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Market Ripe for a Correction

(November 11, 2010)

Dear Subscribers and Readers,

We have discussed this for the last several weeks, but one reason why we haven't been too bullish on U.S. stocks is the negative divergences that have appeared in some of our technical indicators.  For example, while the NYSE Composite Index and other indices are at new cyclical bull market highs, both the NYSE Common Stock Only Advance/Decline Line and the Advance/Decline Volume Line (as shown in the below chart, courtesy of Decisionpoint.com) have not yet confirmed these new highs in the price indices. 

With global liquidity still at challenging levels (especially with the US$ rally in the last four days), the negative divergence between the NYSE Composite and the NYSE CSO A/D and A/D Volume Lines should not be ignored.  At the same time, sentiment among retail investors has gotten more bullish in recent weeks (as exemplified in the AAII, Investors Intelligence, and Market Vane's Bullish Consensus surveys).  Aside from the popular sentiment indicators that we feature every week, subscribers should note that the ten-day moving average of the equity put/call ratio has also hit its most bullish level since early May, as shown in the following chart courtesy of Decisionpoint.com:

Finally, the market has continued to get more overbought, even as the underlying technicals get weaker.  One measure of the overbought/oversold condition is the 21-day or the 55-day moving average of the NYSE ARMS Index.  While the NYSE ARMS Index has historically been more useful as an oversold indicator, there's no denying that with the 55-day moving average of the NYSE ARMS Index at its most overbought level since mid-April (see below chart, again courtesy of Decisionpoint.com), subscribers need to remain cautious of the market going into Thanksgiving, and probably into Christmas:

As we have mentioned before—for subscribers that need to remain fully invested, one may want to buy US$ (or short both the Euro and the Yen) as a hedge to a correction in the market.  At this point, I don't believe the correction would be anything much more than a 5% correction.  With long-term technicals still flashing bullish signals, I anticipate shifting from a 50% long position to a 100% long position in our DJIA Timing System once we've determined that the upcoming correction has nearly run its course. 

Signing off,

Henry To, CFA, CAIA

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