve.  For example, Lowry's proprietary buying power index has consistently been making new bull market highs, while its selling pressure index is just four points away from its bull market low.  In addition, the number of new 52-week highs has expanded in the latest rally attempt in July, versus the weaker rally attempt in June.  Just as important, the mainstream media still has many doubts about the lack of sustainability of this rally.  Our current take on the market is this: As mentioned numerous times before, the cyclical bull market that began in early March 2009 is still in place.  In the short-term, the market is overbought, so I would not be surprised if the market experiences a short-term correction this week or next week.  I think the market will be stuck in a consolidation period for the next 6 to 12 weeks, but should make a new cyclical bull market high by early next year at the latest.  We are looking to shift from a 50% long position to a 100% long position in our DJIA Timing System on weakness – and most probably at some point over the next few months.

Since we just completed the month of July, I feel it is appropriate to update one of our major liquidity indicators.  This liquidity indicator – the “investable cash on the sidelines” versus the S&P 500's market cap – has come down dramatically since the February 2009 peak, as shown in the following chart:

As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has declined to new rally lows consistently since the beginning of this bull market.  This somewhat changed with the stock market correction since the beginning of May – with the ratio rising by 2.18%.  However, this ratio has come down too far, too fast, and remains low relative to its readings over the last two years despite the recent uptick.  From a purely liquidity standpoint, probability suggests that the market will undergo more consolidation over the next 6 to 12 weeks, unless: 1) A major central bank announces a new liquidity facility (e.g. the Federal Reserve announces an extension of its “credit easing” program or if the European Central Bank monetizes Greek sovereign debt), or 2) a major technology (one that could speed up global productivity growth) is commercialized over the next several months (which is not likely).  Until we see some kind of improvement in our liquidity indicators, chances are that we will remain 50% long in our DJIA Timing System, as opposed to going 100% long.

Another liquidity indicator - equity mutual fund cash levels – have bounced significantly as of month-end June 2010 to 3.8% from just 3.5% from month-end May, as shown in the following chart:

Despite the uptick in June to 3.8%, subscribers should note that the S&P 500 also appreciated 7.01% during that period.  This is likely a function of mutual fund managers deploying cash back into the markets on a net basis again, as opposed to retail investors buying more mutual funds.  As a result, there's no doubt that cash levels declined in July yet again.  Again, we will continue to take a wait-and-see approach.

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 July 30, 2010, the Dow Industrials rose 41.32 points, while the Dow Transports rose 53.23 points.  The ability of the Dow indices to make new six-week highs in the face of a short-term overbought condition is very impressive – all the more so given that the Dow Transports has already surpassed its 200-day moving average.  Despite the ongoing threat of a Greek default, both the price and technical action suggests the future looks bright, even with our weakening liquidity indicators.  For now, we will remain 50% long in our DJIA Timing System, and may shift to a 100% long position depending on how the market action and fundamentals pan out in the coming days.

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 increased from a reading of -9.9% to -6.6% for the week ending July 30, 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:

This reading bounced higher for the first time in four weeks (after declining to its most oversold level since the week ending April 10, 2009).   More importantly, this reading is still oversold, even relative to its readings over the last two years.  While our liquidity indicators do not suggest much upside in the market, our fundamental and technical indicators are improving, especially in light of the recent publication of the EU's bank stress tests.  Again, we are looking to shift to a 100% long position in our DJIA Timing System, and would likely do so once our liquidity indicators improve.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  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:

The 20 DMA increased yet again from 101.0 to 103.0 last week.  From late May to early July, the 20 DMA had vacillated in an oversold range of 90 to 98, and in fact declined to as low as 90.0 on June 16th – its most oversold reading since April 1, 2008.  Three weeks ago, the 20 DMA finally pierced through the 98 level convincingly.  In addition, the 50 DMA has also declined to a historically oversold level.  With all our sentiment indicators now at an oversold level, and with the improving technical conditions, there's no doubt that the cyclical bull trend remains intact.  However, we are still looking for a further consolidation period over the next 6 to 12 weeks, and will only shift to a 100% long position should the liquidity conditions improve.

Conclusion: In last weekend's commentary, we stated “With the publication of the EU bank stress tests, a significant amount of uncertainty has been lifted off investors' minds, despite the relative ease with which the vast majority of the 91 banks in passing the stress tests.”  With the hindsight of last week's action, this statement appears to be true, although there is still a lingering concern over Greek debt, for example.  In addition, the technical conditions of the market are still improving, although the liquidity backdrop remains tough.  Should our liquidity indicators become more bullish, we will not hesitate to shift to a 100% long position in our DJIA Timing System, from our current 50% long position.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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