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Short-Term Negative Divergences Developing

(October 3, 2010)

Dear Subscribers and Readers,

In the realm of Greek mythology, the hero Perseus is the most virtuous of them all.  Perseus slayed the Gorgon Medusa through cunning strategy, wits, and tactics (with some help from the gods Athena and Hermes). He saved both his future bride, Andromeda, and his mother.  He became a beloved king.  More important (especially in the realm of classical mythology), Perseus stayed true to Andromeda through their marriage.  The ancient Greek poet, Homer, described Perseus as the “most renowned of all men.”

In last weekend's commentary (“Know Thyself”), I asserted that the key to investing success—and general happiness—is to “know thyself” through a lifelong process of self-discovery.  The hero Perseus is no doubt an unreachable standard, but we can always try.  Not only does a discovery and cultivation of one's talents allows one to maximize one's potential in life (and the potential in finding the perfect mate), but also one's happiness.  One can get more enjoyment out of everything; and never become bored.  Case in point: Since starting my psychic meditation classes a couple of months ago, my mind have become clearer.  I am enjoying more of the present and have become more appreciative of every little event and person in my life and finding meaning in each.  I highly recommend meditation in all forms.  Ultimately, a society with a goal of finding and cultivating its citizen's own talents is a much better metric than GDP growth in terms of gauging general happiness and potential long-term economic growth.

Let us now begin our commentary with a review of the 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 684.68 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.

While the long-term technical conditions remain strong, the stock market is now highly overbought in the short run.  More important, short-term negative divergences are now emerging in the U.S. stock market.  One example is the (small) negative divergence between the action of the NYSE Composite and the NYSE Common Stock Only Advance/Decline Line, as shown in the following chart:

The NYSE Composite is now sitting at its mid-May levels, and yet, the NYSE CSO A/D Line remains significantly lower than its level during mid-May.  A similar situation has developed in the NYSE CSO A/D Volume Line (lowest panel).  Given the overbought conditions in the stock market, and given the challenging global liquidity conditions (which we have discussed for the last couple of months), we believe that the stock market will consolidate into Thanksgiving or even Christmas.

Next, I want to address the amount of leverage within the stock market, as exemplified by the amount of margin debt outstanding.  Since the February 2009 bottom, total margin debt outstanding has increased by 34%, and in fact has retraced over 30% of its peak-to-trough decline from July 2007 to February 2009.  Since peaking at the end of April (at $295.6 billion), total margin debt outstanding has declined by $27.2 billion to $267.5 billion at the end of August 2010.  That said, margin debt outstanding remains near its cyclical bull market high, as shown in the following chart:

Again, total margin debt remains relatively elevated at $267.5 billion.  Given the ongoing European sovereign debt crisis and the deleveraging process in the G-7 countries, it is highly likely that margin debt outstanding will stay at current levels or even decline going into the end of the year.  Moreover, it is likely that the market has already taken into account the Fed's “Quantitative Easing II” policy.  In addition, the mainstream media is already reporting that the Bank of Japan will likely engage in additional easing measures (in the form of 3 to 6-month funding)—to be revealed at either its October 4-5 or October 28 meeting.  For now, we are in “no-man's land.”  We thus remain 50% long in our DJIA Timing System.  Given the short-term overbought condition and the negative divergences in the market, we expect the market to consolidate further into Thanksgiving or even Christmas.

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 July 2007 to the present:

For the week ending October 1, 2010, the Dow Industrials declined 30.58 points, while the Dow Transports declined 5.93 points.  Both the Dow Industrials and the Dow Transports are decisively above their 200-day moving averages and their early August highs.  While the technical condition remains solid, the market is now overbought on a short-term basis and starting to exhibit negative divergences.  Subscribers should also be concerned about “whipsaw risk,” as the market has been really volatile and “indecisive” over the last few months.  Combined with the lack of bullish signals from our global liquidity indicators and the lingering default risks for Greek sovereign debt, the market action could remain indecisive into Thanksgiving or even Christmas.  For now, we will remain 50% long in our DJIA Timing System.

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 3.9% to 9.5% for the week ending October 1, 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 1998 to the present week:

The four-week MA increased from a reading of 3.9% to 9.59% last week, and is now at its highest level since mid to late May.  This sentiment indicator is starting to get overbought—at least relative to its readings over the last few years.  In addition, our liquidity indicators are not yet flashing bullish signals.  We will thus retain our 50% long position in our DJIA Timing System.  In the meantime, the action of the U.S. stock market will likely remain range-bound into Thanksgiving or even Christmas.

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 from 111.6 to 118.6 last week—reaching its highest level since early May—while the 50 DMA increased from 109.1 to 111.3.  The 20 DMA rose above its 50 DMA three weeks ago, suggesting that ISE Sentiment is in an uptrend.  While this is normally a bullish signal, subscribers should keep in mind that the market has nonetheless remained range-bound for the last several months.  Moreover, our liquidity indicators are not flashing bullish signals—which suggests that the market will likely be mired in a consolidation period into Thanksgiving or even Christmas.  We will thus remain 50% long in our DJIA Timing System.

Conclusion: The market remains very overbought in the short-term.  Combined with the development of various negative divergences in our technical indicators, probability suggests that the market will likely correct or consolidate further in the short run.  Global liquidity conditions remain challenging, despite the promise of more easing from both the Bank of Japan and the Federal Reserve (both of which have likely been discounted by investors already). We are thus staying with our wait-and-see approach, and remain 50% long in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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