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Negative Divergences Still in Play

(October 10, 2010)

Dear Subscribers and Readers,

As time moves forward, the entropy (disorder) of the universe increases.  Similarly, the entropy (disorder) of global society tends to increase under a global capitalist system, especially in an environment of loose regulations and free trade and currency flows.  This is not necessarily a bad thing.  Each successive technological wave, for example, was accompanied by a significant amount of societal disorder as old jobs and technologies are displaced.  Farm workers were replaced by the mechanical reaper.  Horse and cart by the railroads, and later, electric trolleys and automobiles.  The Pony Express by the telegraph.  Whole industries, especially those in developed countries, were also displaced.  As countries such as China, India, Brazil, Indonesia, and Vietnam accrue more power, and as their populations become more educated, the world order will shift dramatically.  More importantly, there would be giant social upheavals in developed countries, especially as the baby boomers start “retiring.”  The next wave of technological/Schumpeterian growth—most probably initiated by the commercialization of quantum computing—would further increase the “entropy” of the global economy/society.  It would be truly exciting, and scary (for the unprepared).

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

Last week, I mentioned that while the long-term technical conditions are strong, short-term negative divergences were developing—thus leaving the market vulnerable in the short-run.  Since then, both the Dow Industrials and the S&P 500 has risen by 1.6%, but the negative divergences remain.  For example, the recent action of the NYSE Common Stock Only Advance/Decline Line still isn't confirming the strength in the NYSE Composite, as shown in the following chart:

The NYSE Composite has risen to its early May levels, while the NYSE CSO A/D Line is still lower than its level during early to 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.

Nevertheless, there is one tailwind for the bulls.  Over the last 60 years, the U.S. stock has risen by an average of 18% nine months after a mid-term election.  Moreover, the worst performing nine-month period post any mid-term election is still over 5%.  Following is a chart (per Goldman Sachs) showing the average (and range of) returns for the S&P 500 post all mid-term elections since 1949:

Goldman asserts that this historical bullish phenomenon has been driven by two things: 1) a more divided government post mid-term elections (resulting in “gridlock”), and 2) a more generous fiscal policy that typically occurs in the third year of the presidential cycle.  With predicting a 75% change of the Republicans taking the House, a credible argument exists for “gridlock”; subscribers should note, however, that the market has become more efficient over the last 60 years.  Most likely, the possibility of a gridlock has already been factored into stock prices.  Moreover, it is difficult to envision that Congress or the President would press for a more generous fiscal policy, given the historic budget deficits and a general populist call for cutting the fiscal deficit.  Bottom line: This time may actually be different.  Stock prices do not necessarily have to make outsized gains post the U.S. mid-term elections.

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 8, 2010, the Dow Industrials rose 176.80 points, while the Dow Transports rose 119.31 points.  Both the Dow Industrials and the Dow Transports are decisively above their 200-day moving averages and their early August highs—and just slightly below their cyclical bull market highs.  While the technical condition remains solid, the market is overbought on a short-term basis still exhibiting negative divergences.  Subscribers should also be concerned about “whipsaw risk,” as the market has been mired in a trading range over the last five months.  Combined with the lack of bullish signals from our global liquidity indicators, 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 9.5% to 12.6% for the week ending October 8, 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 9.5% to 12.6% last week, and is now at its highest level since mid-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, even if the Republicans take the House in the upcoming mid-term election.

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 118.6 to 122.2 last week—reaching its highest level since early May—while the 50 DMA increased from 111.3 to 112.6.  The 20 DMA rose above its 50 DMA four 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 five 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, even if the Republicans take the House in the upcoming mid-term election.  We will remain 50% long in our DJIA Timing System.

Conclusion: The market just keeps getting more overbought.  While this usually isn't a problem in a bull market, subscribers should note that various negative divergences have been developing in our technical indicators.  Combined with the fact that the market has been range-bound over the last five months, and combined with the challenging liquidity conditions (investors have already factored into a $500 billion to $1 trillion “QE2” policy from the Fed), probability suggests that the market will likely correct or consolidate further in the short run.  We are 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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